Chris Jurgens
Director, Reimagining Capitalism

There’s More Than One Missing Middle: Segmenting small and growing businesses by their financing needs

October 24, 2018

A cooperative of smallholder farmers in Peru is exporting high-quality coffee to an expanding international market.  

A start-up tech company in India is creating a B2B logistics software solution for the freight industry that has the potential to disrupt the market.  

A Rwandan auto shop has grown from a family-run microbusiness to provide two dozen local employees with jobs.      

A social enterprise is pioneering a new technology and distribution model for providing affordable water filters to households on Indonesia’s Sabu Islands that lack access to a safe water supply.  

All of these are examples of “small and growing businesses (SGBs),” defined as commercially viable businesses with five to 250 employees that have significant potential and ambition for growth, and that typically seek growth capital from about $20,000 to $2 million[1]

As these examples illustrate, SGBs contribute to significant positive social and environmental impact in emerging and frontier markets: they create jobs, drive inclusive economic growth, spark innovative technologies and business models, and provide underserved populations access to essential goods and services. These examples also show the tremendous diversity of SGBs, and the equally diverse entrepreneurs who run them.  

SGBs in emerging markets face formidable challenges – most notably a lack of access to appropriate capital.  According to the International Finance Corporation, SGBs in emerging markets face a $930 billion financing gap. Accessing financing is particularly challenging for certain types of enterprises, such as early stage ventures and businesses with moderate growth prospects, that are stuck squarely in the “missing middle” of enterprise finance: they are too big for microfinance, too small or risky for traditional bank lending, and lack the growth, return, and exit potential sought by venture capitalists. 

In order to move the needle on addressing the SGB financing gap, we need to better understand and dissect this huge and diverse market. While a useful concept, the “missing middle” lumps together enterprises with vastly different business models, growth prospects, and financing needs, not to mention diverse entrepreneurs who have widely varying aspirations and attitudes towards external investment. We need to better segment SGBs to be able to efficiently identify financing solutions that address distinct needs within this market.     

That’s why Omidyar Network partnered with Dutch Good Growth Fund (DGGF), Dalberg Advisors, and the newly-launched Collaborative for Frontier Finance on an effort to segment SGBs according to their financing needs. Today, we’re releasing the results of our four-month study in a new report: The Missing Middles: Segmenting Enterprises to Better Understand their Financing Needs.  

By segmenting the SGB market into multiple “missing middles,” we aim to more effectively diagnose the distinct financing needs and gaps faced by different types of enterprises, and in turn better focus on scaling the financing solutions that are most needed to empower enterprises of all types to meaningfully contribute to inclusive economic growth.  

What makes this segmentation unique – and additive to existing frameworks – is that it integrates several segmentation approaches that are often used independently, but rarely in concert with each other.  Our methodology integrates perspectives from leading SGB investors on how they segment the market; analysis of enterprise-level quantitative data from the portfolios of SGB investors; and behavioral analysis of entrepreneurs using human-centered design techniques. 

Our research identifies four distinct classes of SGBs, which we call “families,” that occupy the missing middle.  Each of these families has distinct growth, product, and management characteristics, and thus distinct financing needs. They each play a distinct role in driving inclusive economic growth and job creation.  And each family also faces different challenges in accessing financing, which are manifested in the form of gaps or mismatches in the market between what investment options are available and what solutions are best suited to enterprise needs. 

High-growth Ventures pursue disruptive business models and target large addressable markets. These enterprises have high growth and scale potential, and are typically run by entrepreneurs with the capacity and ambition to manage a scalable business that pioneers new products, services, and markets.   Such businesses need staged growth capital – often from venture capital and private equity funds – to fuel their rapid growth trajectories.  Think of a tech start-up in Bangalore or Nairobi, or growing business providing household solar solutions to low-income customers across multiple markets in West Africa.  

Within this family, we differentiate between “asset-light” High-growth Ventures that tend to be based on digital technology, and companies that are more asset-intensive, as their financing needs differ significantly.

Niche Ventures create innovative products and services that target niche markets or customer segments.  They seek to grow but often prioritize goals other than massive scale—such as solving a specific social or environmental problem, serving a specific customer segment or local community, or maintaining a product/service that is particularly unique. They produce innovative or differentiated products and services, but target smaller addressable markets compared to High-growth ventures. 

Artisan-driven businesses are a common type of Niche Venture, like Bombay Atelier, a small company in Mumbai run by a designer that produces unique, artistic furniture targeting a high-end local market.  Social enterprises focused on serving the needs of a specific local community often fall into this family as well.  

