ifc.org An Assessment of the State of Risk Capital Finance to the Micro, Small and Medium Enterprise Sectors in India November 2018 IN PARTNERSHIP WITH Creating Markets, Creating Opportunities GOVERNMENT OF JAPAN ACKNOWLEDGEMENTS WBG Team Ashutosh Tandon Swati Sawhney Peer Reviews Niraj Verma Simon Bell Intellecap Team Nisha Dutt Mukund Prasad Amar Gokhale Rishab Parakh Editor: Debashish Mukerji This assessment was conducted and document written for the International Finance Corporation (IFC) by Intellectual Capital Advisory Services Private Limited. The assessment was undertaken with funding support from the Government of Japan. IFC Disclaimer “We note that the study reflects the views of the IFC/ WBG and does not necessarily reflect the views of the government of India and the findings are not binding on the government of India. This publication may contain advice, opinions, and statements of various information and content providers. IFC does not represent or endorse the accuracy or reliability of any advice, opinion, statement or other information provided by any information provider or content provider, or any user of this publication or other person or entity.” Table of Contents ACKNOWLEDGMENT 02 Executive Summary 06 Demand from the MSME Sector 08 Supply to the MSME Sector 09 Venture Debt 10 Unsecured Debt 10 Demand-Supply Gap 11 Recommendations and Potential Interventions 11 Chapter 1 MSME Landscape In India 14 1.1. Importance of the MSME Sector in India 15 1.2. MSME Sector – Definition 16 1.2.1. MSME Sector by Size of Enterprise (Micro, Small and Medium) 17 1.3. Challenges Faced by the MSME Sector 18 Chapter 2 Overview of Risk Capital Finance 20 2.1. Sources of Finance for MSMEs 21 2.1.1. Secured Debt 22 2.1.2. Risk Capital 22 2.2. Evolution of Risk Capital in India 25 2.3. Enterprise Lifecycle Framework 26 Chapter 3 Demand for Risk Capital Finance from MSMEs 28 3.1. Overall Equity Demand from the MSME Sector 29 3.2. Addressable Equity Demand from the MSME Sector 30 3.3. Segmentation of Addressable Equity Demand 31 3.3.1. Breakdown of Equity Demand by Enterprise Lifecycle Stage 31 3.3.1.1. Early-stage Enterprise Segment 33 3.3.1.2. Growth-stage Enterprise Segment 33 3.3.1.3. Mature-stage Enterprise Segment 34 3.3.2. Breakdown of Equity Demand by Enterprise Size (Micro, Small and Medium) 34 3.3.3. Breakdown of Equity Demand by Enterprise Type 35 (Manufacturing and Services) 3.4. Demand for Other Risk Capital Products 37 Chapter 4 Supply of Risk Capital Finance to the MSME Sector 39 4.1. Supply of Risk Capital to MSMEs 40 4.1.1. Equity Investments 41 4.1.1.1. Equity Investment in MSMEs 41 4.1.1.2. Breakdown of Equity Investment by Lifecycle Stage 43 4.1.1.3. Equity Raising Process 46 4.1.1.4. SIDBI Venture Capital Ltd. 49 4.1.2. Venture Debt 50 4.1.3. Unsecured debt 54 4.2. Emerging Models of Risk Capital Financing 57 4.2.1. Merchant Cash Advance (MCA) 57 4.2.2. Crowdfunding 58 Chapter 5 Assessment of the Demand-Supply Gap 63 5.1. Demand-Supply Gap by Enterprise Lifecycle Stage 64 5.1.1. Early-stage Enterprise Segment 65 5.1.2. Growth-stage Enterprise Segment 66 5.1.3. Mature-stage Enterprise Segment 67 5.2. Demand-Supply Gap by Nature of Enterprise (Manufacturing and Services) 67 5.3. Factors Influencing Demand-Supply Gap 69 Chapter 6 Enabling Environment for Risk Capital Finance to MSMEs 71 6.1. Overview of the Enabling Environment 72 6.2. Regulatory Framework and Taxation 73 6.2.1. Investment Regime for Onshore Funds 73 6.2.2. Investment Regime for Offshore Funds 74 6.2.3. Taxation of Investors 76 6.3. Government schemes 76 6.3.1. Credit Guarantee scheme 76 6.3.2. Refinance scheme 76 6.3.3. Government Promote Funds 77 6.4. Supporting Infrastructure 80 6.4.1. Incubators and Accelerators 80 6.4.2. Angel Networks 83 6.4.3. SME Exchanges 83 Chapter 7 Recommendations and Potential Interventions 86 7.1. Catalyze Access to Diverse Risk Capital Providers 89 7.1.1. Unlock Domestic Pools of Capital for MSME Financing 90 7.1.1.1. Commercial Banks 90 7.1.1.2. Pension Funds 91 7.1.1.3. Endowment Funds 92 7.1.1.4. Insurance Companies 92 7.1.1.5. High Net-worth Individuals 92 7.1.2. Promote Innovative Funding Models 94 7.1.2.1. Patient Capital 94 7.1.2.2. Returnable Capital 95 7.1.2.3. Blended Finance 95 7.1.2.4. Government–Private Sector Co-investment 96 7.1.3. Encourage Debt-based Risk Capital 97 7.2. Bolster the Supporting Infrastructure 100 7.2.1. Strengthen Incubation Facilities for Entrepreneurs 100 7.2.2. Bridge Information Asymmetry between MSMEs and Investors 103 7.2.3. Increase Financial Awareness among MSMEs 106 7.3. Foster an Investor-friendly Enabling Environment 107 7.3.1. Ease Exits for Risk Capital Providers 107 7.3.2. Create a Coherent Regulatory and Policy Framework 108 7.3.3. Provide Tax Incentives to Equity Investors 109 Appendices 112 Appendix A – Demand Estimation Methodology 113 Step 1: Estimating average finance demand per enterprise and 113 overall finance demand Step 2: Estimating overall equity demand 115 Step 3: Identifying addressable subset of the MSME universe 115 Step 4: Estimating addressable equity demand 116 Appendix B – Supply Estimation Methodology 117 Appendix C – Proposed Amendments to MSME Definition 118 Appendix D – Details of Primary Research 119 Appendix E – Government Schemes for MSME Financing 121 Executive Summary It is estimated that promoters of more than 22 million micro, small and medium enterprises in India have to rely on their own funds, or loans from friends and family, for capital. These sources, however, are often inadequate or expensive, and act as a constraint on growth. Enterprises need access to institutional sources of debt and equity. However, debt from institutional sources such as banks and non- banking finance companies often requires collateral, which early stage MSMEs and entrepreneurs often struggle to provide. In such cases, there arises a need for equity or unsecured debt – collectively referred to as risk capital. Executive Summary It estimates the gap in the demand and supply of risk capital to the sector, with It is estimated that promoters of more a focus on equity capital (in the form of than 22 million micro, small and medium private equity, venture capital and angel enterprises in India have to rely on their investments). It assesses the relevant own funds, or loans from friends and enabling environment and supporting family, for capital1. These sources, policy infrastructure, and in conclusion, however, are often inadequate or provides recommendations and expensive, and act as a constraint on potential interventions to mitigate the growth. Enterprises need access to demand-supply gap in MSME risk institutional sources of debt and equity. capital financing. However, debt from institutional sources such as banks and non-banking finance Generally, risk capital providers do not companies often requires collateral, rely on the legal definition of MSMEs for which early stage MSMEs and their investment decisions. They place entrepreneurs often struggle to provide. greater emphasis on the lifecycle stage In such cases, there arises a need