Financing the RESCO Business in Fiji

Financing the RESCO Business in Fiji

Office for the Promotion of Renewable Energy Technologies

Fiji Department of Energy

Prepared by:

Herbert A. Wade

August 2003

Table of Contents

A RESCO’s need for finance

What investment is needed by RESCOs?

How much finance do you really need?

Where does business finance come from?

Debt Finance

Equity Finance

International Donors and International Banks

Negotiating financing

The importance of good credit

A RESCO’s need for finance

A Renewable Energy Service Company (RESCO) provides renewable energy based electrical services by purchasing renewable energy powered generation systems (such as solar PV systems) and selling the services of those systems to end users with the capital investment amortised over many years in order to keep the ongoing cost to the customer as low as possible. Therefore, the typical RESCO requires a great deal of capital since there usually is the requirement for the RESCO to purchase the renewable energy equipment then receive repayment spread over 10 or more years. This has been a great barrier to the development of RESCOs in developing countries since the large amounts of capital needed is difficult to obtain for companies in a developing country. In an attempt to help qualified companies obtain capital financing for renewable energy projects, a number of private and semi-private investment funds have been created in recent years. For example, the Solar Development Capital group was established specifically to provide capital for the financing of solar in developing countries. However, those funds typically are directed toward larger countries where a relatively large investment can be made and the return on investment tends to be more assured. So these funds are generally not available small countries such as Fiji.

In any case, in Fiji at this time, it appears unlikely that a privately financed RESCO can be created that will be able to provide services to more than a small percentage of rural households. The cost of investment in renewable energy systems, system operation, maintenance and repair will all together be too expensive for the majority of rural households. This has been recognized by the Fiji Department of Energy (DOE) for many years. The DOE has provided substantial (90%) subsidies for capital investment by communities for rural electrification and has now devised an approach that will permit subsidies to be provided for capital investment using private RESCO operators.

This is accomplished through the DOEdirectly purchasing the renewable energy systems and making them available to RESCOs through a long term lease arrangement at a subsidized rate. In essence, the Government is providing the majority of finance for a RESCO through acting as a leasing company. By this means, a RESCO can lease the renewable energy systems from the DOE and install and rent them to end users, charging users an affordable fee for the installation, operation and maintenance of the renewable energy systems. To access this program, the RESCO must agree to meet or exceed technical and business standards set by the DOE for installation and maintenance, follow procedures set out by the DOE for financial management and operations and generally provide quality, reliable services to the end users. Through this means the entire requirement for capitalization of the renewable energy systems is borne by the Government and the private RESCOs only have to be prepared to finance installation, operation, maintenance and repair of the systems, an amount well within even small Fiji based companies. With the subsidies provided by DOE, the end user fees can be low enough for the majority of rural households and businesses to be able to afford at least basic electrical services.

What investment is needed by RESCOs?

For a RESCO business to operate successfully two types of capital are necessary:

Fixed capital that is invested in land, buildings or long life items necessary to the business such as land, buildings, vehicles and business machines. This capital is recovered over a long time, typically 5 – 20 years according to the effective life of the goods involved.
Working capital that is necessary to pay the day to day operation of the business such as payrolls, taxes, utilities, vehicular fuel, repairs to equipment and facilities. Working capital constantly turns over with income from sales of services constantly offsetting the expenditures. Thus sufficient working capital is needed to cover costs before income generation from received fees can catch up.

The approach to financing fixed capital and working capital are typically different since the term of finance is quite different and the end use also different.

How much finance do you really need?

