SMEs and Startups Under Ethiopia’s New Investment Law

In today’s globalized world, FDI follows higher earning rates, provided a conducive business ecosystem is in place. Although most developed countries do not have investment-specific legislations there is competition amongst developing countries to adopt a more market-friendly policy to attract the much-sought FDI for their economic development.

Ethiopia is not an exception in this regard. With the policy objectives of catching-up with changes, sending out a new message to the world that Ethiopia welcomes productive investments, and be competitive in a global market a taskforce, where I was one of the members, was set up to come up with a new investment law. The Ethiopian parliament and council of ministers passed the new investment proclamation and regulation recently, which culminated the work of the team. The new law shifted towards negative listing of investment areas, opening a wider space for foreign investors.

Requiring a minimum capital is a policy decision of governments and is generally perceived as one of the legal barriers to FDI and the ideal scenario is to abolish it entirely. However, many developing countries require minimum capital with the policy considerations being the monitoring of rent seeking behaviors and considering FDI as a source of FOREX for the country’s economy. The new investment proclamation maintained the position of the previous legislation requiring a minimum of USD200,000 from foreign investors with some exceptions. I am of the opinion this should have been partly modified to attract FDI into the flourishing SMEs and Startups in Ethiopia.

The kind of equity investment envisaged in SMEs and startups is characterized as a portfolio (indirect) investment and is not usually the primary concern of investment laws. The investors might have a short-term interest and usually do not have control of the management of the business. It is common practice to leave the supervision and regulation of portfolio investments to monetary and financial authorities such as central banks, ministries of finance or treasury departments, and security and exchange commissions. Under the Ethiopian context, we do not have an office equivalent to the Securities and Exchange Commission though the need is desperately there and MoF and NBE do not have a mandate on the subject. Until the regulatory environment improves, portfolio investors’ cases, based on the practice and provisions of existing laws, are entertained by the Ethiopian Investment Commission although there seems to be inherent incongruity.

Depending on the size of the economy of a country, the specific definition of SMEs could differ. According to the World Bank study conducted some years back under the Ethiopian context, firms which have 20 or less employees would fall in this category. Across the globe there is no contention that SMEs outnumber large companies by a wide margin and employ more people. Despite these positive facts about SMEs, they face difficulty in access to finance, especially in developing countries. In developed economies, SMEs usually receive around USD50,000 in capital injections. Ethiopia’s investment laws are still unwelcoming for foreign equity and angel investors, which are highly vital for SMEs’ growth.

Banks usually focus on bigger businesses and SMEs are neglected because loan applicants lack qualified collateral, are short of financial and managerial knowledge, and have high default rates, among other reasons. Further, reliable historical data for SMEs is also absent.

Naturally, the sequence of financing would be to first get equity investment to be followed by debt financing. Young entrepreneurs in this situation face a dire reality where their innovative skills would not get a receptive potential investor and would eventually see her/ his novel business idea wither away.

The first big limitation is that Ethiopian banks do not have an investment arm. We do have 18, relatively small, banks in the market now but none would entertain an equity investment request. The Ethiopian banking industry is insulated by a protective regulatory regime which might have contributed to Ethiopian banks’ lack of zeal to expand their territory. The banks generate relatively better rates of return on investment for their shareholders and are growing fast, which might have made the industry leaders content. I am hopeful that sooner than later the industry will start to attract never-satisfied, ambitious, and well-educated leaders; and have exposure to developed financial markets who would start challenging the status quo and endeavor to create an investment arm for the industry.

In addition to the isolation of the banking industry from the global financial market, the National Bank of Ethiopia’s regulatory framework is not enabling enough for Ethiopian banks to consider equity investment as part of their business. Banking business is defined under current laws in a very traditional way and if Ethiopian banks consider managing the equity investments of their customers, it would entail regulatory risk. Even using their own resources, there is a cap on the banks per “Limitations on Investment of Banks,” of the amended 2015 directive, “not to exceed 10Pct of their net worth.” Banks’ basic role in any economy is the intermediary service they provide by mobilizing money and channeling it with a margin to a destination where it is needed. Ethiopian banks are playing a traditional and very limited intermediary role in the economy which needs to expand.

Another discouraging reality for startups and SMEs are Ethiopia’s business corporates and high net worth individuals who do not have the culture and level of sophistication to have portfolio investments. Even if they have excess liquidity and could inject equity into other businesses, the norm is to refrain from doing so and the major explanation is the big doubt on portfolio investment success. Ethiopian business corporates and high net worth individuals are control freaks and not willing to put their money in businesses where they do not control or shine. Additional explanations could be Ethiopia not having a corporate governance code and a regulatory framework for public companies which would give confidence to investors.

When the need for minimum capital was discussed, paramount importance was given to its role in the generation of forex but the mistrust was also there. It is ‘feared’ that if the minimum capital requirement is reduced foreigners would flock to the country. There seems to be a very strong sense of control and not to be taken advantage of. Although there might be some grain of truth given that we are one of the weakest players in the global economy, the solution is to face the reality and to gradually integrate. Shying away and mistrust would unduly perpetuate our poverty which we cannot afford. Incidentally, our commitment to AfCFTA and WTO accession efforts should be with a genuine belief that integrating with the global economy is not a choice but a must-do to realize the aspirations of young Ethiopians.

The minimum capital requirement of USD200,000 is not a magic number planked from thin air but is fixed with proper policy considerations. For SMEs and startups, the absence of local equity investment and the regrettable blocking again of foreign sources by the new investment proclamation leaves young Ethiopian entrepreneurs and SMEs to choke out their business innovation ideas.

In fact, having a minimum capital requirement would give some level of protection to smaller businesses in addition to the sectoral protection provided in the laws. However, the requirement should fully resonate with the policy objectives of the country. The requirement should not be implemented with a mis-fitness undermining the bigger development objectives of the country. One instance would be applying it to institutional investors. According to the Organization for Economic Co-operation and Development (OECD), “institutional investors are financial institutions that accept funds from third parties for investment in their own name but on such parties’ behalf. They include pension funds, mutual funds, and insurance companies which are major forces in many capital markets. Under the new investment law such institutional investors are required to meet the minimum capital requirement both for direct and portfolio investments.

Although the root cause could be the omnibus nature of the law regulating both direct and portfolio investments, a temporary solution would have been to make exceptions to institutional investors. In my recent visits to London, I explored a private equity (PE) fund focused on technology startup companies channeling USD50,000U per target company. The fund is considering a series of investments across the country where the cumulative FDI would be much higher than the minimum capital requirement but it is not allowed to operate in this market. The exclusion of such funds from coming to Ethiopia is clearly against the policy objectives of the country. When a number of startups are desperately looking for such equity investment, we are becoming insensitive to their needs.

Under the present-day Ethiopian reality, the importance of economic development cannot be over-emphasized. All the endeavors of the government and other stakeholders are not carried out for the sake of doing but rather to realize the economic aspirations of millions of Ethiopians. It is a universal fact globally that SME’s are big players in any economy, especially on job creation.

SMEs and startups have a big potential as scalable businesses especially in a country like Ethiopia where the median age is 20. It is my considered opinion the new investment law should have some exceptions to allow institutional investors to engage in portfolio investments without any minimum capital requirement.

9th Year • Feb 16 – Mar 15 2021 • No. 95