for of the enterprise. In addition to the equity or unsecured debt – collectively lack of collateral, the absence of referred to as risk capital. contractually agreed returns imparts an additional element of risk to risk capital This study aims to assess the state of investments. To compensate for this risk capital finance to the MSME sector additional risk, the return expected by in India. It focuses on analyzing the risk capital providers is usually higher forms, sources and availability of risk than that of secured debt providers. capital products, such as equity, venture debt and unsecured debt to the sector. Mature Livecycle stage of enterprise Unsecured Debt Private Equity Secured debt Growth Venture Capital Venture Debt Early Risk Capital Angel 12% - 18% 18%-25% >25% Return expectation (IRR) 1 Definition of Micro, Small and Medium Enterprise is based on a maximum cap on investment in plant and machinery and equipment, as defined in the MSMED Act, 2006, WBG - Intellecap Analysis 07 Demand from the MSME Sector equity infusion from external institutional sources. Primary research According to the Annual Report of indicates that from a quantitative the Ministry of MSME, there were perspective, only MSMEs that exceed 55.8 million MSMEs in India as of 20172. certain thresholds of turnover and The overall demand for finance from the annual growth rate can be considered MSME sector in 2017 was estimated at potential enterprises for external USD 1,349 billion (INR 8,771 thousand institutional equity infusion. crore), of which USD 283.3 billion (INR 1,842 thousand crore) was equity Thresholds for estimating demand. Equity demand can be fulfilled addressable demand by three broad sources – friends and Enterprise Turnover Growth family, retained earnings and external Turnover (INR) Rate (Y-o-y) institutional equity capital infusion. However, demand from all MSMEs 25 lac 25% cannot be considered amenable to The addressable equity demand from the MSME sector is roughly USD 44.4 billion (INR 289 thousand crore). The following flowchart indicates the process used to arrive at the addressable equity demand. Debt Demand 1,066 (6,931) Overall Finance Excluded Demand Demand (79%) 1,349 (8,771) 223 (1449) Internal Sources Equity Demand (26%) 283 (1842) 16 (104) Potential Demand Based on leverage ratio of 3.1 (21%) for Early-stage enterprises 60 (393) and 4:1 for Growth and Mature-stage enterprises Addressable Demand Based on turnover and (74%) growth rate of 44 (289) enterprise Addressable Equity Demand Estimation Since early-stage enterprises3 find it Consequently, a mature-stage harder to access debt finance, they tend enterprise demands less external equity 2 Ministry of MSME, Annual to depend more heavily on equity – infusion as compared to a growth-stage Report, 2016 - 17, WBG – Intellecap Analysis which is often provided by informal enterprise4. However, almost 50 percent 3 For this study, a definition of sources. Growth-stage enterprises tend of the MSME sector consists of mature enterprise lifecycle stage to have relationships with financial enterprises. As a result, at an aggregate based on vintage of enterprise has been adopted. Early-stage: institutions which allow them to raise level, more than half the addressable <5 years; Growth-stage: 5 - 10 debt more easily than early-stage ones. equity demand – USD 23.4 billion years; Mature-stage: More than 10 years Mature-stage enterprises tend to have a (INR 152 thousand crore) – comes from 4 Please refer to Table 8 in larger pool of internal accruals and are enterprises in the mature stage. Chapter 2 – Overview of Risk Capital Finance able to access debt capital more easily. 08 Share of Demand 24% 24% 53% 23.4 (152) 10.5 10.5 (68) (68) Early Growth Mature Figure in USD billion; figure in brackets in thousand crore Indian rupees Source: MSME Census, WBG - Intellecap Research Enterprises often need capital to meet short-term growth requirements. However, they often lack the collateral required to raise debt finance. Raising equity is typically a protracted process and may also not be the most cost-effective mode of financing for working capital in such cases. Venture debt and unsecured debt have emerged as products that help meet such short-term working capital requirements. It is estimated that working capital accounts for 30 to 40 percent of the addressable equity demand. Supply to the MSME Sector Risk capital is supplied through various sources in India: Bank NBFCs SIDBI Angels VC/PEs Equity Venture debt Unsecured debt Equity: It is estimated that USD 1.05 billion (INR 6,851 crore) was invested in MSMEs in India in 20175. Almost 70 percent of this was in early-stage enterprises. While there is more risk associated with early-stage investments in enterprises with relatively less proven business models, the growth prospects and the ability of the investor to influence the business model are much higher. Consequently, investors tend to prefer early-stage enterprises to maximize returns. 5 Venture Intelligence, WBG - Intellecap Analysis 09 Share of investment Quality of 69% 19% 12% management team Robustness Alignment of business with model investor Key considerations for equity investors Growth Industry prospects outlook Market access venture debt are customized to the requirement of the enterprise and the 0.73 0.20 risk-return perception of the provider. 0.13 Venture debt providers may also build financing structures that provide them Early Growth Mature with equity-like returns on a portion of Figure in USD billion; figure in brackets in thousand crore Indian rupees their lending. The venture debt supply Source: Venture Intelligence, WBG - Intellecap Analysis in 2017 was roughly USD 140 million (INR 910 crore). Within the early-stage, there is increasing investor interest in pre - No collateral Optimization of revenue, proof-of-concept stage requirement overall cost of capital enterprises. This is partly owing to the Key Benefits emergence of a new class of investors – angel investors such as high net-worth Addresses immediate No equity liquidity needs dilution individuals (HNIs), family offices and successful professionals who have a higher appetite for risk. A mushrooming Unsecured Debt of enabling infrastructure for start-ups, Unsecured debt providers give short-to- such as incubators, accelerators and medium term loans to MSMEs for angel networks, is encouraging and working capital needs, purchase of assisting such investments. equipment, business expansion, and more. Unsecured debt is popularly Venture Debt known as business installment loans Venture debt providers give unsecured or small business loan. The supply of structured loans to early-stage MSMEs. unsecured debt in 2017 was roughly The terms and repayment schedule of USD 6.5 billion (INR 42,000 crore). 