It is important to borrow only when you can reasonably expect to make money with the new finances at a rate higher than the interest that is charged. For example it is common for a new business to immediately purchase a new vehicle. Before borrowing money to buy that vehicle you should carefully consider how much its ownership will cost and what it will do for the business that increases its profitability. When carefully considered, a new vehicle is usually a bad financial investment and a good quality but used vehicle is much better since the cash value a vehicle usually falls much faster than its utility value. A vital rule often violated, particularly in new companies is:

Only use debt or equity finance to pay for goods or services that will directly increase profits more than the cost of the goods or services over their useful life

and then only borrow if the increased profitability is greater than the interest cost. It is very, very easy to lose a great deal of money by borrowing money to purchase items that add little or nothing to profitability and that is the sure road to business failure. If you want that new vehicle that will almost surely cost your company rather than make it more money, make its purchase a goal for the future when your company has a proven profitability and you can pay for it from profits, not from borrowed funds.

Where does business finance come from?

In general there are two basic types of finance: debt and equity.

Debt finance means the provider of finance sets specific terms for repayment and has no interest in the business other than recovery of the loaned money. Purchasing a vehicle on credit terms is a common form of debt finance for a RESCO. Debt financiers charge a rate of interest on their finance in relation both to the existing market rate for money and their perceived risk. The higher the perceived risk, the higher the interest rat. Interest rates are usually stated as an annual percentage of the outstanding balance owed but according to how it is calculated it may be actually somewhat higher or lower.

Equity finance is the finance provided by the owners of the company. They may be individuals or other companies.

Debt Finance

There are a number of sources of debt finance open to the RESCO:

Personal loans from individuals. Individuals who are participating in the company, family, friends and in some cases others who individually make a practice of providing loans to individuals or companies. Loans of this type are typically for relatively small amounts and for a short term, sometimes only a few days but rarely more than a year. In most cases, interest will either be minimal (as is likely with close friends or family members) or very high (as will be the case with “loan sharks” who make their living by loaning money for short terms at high rates of interest. This source generally best fits finance of working capital.
Commercial banks. Loans can be obtained from commercial banks for business purposes in moderate to large amounts with payback periods from a few months to many years. Interest rates vary according to the bank’s perceived risk, the term of the loan and the credit worthiness of the borrower. Rates from a few percent above the rate paid for savings accounts to over three times that rate may be charged. In general, it is difficult to obtain a long term or large bank loan for a new business unless the owner has a long history with the bank and has other assets that can be used to guarantee the loan (called collateral). The shorter the term, the easier it is to obtain a loan with many banks providing several thousand dollars of overdraft loan facility quite easily though pay back is expected within a short time and interest rates are high. Loans can be made quite quickly, typically a week or less. Loans from commercial banks can fit into either working capital or fixed capital finance.
The Fiji Development Bank. Created specifically to assist in developing private business in Fiji, the Fiji Development Bank generally can provide finance to higher risk borrowers – such as is the case with most new companies – and sometimes at better payback terms than commercial banks. In general interest rates are little different from those offered by commercial banks but approval is usually easier, payback may be longer and sometimes a few months in the beginning may be provided with no payment required (what is called a “grace period”). Loan processing tends to be slow and in a few cases known to the author, more than a year between application and approval has passed. Both working capital and fixed capital can be financed.
Loans from other companies. In those few cases where your business will help support another business (such as supplying raw materials to a processing company or providing important services needed by the other company), the other company may be willing to provide short term finance to assist in your business start up. In a few cases longer term loans have been made but in the case of the RESCO business it is unlikely that this source will be available. Inter-company loans are generally for working capital.
Commercial finance companies. There are a few companies in Fiji that specialize in providing business finance for the purchase of long term capital goods such as vehicles, land and buildings – essentially they will finance any capital good that can be sold for the loan value should you default on payment. Interest rates may be somewhat higher than a commercial bank for the same type of loan but typically are similar. Credit companies are mostly used to finance fixed capital.
Term finance from suppliers of goods. It is common for companies that supply other companies to offer extended payment terms. For example, a supplier of solar equipment may allow your company 45 days after delivery to make payment. Interest may or may not be charged. In the case of the RESCO, there is little turnover of goods so this source of short term finance is not very useful. This form of finance is only for working capital.
Seller finance and consumer finance companies. For business goods such as computers, office furniture and expensive tools, sellers may offer “time payment” terms whereby payment can be made on a monthly or quarterly basis over a period of several years. Interest rates are generally higher than commercial bank rates but the finance is readily available and approval usually only a matter of a few days. Seller finance is only used for fixed capital.