This segment is not recognized in the existing literature on SGBs, and came to light during our human-centered design research, which informed how entrepreneur motivations shape attitudes towards growth and scale.  

Dynamic Enterprises operate in established “bread and butter” industries—such as trading, manufacturing, retail, and services—and deploy proven business models. Many are well-established and medium-sized, having grown steadily over a substantial period. They seek to grow by increasing market share, reaching new customers in adjacent markets, and making incremental innovations and efficiency improvements.  Successful Dynamic Enterprises can achieve attractive growth rates, well above local rates of GDP growth, but their pace of growth is tempered by the dynamics of mature, competitive industries.   

Multi-generational family businesses are a common form of Dynamic Enterprise.  One example is Stick Pack, an Egyptian flexible packaging and sticker products manufacturer that has grown over the course of several decades, thanks in part to financing to support expansion of product lines, and now several hundred people.  

Finally, Livelihood-Sustaining Enterprises are small family-run businesses selling traditional products and services that are on a path of modest, incremental growth. These businesses may either be formalized or on the path to it, and tend to operate on a small scale to serve local markets or value chains.

Such businesses often start out as “mom and pop” shops at microenterprise scale, but subsequently grow incrementally to hire additional employees.  An example is a shoe manufacturer in Nicaragua that started with family founders, and now employs 15 people and serves a regional market.  

Looking at SGBs through the prism of the “four families” brought several insights to light for us.  

First, each of these families plays distinct and important roles in driving inclusive economic growth, job creation, and innovation – yet most investors are focused on only a tiny fraction of the SGB market.  High-growth Ventures are engines of innovation and disruptive growth, but represent only a tiny fraction of SGBs.  Dynamic Enterprises and Livelihood-Sustaining Enterprises have more modest growth profiles, but they play essential roles in creating and sustaining jobs, particularly for low-income and rural populations.  And they represent the lion’s share of businesses that form the backbones of local economies. In many markets, early stage investors are disproportionately focused on High-growth Ventures – for understandable reasons.  But we see a huge gap, and opportunity, to focus on financing Dynamic Enterprises – a very large segment of businesses that often receive less investor attention due to operating in more traditional industries that are not well connected to entrepreneurship ecosystems and stakeholders focused primarily on start-ups.  

Second, the segmentation highlights several key “risk-return mismatches” in the SGB financing market. For example, we see a frequent mismatch in applying traditional venture capital structures and expectations to companies that don’t have the scale and exit prospects of successful digital technology companies. This research has reinforced Omidyar Network’s finding in Frontier Capital that we need differentiated approaches to financing High-growth Ventures that are asset-light (e.g., digital technology companies) versus asset-intensive ventures, which have different scale trajectories and economics due to their focus on producing physical products and/or their need for brick and mortar infrastructure.  

To address this mismatch, we see promise in the growing number of financial service providers that are using alternative vehicle structures – such as open ended or evergreen funds – that allow for more flexible time horizons. We’re also encouraged by the growing use of alternative financing instruments – such as quasi-equity, revenue-based investing, and mezzanine debt – as alternatives to straight equity that allow for structured exits. Furthermore, we think models that mobilize local investors to provide early stage risk capital – such as angel investing networks and seed funds that mobilize local LPs – offer potential to serve a wider set of SGBs in need of growth capital.  

The research also highlights a “transaction cost gap” that impacts the ability of Dynamic and Livelihood-Sustaining Enterprises to obtain affordable lending. The cost of providing low-ticket-size working capital financing or mezzanine debt can exceed the income that such products can generate for lenders. Here, we see tremendous promise in new technologies and tools being advanced by a growing cohort of financial services innovators that drive down the cost of credit assessment, underwriting, and servicing SGBs.  

Finally, this research makes clear that there is no “silver bullet” financing solution to addressing the SGB financing gap. Rather, what is needed is a diverse, robust ecosystem of SGB finance providers that can meet the needs of different families of SGBs at different stages of their growth journeys.  

We hope this segmentation framework provides vocabulary that can help investors and intermediaries more clearly communicate where they are playing in the market, what types of entrepreneurs they strive to serve, and thus contribute to a more efficient financing market that better matches enterprises with the right classes of financial service providers.

And ultimately, we hope the research provides a roadmap for scaling financing solutions that meet the needs of a wider range of SGBs, and that it can help advance efforts already underway to help SGBs find the financial and technical support they need to transform their communities and societies.

[1] As defined by the Aspen Network of Development Entrepreneurs (ANDE). 

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