10 Demand-supply Gap At an overall level, formal equity Limited sector and invested in MSMEs was only around Sheer size of the geography focus MSME sector of investors 2.3 percent of the addressable equity Reasons for demand-supply demand from the sector in 2017. The gap sheer size of the sector (55.8 million High pervalence of Information enterprises) is a major reason for the informal finance asymmetry high demand-supply gap. Since investors' focus is primarily on among equity investors that mature- early-stage enterprises, the demand stage enterprises have comparatively supply gap is marginally smaller in this lower growth prospects and would not segment as compared with the growth- provide the expected return on stage and mature-stage segments. The investment. gap is most pronounced in mature-stage enterprises, owing to the perception Recommendations and Potential Interventions The large gap in demand and supply presents an opportunity for investors and financiers to expand their reach. But to achieve this, risk capital providers and enterprises will require sufficient support from regulatory/governing bodies and other ecosystem entities. This study highlights potential interventions to augment the various measures taken by policymakers to address the constraints of MSMEs in obtaining risk capital. Some of the interventions that could potentially improve the flow of risk capital to MSMEs are highlighted below. Reommendation to enhance the risk capital ecosystem Catalyze access to diverse Bolster the supporting Foster an investor-friendly risk capital providers infrastructure enabling environment $ • Unlock domestic pools • Strengthen incubation • Create a coherent of capital for MSME facilities regulatory and policy financing • Bridge information framework • Promote innovative asymmetry between the • Provide tax incentives to equity investors funding models MSMEs, investors and • Ease exits for risk capital • Encourage debt-based other stakeholders investor risk capital • Increase financial awareness among SMEs 11 1. Catalyze Access to Diverse Risk role in facilitating the risk capital Capital Providers infusion process. Incubation support It is estimated that only 10 to 15 percent for early-stage MSMEs can help in of institutional equity capital flowing to professionalizing their business and enterprises is sourced domestically. making them investment-ready. While foreign capital is exposed to Government-driven initiatives currency risk, country risk and other focused on incubation such as the global economic factors6, domestic Atal Innovation Mission and the investor sentiment is not substantially Self Employment and Talent Utilization affected by these. Domestic sources (SETU) scheme can act as stimuli for can provide long-term stable capital private sector involvement. The Ministry to MSMEs. Sophisticated domestic of MSME can spearhead programs to investors such as commercial banks, support university incubators. Virtual insurance companies, pension funds, incubation as a concept can be explored endowment funds and HNIs could be to reach entrepreneurs in remote encouraged to invest in the venture locations. capital/private equity asset class. Information asymmetry within the Additionally, innovative funding MSME sector also needs to be tackled structures – such as patient capital, using modern credit assessment returnable capital and blended finance – methodologies, based on alternative that align the risk and return enterprise data such as cash-flows, characteristics of MSMEs to those customer ratings and reviews and trade of investors could be explored. invoices. Credit information and rating Unsecured debt as a form of risk capital agencies should be made more effective for MSMEs can also be expanded by an by expanding data streams for scoring, increased focus on cash-flow based and providing detailed credit-worthiness lending. Financial institutions could be reports to both banks and MSMEs. incentivized to increase lending to Entrepreneurs' lack of financial MSMEs by strengthening the existing awareness can deter them from Credit Guarantee Scheme and exploring external institutional equity promoting robust risk management as a viable source of finance. practices in the Micro Units Entrepreneurship development Development Refinance Agency's institutes such as the National Institute recently implemented scheme. Venture for Entrepreneurship and Small Business debt can be adopted by lending Development, Noida, the National institutions as a special instrument to Institute for Micro, Small and Medium lend to early-stage enterprises that are Enterprises, Hyderabad or the Indian backed by venture capital. Institute of Entrepreneurship, Guwahati, 2. Bolster the Supporting could play an important role in Infrastructure educating them by conducting financial literacy campaigns, awareness programs Supporting ecosystem entities such as and networking events for MSMEs, incubators, accelerators, angel networks especially in Tier-II and Tier-III cities. 6 Concept note prepared by TVS and credit bureaus play an important Capital Funds Limited, 2014 12 Industry bodies like the Confederation of For AIFs to succeed, the regulatory Indian Industry, the Federation of Indian regime for onshore pooling must be Chambers of Commerce and Industry, made favorable to foreign investors. the Associated Chambers of Commerce This will give confidence to domestic and Industry of India and the Federation institutional investors to co-invest and of Indian Micro, Small and Medium thus spur a robust localized fund Enterprises could also take similar management ecosystem. Liberalizing initiatives. sectoral restrictions and enabling the 3. Foster an Investment-friendly automatic route for investments Enabling Environment through SEBI's Foreign Venture Capital Investment regime would allow a Enabling policy and a regulatory greater number of foreign investors to framework are critical to facilitating risk register with SEBI and benefit from the capital financing for MSMEs. This entails relaxation of pricing norms under this developing a favorable domestic regime. This would also enable SEBI to investment climate for risk capital assess the quality of foreign investors investors in terms of operational and extend better oversight on systemic flexibility and regulatory clarity. Market risks. regulator Securities and Exchange Board of India enacted the Alternative Tax incentives to risk capital providers Investment Funds (AIF) Regulations in could also boost early-stage investment. 2012 to delineate different pooling Rationalizing anomalies and hurdles in vehicles for equity investments and taxation would ease investor concerns promote AIFs as a distinct asset class. significantly. A more efficient secondary The introduction of AIFs has created an market through SME exchanges and opportunity for investors to explore new institutional trading platforms could investment strategies through onshore mitigate liquidity risks for investors. In funding structures. A greater flow of case of bankruptcy, a quicker procedure investments from AIFs into MSMEs can of insolvency resolution would also ease help boost local level entrepreneurship investor concerns over exits. ecosystems and help unlock capital from domestic investors. 