In determining whether or not to provide a loan, debt financers look for:

Evidence that you are a good credit risk. Have you a history of always paying commitments on time? Do you have other sources of income that could cover the payments if this business fails? Does business plan for the RESCO business look reasonable and does it project a good profit?
Business management capabilities at the top level of the business. Have you prior business experience in a similar business? What are your qualifications to manage the RESCO
What assets do you have that can be used as collateral for the debt (private land, vehicles, buildings, etc.)
Are you personally investing a substantial amount in the RESCO business. A debt financier will be worried if you are not willing to invest your own money in the company.

The advantage of debt financing is that you retain complete operational control of your business. The financier is only concerned that you make the agreed upon payments on time. So long as that happens, you will never hear from him. Also, the debt has a predetermined time period. Once the debt is paid, you have no obligation at all to the financier.

Equity Finance

With debt finance, a promise – usually backed up with collateral or at least a strong credit reputation –is made to repay the loan in a specified time with some specific rate of interest. The finance company has no specific interest in what you do with your company so long as the payments are made. With equity finance, a share of the company is exchanged for the finance. In essence there is a sale of part of the company to the individual or organization providing the equity finance. In return, the equity financier expects to get a share of the profits made by your company that is comparable to the share of equity it owns. Since the return on equity investment depends on the profits made by your company, in most cases, an equity investor will take a strong interest in the policies and operation of your company. If an experienced businessman is the investor, this interest may be of value to your company through the advice provided but in some cases it also can be a serious problem when the investor is not familiar with your type of business or is not himself an experienced businessman but attempts to force you in a business direction that you may feel is inappropriate. In most cases, it is unwise to accept equity finance unless you are comfortable with the prospect of having the investor as anactive partner in the business.

Sources of equity finance include:

Individuals. Although a few individuals may make substantial equity investment in a company without wanting to actively participate in its operation, by far most individual investors are actively working in the business, effectively becoming business partners. In some companies, all employees are encouraged to buy some share of the company, providing equity finance to the company through a deduction from their salaries. In most cases only upper management will “buy into” the company with equity finance. The advantage is that you will have a group of people strongly committed to making the company generate a profit. The principal disadvantage is not everyone will agree as to the best course of action to maximize that profit and if there is a problem with an investor working within the company it is very difficult to resolve amicably.
Other companies. Equity investment may come from other companies in the same general field with the intent of “hedging” their investment by effectively buying a larger market share of the business. Some companies want to invest in a diversity of businesses – a holding company concept – so that if one area of business weakens there is a likely strengthening in another area. In all cases, you can expect the investing company to take a strong interest in how you manage your company which may be to your advantage or disadvantage according to your personal attitudes and needs and the quality of advice available from the investing company.
Investment firms. Typically an invesement firm establishes a capital fund that combines the resources of a number of companies, organizations or individuals then seeks to invest money from that fund in companies that have promise of reaching the profit goals of the fund manager. The terms of investment vary widely. Some offer investment with the intent of selling the share either back to the original investors or to another party within 5-10 years an making a profit on that sale (typical for start up companies that are unlikely to have an early profit but will grow fast) or permanent equity where there is no intention of selling the share in the future but making the investment profit from the distribution of company profits (typical for a company that can expect operational profits from the time of investment onward). The Solar Development Group (SDG) manages a $30 million investment fund of this type.
Joint Venture (JV). In this approach, you and an outside company form a partnership with you providing the day to day management and operating the business and the other company providing capital investment and business advice and support. Profits and growth gains are shared according to a formula agreed upon at the time of the formation of the JV.

According to the type of business structure you have (proprietorship, partnership, limited proprietorship, limited liability company, etc.) the legal aspects of equity financing differ. But in all cases, an equity investor literally owns part of your company and has a share both in the operational decisions and in the profits in proportion to the share of investment.