The comprehensive review accompanying last week's budget speech included an unpleasant surprise: the termination of the Section 12J tax incentive. The decision sounds the death knell for billions of rand in equity funding for local SMEs and calls into question government's commitment to small business development.

The Section 12J tax incentive was introduced in 2009 to encourage private investors to fund local entrepreneurs in exchange for a 100% tax deduction. While the primary intention was to develop SMEs and create jobs, it also kept capital in South Africa that would have otherwise been invested offshore.

According to the 12J Association of South Africa, the incentive has raised R9.3b for 360 SMEs and created over 10 000 jobs at a fiscus cost of just R1.3b (after accounting for venture capital company taxes, dividend withholding taxes, and capital gains taxes). That's an average cost per job of approximately R126 000.

So why was it terminated?

According to Treasury, the incentive amounted to "a significant tax deduction to high net-worth taxpayers", which is a curious criticism because that is, quite literally, what it was designed to be. Who else, other than wealthy investors, are going to risk funding SMEs on an equity basis?

More important, Treasury alleges that the incentive has had a "limited economic impact". While they broadly agree with the 12J Association's report, they claim that only 8 239 jobs were created at a fiscus cost of R1.8b. That works out to an average cost per job of R218 473.

How does that compare?

Well, during the 2020 financial year, the Department of Trade, Industry and Competition disbursed R5.3b and the Industrial Development Corporation disbursed R11.7b. The DTIC created 9 984 jobs, while the IDC created 10 414. That works out to an average cost per job of R530 849 and R1 123 487 respectively.

Even by Treasury's own numbers, the Section 12J tax incentive has comprehensively embarrassed government's flagship economic development agencies.

Maybe that's the real reason for ending it?

Back in 2015, I explained how government funding programs were being increasingly aligned to Broad-Based Black Economic Empowerment (B-BBEE) compliance and why I expected that trend to intensify.

Last year, I predicted that majority black ownership would become a mandatory qualification requirement for government funding, regardless of an applicant's commercial merit or social impact.

Lo and behold, the future of government funding has arrived.

A few weeks ago, the Department of Tourism announced the Tourism Equity Fund (TEF). Just like its predecessor, the Tourism Transformation Fund (TTF), the TEF is a grant funding program reserved exclusively for black entrepreneurs.

However, while the TTF was designed to help sustainable black-owned enterprises scale further, the TEF will provide black entrepreneurs with acquisition finance. This is problematic for several reasons.

For starters, the TEF will do nothing to drive economic growth. It will simply transfer existing jobs, income streams, and assets from one set of owners to another.

Furthermore, the timing of the TEF couldn't be more repugnant. The tourism industry has been devastated by COVID, yet relief funding (in the form of the Tourism Relief Fund) was limited to black-owned enterprises. Introducing an acquisition fund on the back of these developments appears to be a brazen attempt to extort discounted buyouts from financially distressed companies.

Thankfully, the TEF has not escaped notice. Daily Maverick published an extensive critique, while threats of legal action from Solidarity and AfriForum precipitated the TEF's temporary suspension. Minister of Tourism Mmamoloko Kubayi-Ngubane has predictably accused critics of attempting to "stifle transformation".

So far, none of this is particularly surprising. Anyone who has been paying attention to government funding trends over the last several years would have anticipated this. However, there is a disturbing footnote to this story that appears to have escaped everyone's attention.

Buried in the TEF brochure published by the Small Enterprise Finance Agency (SEFA) is the following concerning provision: "we might require step-in rights if we are concerned that the business may fail."

So let's get this straight:

1. Government deliberately excluded some enterprises from relief funding.

2. It's planning to use taxpayer money to finance acquisitions in the same sector.

3. It can potentially take over the acquisitions that it funds.

This isn't transformation. It's a land grab.

With the gazillions of financing options available to fund your business growth, unfortunately, many entrepreneurs focus too much on what they can get and the interest cost. Although these are critical factors, not enough attention is given to how to end the financing relationship.

It’s all about liquidity.

To be fair, this isn’t a typical issue with “regular” debt funding, like mortgages or vehicle finance, because repayment of the capital raised is a key feature that’s front and centre in the deal’s terms. It’s much more of a concern with equity-based funding.

