Scaling small businesses with alternative finance

GettyImages-879574316Lack of access to finance is the most widely cited constraint by SMEs for growth and scaling up business. Generally commercial banks perceive SMEs fall in the category of high default risk due to limited collaterals, smaller in asset size and limited historical track record.

Governments in various countries have taken multiple steps such as subsidised interest rates, collateral free loans, partial credit guarantee, credit insurance, matching grants and so on to improve the institutional credit flow to SMEs.In the recent past many countries have started separate stock exchanges for SMEs to facilitate access for capital market resources. However, the institutional finance channel is still not efficient, and many SMEs are unable to scale-up their operations.

The emerging channel in financial intermediation is alternative finance, which is considered outside of the conventional financial system, mostly these are technology driven. Crowd funding and Peer to Peer (P2P) lending are two such technology-based institutions meeting the financing requirements of SME businesses.

Crowdfunding is a technology portal mainly connects three parties: the entrepreneur or SME firm looking for funds, the contributors interested in supporting the cause or project, and the moderating organisation that facilitates the engagement between the contributors and the initiator. The moderating organisation enables the contributors to access information about the different initiatives and funding opportunities for the development of products/services. The three most popular business models of crowd funding are rewards-based crowdfunding, donation-based crowdfunding, and equity-based crowdfunding.

A reward based model facilitates both debt and equity, the borrower sets the interest rate that they are comfortable with and can assure refund of principal amount also with a specific time period. In return for a fund from supporters of a project, the business typically gives some type of rewards. Donation-based crowdfunding is a way to source money for a charity project by asking donors to contribute money to it. Both rewards based and equity-based crowdfunding are appealing options for small and medium-sized companies (SMEs).

Equity-based crowdfunding allows entrepreneurs to reach investors interested in acquiring equity in their start-up or other privately held small business. In equity-based crowdfunding, fund-seeking entrepreneurs give up a portion of the ownership in exchange for the funds. Angelpaisa, Lentra, Crowd invest, Wealth book, Seedex, Private circle, Letsventure are some examples for equity based crowd funding.

Although some platforms are still actively working, there is no proper regulatory framework for equity-based crowd funding and has remained as a grey area awaiting further input from SEBI. While several platforms are operating in this space, there still is a lack of clarity on their authorisation and legal status. As per the draft regulations, only ‘accredited investors’ were permitted to invest, while institutional investors had to own at least 5% of issued shares. The maximum number of individual investors is 200 (excluding QIBs and employees of the company) and only startups less than two years old are permitted to participate. There are restrictions on investment by retail investors with a view to reduce risk.

P2P portal allows individuals and businesses to lend and borrow between each other. Thanks to the IT architecture, P2P platforms can offer low interest rates and an improved lending process for lenders and borrowers. A subtle distinction from a bank is that these fintechs are match makers- matching lenders with borrowers and working on a fee based model. Because of this distinction, P2P lending fintechs do not need to meet the capital adequacy requirements.

P2P may facilitate both debt and equity and Faircent, LoanMeet are the examples of P2P portals. P2P Lending platforms are registered as NBFCs with the RBI and law stipulates minimum net owned fund of Rs. 20 million. As per the regulations, the platform cannot provide or arrange any credit enhancements or credit guarantees, and international flow of funds are not permitted. For lenders, aggregate exposure to all borrowers at any point of time, across all P2P is subject to a cap of Rs 1 million. These online alternative financing instruments are promising for SMEs, but not sufficient to meet all their needs.

For an SME to scale its business it requires risk capital and at the mandate of the Government, financial institution SIDBI has established risk capital fund. The term ‘risk capital’ includes equity as well as mezzanine/ quasi equity financial products that have features of both debt and equity. Quasi/mezzanine finance is mainly a structured unsecured debt with a component of cash income (from interest/ dividend) and benefits from additional potential upside return from equity participation such as warrants, convertibles, options, royalties or over all hybrid structure.

Venture debt is an information-based finance rather than collateral. In the equity-based approach, a critical issue is the exit route for the finance provider, increasing capital market on the two SME exchanges are facilitating exit route through an IPO. More than 450 SMEs have raised equity through IPOs and listed on the SME exchanges. The regulator has provided relaxations in listing fees and compliance for SMEs to encourage the SMEs to for capital market resources for scaling up operations. To facilitate the alternative finance sources for SMEs, there is need for designing regulation that supports a range of financing instruments for SMEs, while ensuring financial stability and investor protection and tax incentives to encourage investments in SMEs. Also, there is a information programmes to increase SME awareness and understanding of various financing options and overall ecosystem for alternate finances.