13 Chapter 1 MSME Landscape in India MSME Landscape in India Key Takeaways • The MSME sector in India comprises 55.8 million enterprises and employs over 124 million individuals. • Enterprises are classified as Micro, Small or Medium based on their investment in plant and machinery and equipment. • The MSME sector contributes to 39 percent of India's gross domestic product and 45 percent of its exports. • Lack of sufficient infrastructure, limited access to technology, talent gap, institutional delays and lack of access to capital are the key challenges faced by the MSME sector. 1.1. Importance of the MSME Sector in India The MSME sector in India has been widely recognized as a critical driver of growth of the Indian economy and vital for employment generation in both urban and rural areas. An IFC study in 2012 estimated the size of the sector at 29.8 million enterprises in 2010. That number has grown to 55.8 million enterprises in 2017 as per the MSME Ministry's annual report for that year7. The MSME sector is estimated to employ over 124 million individuals8. The 11th Five Year Plan refers to MSMEs as ‘instruments of inclusive growth which touch upon the lives of the most vulnerable, the most marginalized people’9. Figure: Growth of MSME Sector 2011–2017, million enterprises 53.4 55.8 51.1 48.8 44.8 46.8 42.9 7 Including activities of wholesale/retail trade, legal, education & social services, hotel & restaurants, transports and storage & 2011 2012 2013 2014 2015 2016 2017 warehousing (except cold storage) for which data were Source: Ministry of MSME, Annual Report, 2016 - 17, WBG - Intellecap Analysis extracted Economic Census 2005, Central Statistics Office, M/o SPI, and reported as part Micro, small and medium enterprises are spread throughout urban and rural India, of the MSME sector starting and account for roughly 31 percent of the country's GDP10. According to the Sixth 2012-13, Ministry of MSME, Annual Report, 2016-17, Economic Census, almost 60 percent of MSMEs are located in rural areas. The MSME WBG-Intellecap Analysis Census notes that the employment intensity of MSMEs in rural areas is more than 8 Ministry of MSME, Annual Report, 2016-17, WBG- 1.5 times that in urban areas – indicating that rural MSMEs employ more people per Intellecap Analysis unit fixed investment than urban ones. Focused development of rural MSMEs can 9 http://planningcommission. thus help to reduce the growing rural-to-urban migration in India. nic.in/plans/planrel/fiveyr/11th /11_v3/11th_vol3.pdf 10 Ministry of MSME, Annual Report, 2016 - 17 15 population translates to a demographic dividend that has the potential to raise Share of per capita income. Developing the Share of Manufacturing Share of GDP Output Exports MSMEs sector in low income states can generate many job opportunities to 31% 33% 45% exploit this demographic dividend. Table: MSMEs by Region Additionally, as can be seen from Table 1, Low Income States account for more Share of MSMEs Region (percent) than 40 percent of MSMEs in the Low Income States13 42 country. India has the world's largest youth population11, but the share of Northeastern States 3 children in the 0-6 age group has been Rest of India 55 12 reducing, especially in these states . Source: Department of MSME The resulting fall in dependent MSME’s contribution to economic growth – global experience Globally, it is seen that there is a high correlation between SME share of GDP and development level of the country. Economic growth in developed countries such as Japan, Korea, Taiwan and many others, has been significantly generated by SME activities. The percentage contribution of SMEs to Gross Domestic Product (GDP)/total value added is 60.0% in China, 57.0% in Germany, 55.3% in Japan, and 50.0% in Korea. In China, SMEs contribute 60% of industrial output volume and 40% of the total taxes and profits realized. SMEs are important drivers of employment generation as well. In the EU, SMEs comprise approximately 99% of an estimated 19.3 million firms and employ 65 million people. SMEs account for between 55% and 80% of total employment in Western Europe, Japan and USA. There are approximately 23 million SMEs in the US which employ more than 50% of the private workforce. In China, SMEs provide 75% of total urban employment. Source: The Role of SMEs in Employment Creation and Economic Growth in Selected Countries http://www.ijern.com/journal/2014/December-2014/39.pdf 1.2. MSME Sector – Definition Micro, small and medium enterprises are defined differently in different countries. The typical criteria used for classification include number of employees, sales turnover and balance sheet size. The World Bank classifies an enterprise as an MSME when it meets two of the following three criteria: Table 2: World Bank Group Definition of MSMEs Enterprise Type / Micro Small Medium Enterprise Size 11 UNFPA's State of the World Number of Employees < 10 < 50 < 300 Population report 12 Census of India ≤ USD 10,000 ≤ USD 3 million ≤ USD 15 million Turnover 13 (≤ INR 6.5 lac) (≤ INR 19.5 crore) (≤ INR 97.5 crore) Low Income States include Bihar, Chhattisgarh, Jharkhand, Madhya Pradesh, ≤ USD 10,000 ≤ USD 3 million ≤ USD 15 million Assets Odisha, Rajasthan, Uttar (≤ INR 6.5 lac) (≤ INR 19.5 crore) (≤ INR 97.5 crore) Pradesh and West Bengal 16 In India, MSMEs are defined according to The Union Cabinet in Feb, 2018 approved the Micro, Small and Medium Enterprises a proposal to change the definition of Development (MSMED) Act, 2006. The Micro, Small and Medium enterprises. definitions are based on a maximum cap According to the new definition, a micro on investment in plant and machinery enterprise is a unit where the annual and equipment (Table 3). Since asset turnover does not exceed INR 5 crore, intensity of manufacturing sector a small enterprise is one where annual enterprises is higher than of those in the turnover is between INR 5 crore and service sector, the Act provides separate INR 75 crore, and a medium enterprises definitions for enterprises engaged in is where the turnover is more than manufacturing and in services. INR 75 crore but does not exceed In 2015, the Ministry of MSME proposed INR 250 crore. In order to give this new amendments to the existing definitions MSME definition into effect, the Section 7 to account for inflation and to ensure of the Micro, Small and Medium that the benefits of MSME-focused policy Enterprises Development (MSMED) Act, initiatives reached a wider array of 2006 will be amended. Hence, for the enterprises. The proposed definition purpose of this study, the MSME sector is raised the capital limits of investment in considered as comprising of enterprises plant and machinery and equipment to that comply with the definition set out roughly twice the existing limits14. in Table 3. Table 3: MSMED Act Definition of MSMEs Enterprise Type / Micro Small Medium Enterprise Size USD 38,000 – Investment in Plant, USD 769,000 – ≤ USD 38,000 769,000 Machinery and Equipment 1.54 million ( INR 5 (≤ INR 25 lac) (INR 25 lac – INR 5 (Manufacturing) crore. – INR 10 crore) crore) USD 15,000 – USD 308,000 – Investment in Plant, ≤ USD 15,000 308,000 769,000 Machinery and Equipment (≤ INR 10 lac) (INR 1 crore – (INR 2 crore – (Services) INR 2 crore) INR 5 crore) Source: MSMED Act 1.2.1. MSME Sector by Size of Enterprise (Micro, Small and Medium) Almost 94.9 percent of MSMEs in the country are micro enterprises, while small and medium enterprises account for around 4.9 percent and 0.2 percent of the overall MSME sector, respectively (Table 4). Micro enterprises include a large number of proprietary firms engaged in the manufacture of food products, textile products, furniture, as well as in activities pertaining to wholesale/retail trade, legal, educational and social services, hotels and restaurants, transport, storage and warehousing15. While micro enterprises are present in other sectors as well, enterprises engaged in activities such as manufacture of chemicals and chemical 14 Appendix C products, fabricated metal products, machinery and equipment, tend to be small 15 MSME Census, 2007; Ministry or medium enterprises. of MSME, Annual Report, 2014 - 15 17 Table 4: MSME Sector by Size of Enterprise Micro Small Medium Share of Enterprises 94.9 percent 4.9 percent 0.2 percent Source: MSME Census The MSME census, conducted with • Limited access to technology: To 2006-07 as the reference year, and the stay competitive, MSMEs need to Annual Reports of the Ministry of MSME, modernize and upgrade are the most authoritative and detailed technologically to enhance sources of data regarding the sector. competitiveness. However, MSMEs These publications form the primary have been constrained by low sources of data for this study. The awareness, low access to emerging methodology for estimating the equity technologies and limited investment demand from MSMEs draws upon the in research and development. It is methodology and assumptions used estimated that MSMEs spend less than 20 during a similar exercise carried out in 1 percent of their turnover on R&D . 2012, the results of which were published • Talent gap: Industrial training in IFC's report on MSME Enterprise institutes and industrial training Finance in India16. centers in the country lack adequate facilities, and there is a shortage of 1.3. Challenges Faced by the skilled labor available to MSMEs. MSME Sector Unorganized hiring and a large The MSME sector's contribution to informal workforce limit internal skill India's GDP has grown from around development and creation of 35 percent in 2007 to around 39 percent management expertise within MSMEs. in 2017.17 Over the years, the government • Institutional delays: India was ranked of India has introduced various schemes 77 out of 190 economies in 2018 on the and policy initiatives aimed at World Bank Group's Ease of Doing incentivizing the development and Business rankings. Although a growth of the MSME sector. However, significant improvement from the the sector continues to face significant earlier rank of 130 in 2016, there is challenges18, as it has over the past still a lack of sufficient aggregated 20 years. The main ones are: information, portals and efficient • Lack of infrastructure: More than processes to secure statutory 16 http://www.ifc.org/wps/wcm/ two-thirds of MSMEs in India depend clearances related to power, connect/region__ext_content/ regions/south+asia/publicatio on electricity for their operations19. environment, and labor in India. ns/msme+report Irregular supply of electricity and a Additionally, enforcing contracts 17 Ministry of MSME, Annual perennial power deficit, especially in remains a big pain point. The Bank Report, 2016 - 17 18 http://pib.nic.in/newsite/ rural and semi-rural areas, Group ranked India at 163 out of PrintRelease.aspx?relid=123934 substantially limits the efficiency and 190 economies in the category 19 MSME Census output of enterprises. Additionally, 'Enforcing Contracts'. Enterprises 20 According to National Science & Technology Management poor transport infrastructure limits face institutional delays right from Information System, easy access to markets–especially starting a business through their Department of Science and Technology, Government of affecting MSMEs engaged in the entire lifecycle. India production of perishable items. 18 • Lack of access to capital: Lack of 60 percent of MSMEs. This implies access to adequate and timely capital, that more than 22 million MSME often caused by insufficient financial entrepreneurs have to rely on information, has been identified as a themselves, their friends and families major challenge for MSMEs21. Formal for capital22 (Table 5). sources of finance cater to roughly Table 5: Share of Enterprises covered by formal sources of finance Micro Small Medium Overall Share of Enterprises 48.7% 76.4% 76.4% 60.6% Source: WBG - Intellecap Analysis, MSME Census • Information asymmetry: The businesses. They thus lack the physical difficulty for MSMEs in accessing assets that are accepted by formal formal sources of capital is largely financial institutions as collateral. because of information asymmetry To supplement the supply of debt between capital providers and capital, the MSME sector also needs an enterprises, the lack of adherence to adequate supply of capital that is formal accounting standards by subordinate to secured debt, and is MSMEs and the lack of adequate willing to bear a different risk-return collateral with MSMEs. Information profile. This study focuses on analyzing asymmetry results from the lack of (a) The forms, sources and availability depth of credit information about of such 'risk capital', with a focus MSMEs with financial institutions. on equity capital. The reluctance of MSMEs to approach (b) The demand for risk capital from formal financing institutions also arises MSMEs at different stages in their from their apprehensions about the growth journey. complicated documentation procedures that such institutions (c) The gap in the demand and supply require23. Additionally, a vast majority of risk capital, with a focus on equity of MSMEs are organized as capital. proprietorships and partnerships24 and (d) The enabling environment 21 MSME Census; Prime often do not maintain financial records (regulatory framework, government Minister's Task Force on MSMEs, January 2010; Report that comply with accounting best plans and supporting infrastructure). of the The Working Group on practices. This creates a perception of MSME Growth for 12th Five Year Plan risk and constrains the supply of formal 22 WBG - Intellecap Analysis, finance to the sector. According to IFC's MSME Census 2006-07 23 2012 report on MSME Enterprise Report of the Committee on Medium-term Path on Finance in India, debt from formal Financial Inclusion, December sources caters to less than 30 percent 2015 24 ~95percent according to the of the debt demand from the MSME MSME Census sector25. More than 75 percent of 25 http://www.ifc.org/wps/wcm/ MSMEs are service sector enterprises connect/region_ext_content/reg ions/south+asia/publications/ms and often operate asset light me+report 19 Chapter 2 Overview 0f Risk Capital Finance Overview 0f Risk Capital Finance Key Takeaways • Equity, venture debt and unsecured debt are three broad sources of external risk capital finance available to MSMEs. • The returns expected by risk capital providers are usually higher than that of secured debt providers owing to an absence of any form of explicit collateral and, in the case of equity, an absence of contractually agreed returns. • Risk capital providers place emphasis on an enterprise's lifecycle stage when making investment decisions. 