Equity finance is usually how venture capitalists invest. The VC will inject capital and take ordinary shares in exchange. Then they’ll want to 10X the business value and cash-out 7 years later with a tidy ROI.

If you’re dealing with savvy investors like VCs and, if they’re ethical, they’ll guide you through planning for their exit. This would be part of the deal and negotiated before they invest.

Except, working with VCs and similarly clever investors is something few entrepreneurs experience. Most entrepreneurs are our common garden variety, funded by family, friends and other fools.

More often than I’d like to admit, I’ve seen businesses without even a shareholders’ agreement, let alone a resolution or other written record of the shares being issued.

It’s specifically these situations that can ruin friendships.

But it’s probably not the picture you’re thinking: family and friends put in capital --> a calamity strikes --> the business folds --> family feud ensues.

Obviously, when a business is forced to liquidate, it’s unlikely anything is left to pay shareholders after creditors, staff and SARS have taken their dues. Whether shares are documented or not is moot. Everyone is unhappy. The only problem here is the lost capital.

So, no, it’s not that scenario, either.

I’m talking about successful businesses. Funding a business that becomes successful can also lead to a stalemate of “lost” capital. Picture the company that took on an equity partner and now, a few years later, that partner wants to exit. Problem is, the original owner can’t afford to buy them out.

Perversely, the growth plan worked out and the business is successful, just . . . it’s not successful enough.

Because the business has grown successfully, it’s also grown in value. By our anecdotal experience with our clients, even a marginally more successful business can exponentially multiply the value of the business. But that's not the real catch.

The real issue is the lack of free cash flow.

As a business grows, you'll see on the balance sheet a nice little item called retained earnings steadily grow in value year on year. Wonderful, we think! Only, that retained earnings value seldom represents bags of cash lying around. Regardless of how well a business grows, most owners will struggle to also grow the free cash. In fact, idle cash lying around is cash not being used to scale the business further and faster.

In other words, if you've successfully grown your business with an equity partner's capital, it will usually take a whole lot more than what was invested to buy them out.

You could take out a loan, but can you afford it? How might servicing new or additional capital and interest re-payments stunt your operating cash flow? Do you have “free” assets that aren’t already tied up as collateral for other debt? While VCs like to cash-out through a later and bigger funding round, is that what you want, to further dilute your equity stake with yet more shareholders?

It’s not enough to have a shareholders’ agreement governing how partners exit. You need an exit plan that includes building a reserve so you’re not stuck swapping one partner or “creditor” for another.

If you do this, you’ll be well on your way to building a business that also grows your owner wealth.

Several weeks ago, I published a list of common funding requirements. While most of them are self-explanatory, there's one in particular that deserves closer scrutiny: the cash flow forecast.

Most funders will want to see a cash flow forecast, even if they aren't lending against cash flows. Regardless of how much collateral is available, lenders would rather be repaid than have to seize and liquidate assets.

Many small business owners grossly under-estimate the scope and complexity of a proper cash flow forecast. They often assume that it's as simple as:

  Sales

  (less) Cost of sales

  (less) Overheads

This is actually just a profit and loss forecast. It's a decent starting point, but it doesn't reflect your actual cash inflows and outflows. Unless you're buying and selling everything on a cash basis, you're going to have some customers purchasing on account and some suppliers affording you time to settle what you owe.

In addition to these receivables and payables, you may also have inventory or work in progress. Collectively, these working capital accounts can have a huge impact on your true cash position. For example, debtors and stock can tie up cash that might otherwise be needed to repay a loan.

You also have to consider investing activities. If you're financing property, plant and equipment, then there will be cash outflows for your capital expenditure. This may sound straightforward, but many entrepreneurs overlook important details like the tax implications of depreciation and the subsequent cash flow impact.

There may also be investing inflows from the disposal of old assets. These, too, can have important tax implications depending on whether they result in capital gains or losses.

Finally, there's the funding itself. Many business owners either don't account for this or treat it too simplistically. They rarely amortise loans properly or calculate finance costs accurately. The latter has both a direct impact on cash outflows as well as an indirect effect vis-à-vis taxable income.

