GalaTime: Funding Options for Innovative MSMEs in India

galatime.com - Kaushik Gala

Note: The views & opinions expressed in these essays are strictly my own, and not those of any entity I may be associated with as an employee, consultant, promoter, investor, etc.

Funding Options for Innovative MSMEs in India

(Last revised 19-Feb-2010, Send comments to galatime@gmail.com)

(Thanks to @arjunashar for feedback.)

In my previous essay, I guesstimated that there may be ~ 10,000 innovative (M)SMEs in India, worthy of risk capital in the Rs 20 lakh to 2 crore range.

Let us look at the various sources of funding available to these MSMEs today:

Personal savings, friends, family & the like

This is by far the largest source of funds for MSMEs in India. Tapping into personal savings and trying to get a business up & running at the same time is not good for stress. Believe me, I have 'been there & done that' - at Moneyoga. And if that wasn't enough, our business involved day-trading futures & options! As for using family/friends money for risk capital, I won't even bother listing the sorts of trouble you can get into.

Banks

What is it they say about a banker? 'A banker is a fellow who lends you an umbrella when the sun is shining, and takes it away from you when it rains'. There is no shortage of reasons why banks are reluctant to lend to MSMEs, including:

High administrative costs of small-scale lending
Asymmetric information
High risk perception
Lack of collateral

In light of this, the government has tried various means to get banks to lend to MSMEs. SIDBI - Small Industries Development Bank of India - is the best example.

SIDBI

It helps MSMEs in a variety of ways - direct finance, bills/receivables finance, letters of credit, sector-specific loans, etc. Of course, most of these are short-term, collateralized loans - not risk capital in the form of debt/equity.

There are ways in which SIDBI promotes 'riskier' lending to MSMEs, such as:

Provision of credit guarantees up to Rs 1 crore - Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE). This is like insurance for lenders.
Creation of a credit rating agency for MSME - SME Rating Agency of India (SMERA).
Creation of an asset reconstruction company for MSMEs - India SME Asset Reconstruction Company (ISARC).
Creation of a VC firm that provides early-stage & second round financing for MSMEs with a track record of proven technology or business model and opportunities for growth and earnings - SIDBI Ventures. Moreover, SIDBI has contributed to the corpus of over 33 VC funds across India.
World Bank sponsored scheme - SME Financing and Development Project [SMEFDP]- to provide 'riskier' loans, averaging ~ Rs 55 lakh.

SIDBI Foundation for Risk Capital (aka SIDBI Risk Capital Fund)

This is a relatively new effort - a Rs 2000 crore fund that provides long term-risk capital to MSMEs, using structured, convertible, collateral-free debt. This is big - it actually understands the need of Indian MSMEs w.r.t. how much & in what form do they need/want risk capital. It seems SIDBI is still testing the waters - but let's hope this takes off in a big way. The challenges are in evaluating each MSME and creating a customized ('structured') debt instrument.

Angels

Angels & angel networks (eg. Indian Angel Network & Mumbai Angels) are the de-facto targets for 'seed stage' tech startups. What is worth noting is how few deals get funded through these channels. Despite 100+ angels in these formal networks, each year sees only tens of deals. These angels - in turn - have their own HNI/VHNI networks to tap into, yet few startups get funded. Compare that with the US, where angel funding is more than all VC funding. Of course, there's variety of reasons for this: tax benefits, mature ecosystems, risk-seeking, etc.

Venture Capital

There are 137 VC firms operating in India. However, in a boom year, there are only a few hundred deals. That's ~ 3 deals per VC firm per year, on average! Is this really so? If not, what am I missing?

OF course, there have been reports of VCs investing in publicly listed stocks / PIPE deals, etc. - but that's a bit far from their mandate as VCs, one would think. Essentially, there are behaving like Private Equity (PE) companies in India. And why not? If you've raised $100M in the US, brought it to India (~ Rs 500 crore), have a target IRR of 30% and need to put in tens of crores in each investment - where do you invest? Certainly not tech startups - the deal flow is more of a deal trickle! Oh and by the way, you need to justify your '2 & 20' compensation to the LPs. As they say - 'nice work if you can get it'.

Networks / Forums

Several organizations are trying to leverage the Internet for helping MSMEs, eg:

CII's portal for MSMEs
Intellecap's India Development Gateway - an online capital marketplace, a 'targeted collection of resources, access to mentors and experts and connections to the right investors'.

Looking Ahead ...

No doubt, there are many folks trying to address this gap in risk capital, for example:

Early-stage funds such as Erasmic (now part of Accel), SeedFund, Mentor Partners, Ojas Ventures, etc.
Aavishkar which focuses on 'bottom of the pyramid', rural investments, and uses a variety of instruments - common equity, convertible debentures, quasi equity, preferred convertibles, preferred redeemable, mezzanine loans, royalties, etc.
Various incubators (STEPs & TBIs) & state/central government schemes - eg. TDB, TePP, GVFL, KITVEN, etc.
Angel funding framework proposed by Alok Mittal
Various 'incentive' schemes by foreign governments (eg. Belgium/Wallonia, Finland, Canada) - especially their economic development departments
Sector/MSME focused programs by global institutions - eg. World Bank/infoDev

Despite these initiatives, most MSMEs continue to lack access to risk capital, because

The majority of banks prefer collateralized debt, despite availability of credit guarantees
Bank staff is usually bureaucratic, lacks understanding of risks and has no incentive to help MSMEs
Angels & VCs do not have access to exit options, since Indian stock exchanges aren't amenable to listing MSMEs
VCs have too much money when compared with what's needed for an Indian MSME
Most government funding schemes focus more on technology innovators vs. business model innovators
Most government funding schemes suffer from delays, constraints, paperwork, etc.

Of course, MSMEs have their own set of biases that hamper their access to risk capital, such as

Notions of personal empires / family business that make MSME promoters reluctant to share equity
Trader & service provider mentality vs. innovator & product developer mentality
Thinking small, avoiding technology risks, ignoring customer service & branding, etc.
Bad apples that misuse funds from investors/government agencies and make life difficult for everyone else

Bottom-line: Despite various sources of financing, most innovative MSMEs in India lack access to the correct amount, form, speed & quality of risk capital.