2.1. Sources of Finance for at some point in the growth journey, MSMEs capital available through internal accruals could prove inadequate and act Every MSME needs to raise capital from as a constraint on growth. At such times, external sources at various points in its the enterprise may need to tap into lifespan to sustain itself and thrive. various institutional and non- The capital raised can be utilized to institutional sources to raise capital in either invest in assets and/or meet the form of either debt or equity26. The working capital requirements. When a particular source and form of finance new venture is started, the entrepreneur accessed by an enterprise depends on uses personal savings and often borrows various factors such as lifecycle stage from friends and family to meet initial of the enterprise, cost of capital, needs. As the enterprise grows, retained ease of access, and the quantum of earnings can meet a part of the finance demand. increasing need for capital. However, Table 6: Sources of financing for an enterprise Form Institutional sources Non-institutional sources Friends, family, chit funds, private Debt Banks,Non-Banking Financial Companies moneylenders, trade credit from suppliers Angel investors, venture capital funds, Equity Entrepreneur savings, retained earnings private equity funds, public markets Capital providers adopt different criteria to make their financing decisions. These criteria are influenced by the differing degrees of risk that the provider is willing to bear and the corresponding return expectations. Broadly, there are two modes of financing – secured debt and risk capital. 26 For operational reasons, equity investments are often structured to have a component of debt, or convertible debt. Such a hybrid structure is also called mezzanine finance 21 Figure 2: Risk-return profile of different modes of financing27 Expected return Equity Venture Debt Unsecured Debt Secured Debt Risk Capital Risk Equity finance is generally more provide secured debt against the expensive than debt finance; however, personal assets of the promoter as a high reliance on debt increases the collateral. financial risk for the enterprise by way of creating an obligation for repayment 2.1.2. Risk Capital and exposing the business to the risk of Equity and collateral-free debt (both default. Consequently, most MSMEs seek plain-vanilla and structured) are a balance of debt and equity finance. collectively referred to as risk capital. The distinguishing feature of risk capital 2.1.1. Secured Debt is the absence of any form of explicit In this financing mode, capital is security. In the case of equity, there is an provided by formal sources to additional element of risk due to the enterprises against an asset as security absence of contractually agreed returns. (collateral) and recovered through As a result, risk capital providers are regular coupon (interest) payments. exposed to an additional degree of This form of finance carries a relatively uncertainty in terms of both principal low degree of risk for the provider. repayment and effective return on The expected return is in the range of capital. To compensate for this 12 to 18 percent28. Secured debt is additional risk, the return expected by 27 provided by financial institutions such risk capital providers is usually higher The graph is indicative and not drawn to scale as banks and non-banking finance than that of secured debt providers. 28 Primary research with banks companies in the form of term loans There are three broad sources of external and NBFCs 29 against property or any other asset. risk capital finance29 available to MSMEs Internal sources such as promoter's personal capital Banks also provide working capital – equity, venture debt and unsecured and reinvested retained finance through products such as cash debt30. earnings are forms of risk capital too. However, this credit and overdraft, which are generally Figure 3 sets out an indicative landscape study focuses on mapping the secured against business inventory, of the various risk capital products external sources of risk capital only financial investments made by available for funding at different lifecycle 30 A structured unsecured debt enterprises or fixed assets. Some product for funding early- stages of the enterprise: stage enterprises non-institutional sources may also 22 Figure 3: Type of funding by lifecycle stage of enterprise31 Meture Lifecycle stage of enterprise Unsecured Debt Private Equity Secured Debt Growth Venture Capital Venture Debt early Risk Capital Angel 12%-18% 18%-25% >25% Return expectation (IRR) 1. Equity investors are generally the earliest Equity financing refers to supplying sources of external equity and often capital to an enterprise in return for an invest even before the MSME starts ownership share in it. Equity holders generating revenues. In addition to hold the residual or junior-most claim capital, angel investors also add value against the assets of the MSME. If the by providing mentorship and MSME is liquidated (goes bankrupt) management support to the MSMEs equity holders are paid out only after all they invest in. Angel investments take other claims against the enterprise have place either through networks/groups been settled. Thus, equity holders are or via a fund mechanism. In the former exposed to the highest degree of risk and the transaction is directly from an consequently expect the highest degree individual to an enterprise, and hence of return for the capital invested. unregulated. In the latter, angel funds are privately pooled from HNIs and Equity investors can be broadly classified governed by the SEBI AIF32 Regulations, into three categories, based on the 2012. lifecycle stage of the MSME they invest in: • Venture Capital firms (VCs): VCs pool capital from different • Angel investors: These are mostly HNI institutional/non-institutional investors, generally successful investors into a fund and this fund professionals or experienced makes investments in MSMEs. The entrepreneurs, who invest their professionals who manage the fund personal capital in early-stage MSMEs. are called General Partners and the The ticket sizes of angel investments investors who pool capital are referred are relatively small (less than to as Limited Partners. VCs typically 31 The chart is indicative and not USD 1 million or INR 6.5 crore). Angel drawn to scale. There may be raise capital with the mandate of investors typically invest as part of a overlaps too, which have not focusing on certain sectors that are been shown for ease of network to ensure both better due representation closely aligned with the expertise diligence and spreading of risk. Angel 33 Alternative Investment Funds possessed by the General Partners. 