Ultimately, a proper cash flow forecast can end up much more complicated and look something like this:

  Sales

  (less) Cost of sales

  (less) Overheads

  (less) Finance costs

  (less) Tax

  (plus/less) Changes in working capital

  (less) Purchase of new assets

  (plus) Sale of old assets

  (plus) Funding raised

  (less) Funding repaid

If all of this sounds too overwhelming, speak to your accountant or work with a reputable consultant. You have to be involved in the process because no-one understands your business better than you, but that doesn't mean you have to handle all of the heavy lifting.

Many business owners have approached us for assistance with emergency funding in the wake of COVID-19. Unfortunately, most of them haven't been able to take advantage of the numerous relief programmes because they couldn't collate the necessary paperwork in time.

It's unfair to expect a small business owner to be prepared for a pandemic, but poor administrative readiness is a consistent frustration when helping SMEs source funding. Most entrepreneurs underestimate the scope of work when applying for funding, particularly when approaching government agencies.

While funding applications aren't homogeneous, there is plenty of overlap. Here are some of the most common requirements:

CIPC registration documents

Memorandum of incorporation or association agreement

Annual financial statements for the last three years

Current management accounts

Debtors and creditors age analysis

12 month cash flow forecast

Bank statements for the last six months

Tax clearance certificate pin

Latest income tax return

Latest VAT return

Company profile

Proof of address (e.g. recent utility bill)

Rental agreement

B-BBEE certificate

Trade references

IDs for all members, shareholders, and directors (and their spouses if married in community of property)

Personal statements of income, expenditure, assets and liabilities

(Bear in mind that this list is far from exhaustive. There will also be project-specific requirements, like business plans, supplier quotes, purchase orders, and tenders or contracts.)

In our experience, very few business owners can assemble all of these documents within a few days. Most will need at least a week or two, and it's not uncommon for some to give up in frustration. A good accountant can handle a lot of this for you, but many SMEs don't have particularly good accountants. And even if you do have an excellent accountant, you shouldn't assume that they'll have everything on hand.

Whether you are actively looking for funding or not, there's no sense in being unprepared. Check what your accountant has on file, maintain your own archive, and update your records at least twice a year so that you can seamlessly capitalise on funding opportunities when needed instead of scrambling frantically.

COVID-19 has radically altered the business funding landscape, especially for smaller enterprises. Some investors and programs have suspended new applications, while many new relief initiatives have been introduced to keep SMEs afloat.

What can we expect as lockdown restrictions get lifted and our economy re-opens?

#1 Empowerment-exclusive government funding

Long before COVID-19, there was a clear shift towards government funding getting aligned to empowerment policies. A valid B-BBEE certificate has been mandatory for many government agencies for years, and some investors (e.g. the National Empowerment Fund) finance black entrepreneurs exclusively.

The various COVID-19 relief funding programs introduced by government bodies are simply an extension of this trend. Both the Department of Tourism and Department of Small Business Development have insisted on treating B-BBEE compliance as an application requirement.

The president himself has spoken openly about using COVID-19 to reconstruct the economy so that it is “inclusive, empowering to women, young people and to black people in the main”. The funding implications appear obvious: government finance for SMEs will increasingly and explicitly prioritise target demographics.

Going forward, I expect majority black ownership to become a mandatory qualification requirement, essentially transforming every government lender into an extension of the National Empowerment Fund. However, in addition, I expect more nuanced empowerment requirements, with funding programs positioned exclusively for women, youth, or rural entrepreneurs.

#2 More innovative commercial funding

Many specialist investors and fintech solutions have emerged to capitalise on the SME funding failures of traditional lenders. COVID-19 has dealt them a curveball: how do you finance an inherently high risk market when the immediate future is so uncertain and fluid?

Their only option is to adapt by innovating further. I expect we will see even further specialisation (e.g. investors that only fund specific sectors or projects) as well as creative investment structures (e.g. mezzanine debt with quasi-equity earn-outs). Some lenders (e.g. Spartan Finance) have already begun.

The advantage for small business owners is that they will be able to choose from more nuanced funding solutions. However, a growing selection of increasingly novel or sophisticated options may make it harder to find the right investment partner, and may also drive up finance costs.

