In unorganized sector in India, there are primarily two routes through which unsecured credit reaches the bottom of the pyramid. It is either through government promoted Self Help Groups (in rural areas) or through private microfinance institutions promoted Joint Liability Groups (in urban and peri-urban areas).
Large Scale Problem
There is dearth of credit products for new and existing unorganized micro ventures. Village entrepreneurs go through perils even after being supported by last mile financiers like SHGs or JLGs.
Case of new micro entrepreneurs
Potential candidates for micro entrepreneurship are mostly daily wage earners. Their risk appetite is low as they do not have alternative source of income like agriculture, livestock etc. They cannot afford to start-up a business on loan, since fixed installments increase their vulnerability.
In organized corporate sector, most popular financial instrument for start-ups is “Equity” – personal savings or funds from friends and relatives in exchange of Equity stake. In fact, Equity finance is most preferred and natural form of start-up finance. Typical financial arrangement is as follows –
In case of unorganized sector esp. micro- enterprises, the financial arrangement is as follows –
Absence of appropriate equity instrument in seed & start-up stage results in “Asset Liability Mismatch”. The ‘variable’ cash inflow from business or asset and ‘fixed’ cash outflow towards liability does not match.
What is required is a mechanism which makes financial arrangement of micro-enterprises as follows –
Therefore, there is need of financial instrument which has nature of ‘Equity’.
Case of existing micro entrepreneurs
Businesses are seasonal in nature – be it an organized corporate or a village micro-enterprise in unorganized sector. Sales of businesses vary as follow (illustrative example) –
The working capital requirement mirrors the sales, as follows –
In corporate sector, banks have a standard product ‘Cash Credit Limit’ (“CCL”) or overdraft facility for businesses. It is effectively a source of funds that can readily be tapped at the borrower’s discretion. CCL provides instant credit to business but limits the maximum draw-able amount, which in most cases is pegged to working capital requirement in high season. Interest is paid only on money actually withdrawn. Businesses in organized sector, therefore, use CCL only when working capital is needed, as per seasonality. Once cash comes in, money is deposited back into CCL account, so that unnecessary interest does not accrue.
No such loan product exists in unorganized micro-enterprise space. Owing to lack of such product, micro-enterprises resort to Term Loan from SHGs and money-lenders for working capital needs. During low season, surplus credit from Term Loan gets used in unproductive activities.
Paying interest on credit, which is not used for business, is detrimental for a business. Situation gets worsened when money, stuck in unproductive activities, is unavailable for pulling out at time of high season, when working capital need is at its peak.
This is a mismatch between Loan Purpose and Loan usage. Loan for unproductive activity ends up being used in alternate (most likely, consumption) activity. On one hand, business fails to leverage and on other hand, it gets hit by fixed overhead interest cost. Therefore, there is urgent need of “CCL Product” for ‘individual’ micro-enterprises.
How can problem be addressed
For new entrepreneurs
For first generation entrepreneurs, there is a need of ‘equity-like’ product. Owing to lack of legal nature of unorganized micro-enterprises, micro scale of operations, absence of books of accounts, the most appropriate financial instrument for them turns out to be “Quasi-Equity” – which is hybrid of Equity and Debt. Quasi-Equity refers to structures of investment that take on the same win-win incentives of a normal equity investment but do not rely on a normal “exit” for investors. The most appropriate Quasi-Equity structure, which fits micro entrepreneur’s circumstances and challenges, is ‘Revenue Sharing’.
In Revenue Sharing arrangement, instead of purchasing ‘equity’ in a company, an investor agrees to receive a percentage of a company’s monthly revenues. Typically, there is a limit on this revenue-sharing agreement that is either a multiple of the original investment amount (say 2x the principal) or the revenue share is limited by a period of time (say 5 years). Where appropriate, it can be a blend of the two. In case of village enterprises, blend of investment amount (nX the principal) and limited period (nX years) is the appropriate repayment structure, which can easily be calculated using algorithm on MVC’s tablets.
Characteristic of Equity in Quasi-equity – Repayment is linked to sales revenue. If business succeeds, repayment continues. If business does exceedingly well, repayment is higher than expected. However, if business fails, repayment is discontinued. The financier shares the risk of failure of business. This considerably reduces the risk of individual micro-entrepreneur.
Characteristic of Debt in Quasi-equity – A regular monthly repayment (linked to sales) ensures that amount is repaid regularly to Financial Institution. The duration of repayment varies as per Expected Return on Investment (ROI) of Financial Institution – based on which nX of principal and nX of years is calculated. The borrower even has the option of buying back whole of equity stake and then stopping repayment.
For existing entrepreneurs
In case of existing enterprises, there is need of CCL/ overdraft kind of product. Based on the nature of business, combination of CCL and Term loan can be offered. An illustrative guidance is provided below –
Based on intelligence of regional businesses and local market, CCL limits and repayment pattern can be set.