23 VCs make equity investments in early funding is also known as quasi - equity and growth stage MSMEs. Generally, finance. Although the nature of investment VCs fund an MSME after it has received and lifecycle stage of the MSMEs funded angel funding and/or has started makes the risk similar to equity generating revenues. The ticket sizes investments, the defined repayment of investments by VCs (at roughly structure of venture debt reduces the USD 3 million i.e. INR 19.5 crore) are uncertainty of returns. Consequently, larger than those of angel investors, the return expected (18 to 30 percent) by but smaller than those of PE firms. venture debt providers is lower than that VCs generally insist on representation expected by equity investors. on the board of directors of the MSME 3. Unsecured Debt and are usually involved in strategic A few banks and NBFCs provide decision making. collateral-free debt funding to MSMEs. • Private Equity firms (PEs)33: These This form of debt is commonly known as are similar to VC firms in structure and business installment loan and has a plain form. The key difference is that they - vanilla repayment structure with a fixed generally make investments in the coupon and term. Banks and NBFCs growth and mature stages and invest provide unsecured debt to enterprises a larger ticket size (more than based on criteria such as the profitability USD 3 million i.e. INR 19.5 crore ). track record of the enterprise and its Since PEs generally fund established existing relationship with the bank or businesses, they are exposed to a NBFC. An existing relationship – in the different type of risk as compared form of a current account, overdraft to VCs. facility or a regular term loan advance – 2. Venture Debt provides a degree of security to the lender, though it is not specifically for Venture debt providers give unsecured structured debt capital to early-stage the unsecured advance. This makes MSMEs. The terms and repayment schedule unsecured debt less risky than venture of the capital provided are customized to debt and equity. Thus, unsecured debt the requirement of each enterprise and risk- has lower return expectations than return perception of the provider. Venture venture debt and equity. debt providers may also insist on structures that provide them equity - like returns on a portion of their investment. This mode of 33 Note that venture capital is technically a special form of private equity 24 2.2. Evolution of Risk Capital in India Figure 4: Evolution of risk capital in India 2014: Merchant cash advance and crowdfunding models emerged 2009: Venture Early 2000: Banks debt was and NBFCs started introduced 1999: SIDBI Venture providing Unsecured Capital Ltd. debt to MSMEs 1992: PE industry was formed invested heavily in telecom and IT 2011: Increasing focus on seed and 2004: VC industry early-stage VC 2000: Dotcom started growing investments crash led investors 1996: SEBI Late 1980s: to diversify and regularized the Inception invest in mature-stage VC/PE industry of VC industry In India, the need for venture capital was Till 1992, however, there were only a recognized in the Seventh Five Year Plan handful of funds, with very little private and long term fiscal policy of the participation, and driven mainly by the government. In 1973 a committee on government and the World Bank Group. Development of Small and Medium The nature of risk capital providers in Enterprises highlighted the need to India has evolved greatly in the post- foster venture capital as a source of liberalization era. In the mid-1990s, SEBI funding new entrepreneurs and provided regulatory clarity on Indian technology. The formation of the venture funds and the government of Technology Development and India issued guidelines for entry of Information Company of India Ltd. overseas venture investments into India. (TDICI), promoted by ICICI and UTI, Many foreign private equity funds marked the beginning of VC funding in entered India thereafter. The boom in India. The first VC fund was sponsored the information technology sector in the by Credit Capital Finance Corporation late 1990s and the subsequent telecom and promoted by Bank of India, revolution provided a significant boost Asian Development Bank and the to risk capital providers in India. Commonwealth Development Although investments dropped Corporation. At the same time, Gujarat dramatically after the dot com crash in Venture Finance Ltd. and APIDC Venture 2000, global macro-economic conditions Capital Ltd. were started by state level stabilized by 2004 and fund-raising too financial institutions. Sources of these picked up momentum. Post 2005 there funds were financial institutions, foreign was the concurrent development of institutional investors or pension funds growth-stage private equity investments and high net-worth individuals. and early-stage venture capital 25 investments leading to a growth both in The Biotechnology Industry Research quantity and diversity of capital sources, Assistance Council (BIRAC) has been resulting in investments peaking in 2007. set up as a nodal funding agency for the The global financial crisis substantially biotechnology industry under the ambit reduced private equity investments in of the DBT. BIRAC has launched the SEED India in the subsequent couple of years; (Sustainable Entrepreneurship and however, the trend has been upwards Enterprise Development) Fund to since 2012. The past few years have seen provide equity capital to start-ups and a rise of early-stage focused VC funds enterprises through bio-incubators. and investment in IT and IT Enabled Services, the banking, financial services 2.3. Enterprise Lifecycle and insurance sector, and in health care. Framework In addition to traditional equity Risk capital providers do not rely on investments, new models of risk capital the legal definition of MSMEs, in terms such as merchant cash advance and of investment in plant and machinery, crowdfunding have evolved in the past to base their investment decisions. few years. Interviews with equity investors34 The Government of India has also suggest that they place greater stepped in to support early stage emphasis on the lifecycle stage of the enterprises. The Department of Science MSME. However, there is no definitive and Technology (DST) and the classification of enterprises by lifecycle Department of Bio-Technology (DBT), stage. Factors such as vintage of the have launched schemes in tandem with enterprise, profitability track record and the spirit of 'Start-Up India'. The DST has round of investments all contribute to recently launched the National Initiative defining the stage. Deal databases that for Development and Harnessing track private equity investments also Innovations (NIDHI) Scheme as an typically use enterprise lifecycle stage umbrella program for nurturing ideas classifications in their reporting35. For and innovations. Technology Business the purpose of this study, a definition Incubators (TBIs) have been empowered of enterprise lifecycle stage based on to