For every business, cash runway ought to be a key metric in surviving the COVID-19 crisis. But how is a vital metric for start-ups and venture capital funding relevant at a time like this? Shouldn’t we focus on keeping existing companies going?

Yes. Exactly!

We’re in a global, grand-scale experiment in socialism. The health threat of COVID-19 is important, but this is just the presenting symptom.

Of course, the medical issue is important, especially to each patient infected. By far the bigger threat to us all, though, is the inexorable economic catastrophe.

This is, literally, an existential crisis for the biggest constituency in almost every country’s economy: small business and labour. Directly in the gunsights is the livelihood of entrepreneurs and their employees.

If that’s you, here’s why cash runway must be on your exec dashboard:

First, what is “cash runway”?

The simplest definition is: cash runway indicates how long a new business will survive on its starting capital (or a re-investment) before its cash runs out.

The basic formula is:

  cash runway = cash available ÷ monthly burn rate

It’s measured in months, hence using monthly burn rate. “The burn rate is . . . the rate at which a new company is spending its venture capital to finance overhead before generating positive cash flow from operations.” (Investopedia, 2019)

For example, a cash runway of 8 means the business needs to become self-sufficient within 8 months. When monthly cash flow is positive, cash runway itself loses relevance, but the principles extend into sustainability and shareholder value. (We explain this in our Ownership Wealth and Freedom course for our members.)

Except, you’re not reading this because you’re worried about positive cash flow, right? Like most business owners, you’re probably worried about the life-threatening and sudden shock of a negative cash flow scenario. As well you should be!

So, just like a start-up, now is a good time to hit the financial planning reset button. Whatever cash reserves you have available, plan as if you’re in start-up mode.

You have two priorities:

1. How can you slow down the burn rate to stretch out your cash runway?

2. How can you grow revenue quickly enough before running out of runway?

Why? Because I hope you’re not thinking that lockdown itself is the bad news. Nor is the bad news that lockdown restrictions will be lifted gradually in phases.

The “proper” bad news is that it’s going to take months, maybe years, before most companies will get back to a positive monthly cash flow situation.

This crisis is not happening far in the future. It’s happening now. Act now.

By the time you read this, the national lockdown will have begun. We've been through economic recessions before, but this is uncharted territory. Typical recommendations for surviving tough times, like containing costs and managing working capital more efficiently, simply won't cut it. In the face of plummeting sales and limited cash reserves, the survival of many SMEs will hinge on financing activities.

So what's available?

• Repayment deferments from Standard Bank and Nedbank.

• Tax subsidies of up to R500 per month for employees earnings less than R6,500.

• Accelerated disbursements from the Employment Tax Incentive scheme (ETI).

• Partial deferments for PAYE and provisional corporate income tax.

• R200 million from the Department of Tourism.

• R3 billion from the Industrial Development Corporation.

• R2.5 billion from the Department of Small Business Development (DSBD).

The rapid response from both the public and private sector is commendable. However, while every bit helps, I expect the collective impact to be limited:

• Unless other banks follow suite, many SMEs won't qualify for banking relief.

• The employee tax subsidies will barely make an operating cost dent.

• Many entrepreneurs aren't aware of the ETI or aren't using it.

• Partial tax deferments won't make a significant operating cost difference.

• Tourism and industrial subsidies will only benefit a few sectors.

In theory, the funding from the DSBD offers the greatest hope for broad-based SME assistance. However, the DSBD has a long history of unrivalled incompetence. Case in point: the website set up exclusively for the fund has been intermittently down (and is unavailable as of this writing).

(IT ineptitude appears to be a running theme with the DSBD since their own website has also been periodically inaccessible. It also contains obsolete information, since initiatives like the Black Business Supplier Development Programme and Co-operative Incentive Scheme were suspended years ago. And the Facebook link for the DSBD on the national government website actually points to an imposter).

According to a DSBD media statement, emergency funds will be allocated to three distinct segments:

1. SMEs who supply hygiene or medical products directly relevant to COVID-19.

2. Deferments for SMEs funded by the Small Enterprise Finance Agency (SEFA).

3. SMEs that are in distress as a direct result of COVID-19.

Clearly the third of these will have the broadest relevance, but the DSBD has yet to publish much information about it. In fact, according to my contacts within the department, a number of critical details have yet to be finalised. This is what I have been able to piece together so far:

• The funding will be structured as a low interest loan (prime less 5%).

