SMSEs work in complex markets, so their business structures have to be complex

SMSEs face a complex market. Investors and funders need to understand it to identify the most effective enterprises.

Two markets - urban and rural

Unlike in developed countries, in developing countries there is a very big difference between urban and rural markets. A business adapted to one market may well not be appropriate in the other.

Rural businesses face particular problems. Volumes are small. Credit is less often available or is very expensive. Distribution costs are high.

This does not mean, however, that there are no business opportunities in rural areas. Since there are often higher barriers to entry in the rural market, there are fewer entrepreneurs and so prices (and margins) can be higher to cover costs - there can be considerable pent-up demand in rural areas (see agricultural machinery case study). Put another way, a new rural entrepreneur can have more impact than an urban one. For example, introducing a new credit scheme in an urban area may increase choice or lower prices. In a rural area it may be the only credit available.

Communal thinking

Especially in rural areas, the market is 'communal', rather than individual. Whole communities will accept a product, or decide they do not need it. As Ogilvy, the advertising agency, says "We do not try to understand individual consumer psychology. Most decision making in rural India is collective. Village women bathe together at a well or a pond. Family members and neighbours, usually men or elders, get together over cups of tea and discuss the merits of a tractor"

Community networks can be a powerful tool. Communities can cooperate to buy a new input, like a tractor, or to run an enterprise like a microfinance institution. Villages can decide as a group to invest in new infrastructure, like a water supply, allowing them to use larger and more economic systems. But equally, to convince a whole community of a product's merits can take more effort.

Complex and costly distribution channels

Long distance and communal purchasing make distribution complex, especially in rural areas. Enterprises that innovate to reduce distribution costs create a competitive advantage.

One effective way to reduce distribution costs is to create partnerships with existing networks, such as NGOs or community based organizations. SANASA Development Bank partners with SANASA Primary Societies to reduce the costs of serving rural communities.

Uncertain environments and risk aversion

Businesses in developing countries face more uncertainly. Natural disasters and wars are more common - as Sri Lanka's record clearly shows. Economic conditions and macro-economic policies can also change fast.

Insurance markets for SMSEs are not well developed and, if a business fails, an entrepreneur is unlikely to find alternative employment. Understandably, many entrepreneurs prefer to take a 'safe' approach, maintaining a stable business, rather than take risks. As a result, enterprises tend to avoid capital investment and innovation, preferring a secure, steady income stream to an uncertain, if potentially higher one (see milling case study).

This has implications for business planning. Risk needs to be closely evaluated in business plans and mitigation should be costed in. Products should be designed to accommodate variability in customers' fortunes, for example credits should allow more flexibility in repayments, schools should allow parents to delay payments, medical treatments should not assume customers can continue paying, etc.

Lack of role models

Entrepreneurs in developing markets have less information. Mass communication and media are poorly developed, outside of large towns entrepreneurs will rarely interact. Especially in rural areas, entrepreneurs will not be exposed to many new ideas.

This reduces innovation and diversity. Many markets, both for social and other goods, are characterized by a number of enterprises offering similar products, colluding on pricing, rarely innovating or offering new products.

On the flip-side, entrepreneurs are hungry for new ideas. Introducing new technologies or new business models can lead to rapid growth. The young owner of a farm machinery dealership brought his sales experience gained from work with a larger firm back to his home community, and experienced explosive growth.

Less aware customers

Poorer and rural customers have less access to mass media and less opportunity to communicate outside of their immediate community. Additionally, there are few trusted sources of information, less consumer protection regulation, more difficult access to courts and less knowledge of brands - so more opportunities for unscrupulous traders to trick customer. As a result, the poor are cautious buyers - needing longer to consider a purchase, and a relationship with an enterprise before making a large purchase.

This means distribution channels have a dual role: to bring a product to the customer and to educate customers on a product and its benefits. For example, pharmacy outreach programs will not only have to sell a medicine, but also communicate its benefits. As a result, businesses must create long longer-term relationships with their customers, not only expect to have transactions.

Discontinuous development

Although the markets that social enterprises are working in can appear 'traditional' and 'stable', rapid changes are possible. The most successful innovations lower the cost of a product (such as hand-tractors) or a services (such as communications or credit), allowing mass market expansion and rapid growth. These cost reduction innovations are becoming more common, with new suppliers (China), new technology (wireless telecommunications) and innovative business models (microfinance).

Need to be both small and big

Given complexity, smaller enterprises are often more efficient, since companies need to make local adaptations and communities trust local providers more than external brands. Additionally, remotely managing staff is particularly difficult when communication is slow and there can be many explanations for poor performance.

But there are also disadvantages of being small. Small companies do not learn from others, do not have scale in procurement and have to rediscover best practices.

One solution is to create networks of independent SMSEs. The network provides best practice, skills development and external linkages. The SANASA movement, a network of independent microfinance organizations, is a one example. There could be many others.

Regulation barriers

Government regulations, such as licensing, tax regimes or labour laws are often cited as a major barriers to business development. Sri Lanka is no exception - with large barriers to setting up businesses and hiring staff.

However, discussion with entrepreneurs implies that other issues, such as market instability or lack of role models, may be more important than regulation barriers. All but one entrepreneur reported that they had no problems with government regulations. The only exception, a pharmacist, said she was unwilling to employ more staff as she was worried it would be expensive to release them if her plans did not work out. Her solution was to rent out facilities to free-lance doctors rather than employ them.

Consequences

The overall result of the above is that business models in developing countries, especially for social enterprises, tend to be complex.

Complexity may not, however, indicate lower profitability. All enterprises in the market face the same barriers, so finding a solution can create a step-change in profitability.

It does, however, require more creativity, experimentation and perseverance to design an effective business, which can mean a long delay between start-up and profitability.

However, once a good business model is identified, since it can tap pent-up demand, growth can be explosive.