• Funding limits will be based on applicants' turnover.

• Applicants will need to submit an online form and supporting documentation.

• Applications will be processed by a SEFA task force.

• The task force consists of a dozen people working remotely from home.

• The DSBD's turnaround target is 7 working days.

If this is true, then it is very unlikely that many SMEs will benefit from the fund (or benefit soon enough to make a difference).

A single task team member won't process more than a few dozen applications per day (and even that is an incredibly optimistic estimate if the track record of the DSBD and SEFA for other funding programs is anything to go by). Unless the DSBD dramatically scales their processing capacity, it will be impossible for them to keep pace with the inevitable tsunami of applications.

Officially, the fund will not limited to black-owned SMEs as some have speculated. However, there is circumstantial evidence that this was the DSBD's original intent. This, coupled with the DSBD's heavy bias towards startups, informal enterprises, as well as rural, youth, and women entrepreneurs, leads me to suspect that applications for relief funding won't be assessed equitably.

Earlier this year I suggested that government funding for SMEs would languish as parastatal resuscitation dominates political attention. So imagine my surprise when Tito Mboweni announced during his recent budget speech that R6.4 billion has been allocated to small business incentives.

Small business funding and development has become a routine feature of the national budget speech. However, Tito's announcement is notable for two reasons.

#1 It exceeds previous commitments by a considerable margin

In 2015, Nhlanhla Nene announced that the Department of Small Business Development "will spend R3.5 billion on mentoring and training support".

In 2016, Pravin Gordhan announced that "R475 million has been reprioritised to the Department of Small Business Development for assistance to small and medium enterprises and cooperatives".

In 2017, Pravin announced that budget allocations included "R3.9 billion for small, medium and micro enterprises and cooperatives".

In 2018, Malusi Gigaba (remember him?!) announced that "a fund with an allocation of R2.1 billion over the medium term is being developed between the Departments of Small Businesses, Science and Technology and the National Treasury to benefit small and medium enterprises during the early start-up phase".

And last year, Tito announced that "R481.6 million is allocated to the Small Enterprise Development Agency to expand the small business incubation programme".

So, in that context, R6.4b is a pretty big deal, even if it is dwarfed by the R18.5b that has been allocated to industrial incentives ... or the R16.4b that has been allocated to bail out SAA Airways (again) ... or the R100+ billion that has been wasted on parastatal handouts (despite promises to the contrary).

#2 It specifically involves incentives

Many recent SME funding initiatives (like the SME Fund that was launched amidst much fanfare last year) have involved loans or equity investments. Incentives, by comparison, imply non-repayable funding (which, clearly, is of far greater benefit to small businesses since it dramatically reduces their cost of capital).

This is particularly interesting because there has been a deplorable decline in SME incentives ever since the Department of Small Business Development (DSBD) was launched in 2014. Grant funds like the Black Business Supplier Development Programme and Co-operative Incentive Scheme have languished in limbo for years, while new non-SME initiatives (like the Black Industrialist Scheme) have been heavily prioritised.

Hopefully Tito's announcement will mark a revival, but it will likely be several months before the allocation and structure of the incentives gets clarified. That said, Tito specifically mentioned that only a third of the funds will be transferred to the Small Enterprise Development Agency (which subsidises development interventions instead of providing direct investment).

The most logical destination for the remaining R4b+ is the DSBD. Hopefully that will not be the case since the DSBD has been a cesspool of ineptitude. It is embarrassing that they still don't have their own infrastructure and continue to piggyback off the Department of Trade and Industry (DTI), even though they were established half a decade ago and have been allocated billions of rands!

The DSBD also has a history of heavily prioritising startups and informal enterprises (which is one of the reasons why the grant funds that they inherited from the DTI have languished). So if the R4b+ does get allocated to the DSBD, there is a risk that the "missing middle" (i.e. SMEs that are too big for the DSBD's startup initiatives but too small for the DTI's industrial incentives) will continue to be overlooked.