channelize risk capital to startups vintage of enterprise has been adopted through programs such as the Seed (Table 7)36. Support System and 'Aspire'. Table 7: Enterprise Lifecycle Stage Framework Enterprise Lifecycle Stage Vintage of Enterprise (Years) Early <5 34 Refer to Appendix D Growth 5 – 10 35 Details about investments Mature > 10 made by HNIs and by corporates are often not available in public the domain. Source: Venture Intelligence, WBG - Intellecap Analysis The analysis presented in this study is based on information sourced from deal databases which track reported deals 36 Venture Intelligence deal database 26 Analysis of the MSME Census reveals that almost 50 percent of existing enterprises are mature enterprises (Table 8). Table 8: Enterprises by Lifecycle Stage Enterprise Lifecycle Stage No. of MSMEs (million) Share of MSMEs Early 14.3 25.7% Growth 13.6 24.4% Mature 27.8 49.9% Source: MSME Census, WBG - Intellecap Analysis The classification of enterprises The following chapter focuses on according to lifecycle stage is the analyzing the demand for risk capital primary classification used in the from MSMEs at different stages in their subsequent chapters of this report growth journey – with a focus on equity to segment the demand and supply demand. of risk capital to MSMEs. 27 Chapter 3 Demand For Risk Capital Finance From MSMEs Demand For Risk Capital Finance From MSMEs Key Takeaways • The overall demand for equity finance from the MSME sector in 2017 has been estimated at USD 283 billion (INR 1,842 thousand crore*), out of which † 16 percent (USD 44.4 billion or INR 289 thousand crore) is addressable . • < 1 percent of enterprises in the MSME universe account for the addressable equity demand. • 53 percent of the addressable equity demand comes from mature-stage enterprises. • While small enterprises constitute only about 5 percent of the MSME universe, they account for 50 percent of the addressable equity demand. • While manufacturing sector enterprises constitute only 21 percent of the MSME universe, they account for 75 percent of the addressable equity demand. 3.1. Overall Equity Demand from the Overall demand for MSME Sector equity finance from the The overall demand for finance from MSME sector in 2017: the MSME sector (in 2017) has been estimated to be USD 1,349.4 billion USD 283.3 billion (INR 8,771 thousand crore), of which USD 283.3 billion (INR 1,842 thousand Primary interviews38 with financial 37 crore) is equity demand . The equity institutions and MSMEs reveal that demand can be interpreted as the typically, equity accounts for 20 to 30 amount of annual capital accretion percent of the overall finance demand required by the 55.8 million MSMEs to of MSMEs. Research also shows that for fund operational requirements, invest early-stage enterprises, this proportion in fixed assets and raise additional debt. is higher than that for growth and mature-stage enterprises39. 37 WBG - Intellecap Analysis * USD 1 = INR 65 Figure 5: Overall Finance Demand in MSME Sector, 2017 (USD billion) † Please refer to Section 3.2 – Addressable equity demand from the MSME sector. Estimation of the demand takes into account the 1066 leverage ratio for the stage at 1,349 (6,929) which the enterprise is. A (8,771) certain minimum turnover and growth rate is considered 283 to estimate the addressable (1,842) demand. Please see Appendix A for a detailed description of the demand estimation Total Finance Demand Debt Equity methodology. 38 Figure in brackets is in thousand crore Indian rupees Refer to Appendix D Source: MSME Census, WBG - Intellecap Research 39 Annual finance demand is fulfilled by debt and equity by early-stage enterprises in the ratio of 3:1 and by growth and mature-stage enterprises in the ratio 4:1 29 3.2. Addressable Equity Demand from An analysis of the MSME universe the MSME Sector indicates that less than 1 percent of Equity demand can be fulfilled from enterprises meet the above criteria. three broad sources – friends and family, Owing to their larger size and high retained earnings and external growth rate, these 1 percent enterprises, however, demand a larger quantum of institutional equity capital infusion (both equity per enterprise as compared to the public and private). However, demand average demand from the entire MSME from all MSMEs cannot be considered sector. These 1 percent enterprises amenable to equity infusion from accounted for 21 percent of the overall external institutional sources. Investors equity demand from the MSME sector in make investment decisions based on 2017 – amounting to USD 60.4 billion numerous criteria – both quantitative (INR 393 thousand crore). Further, part and qualitative. Primary research of this equity demand is fulfilled by indicates that from a quantitative internal sources – entrepreneur's equity perspective, only MSMEs that exceed or retained earnings or both. certain thresholds of turnover and annual growth rate are considered An analysis of the capital structure of potential enterprises for external MSMEs suggests that roughly 26 percent institutional equity infusion. It also of the equity demand is met by internal reveals that, in most cases, investors accruals42. This accounts for roughly of equity capital tend to evaluate only USD 16 billion (INR 104 thousand crore) of the potential equity demand of MSMEs with an annual turnover greater USD 60.4 billion (INR 393 thousand than USD 40,000 (INR 25 lac) and an crore). The balance portion of the annual growth rate higher than potential equity demand, i.e. roughly 25 percent40,41 as deserving of external USD 44.4 billion (INR 289 thousand crore) institutional equity. presents an addressable opportunity for 40 Addressable equity investors. Although angel investors often invest in pre-revenue demand for startups, for the purpose of demand estimation from the equity in 2017: MSME universe as a whole, certain minimum cut-offs have been assumed based on USD 44.4 billion primary inputs 41 Roughly 94 percent of MSMEs Figure 6: Addressable Equity Demand Estimation Process are structured as proprietorships and partnerships and hence are Debt Demand not amenable for external 1,066 (6,931) equity infusion. However, Overall finance Excluded Demand interactions with equity Demand (79%) 1,349 (8,771) 223 (1449) Internal Sources investors suggest that legal Equity Demand (26%) structure is not a major factor 16 (104) 283 (1842) Potential Demand in evaluating an enterprise, and conversion to a private (21%) limited enterprise is pre- Based on leverage ratio of 3.1 60 (393) Addressable Demand supposed. Legal structure is for Early-stage enterprises (74%) and 4:1 for Growth and Based on turnover and thus not considered a factor in 44 (289) Mature-stage enterprises growth rate of determining the potential enterprise demand for equity. 42 Financing Firms in India, Allen, Addressable Equity Demand Estimation Chakrabarti, De, Qain, 2007 Figure in USD billion (Figure in brackets is in thousand crore Indian rupees) 30 Figure 7: Addressable Equity Demand from MSME Sector, 2017 (USD billion) 223 283 (1,449) 16 (1,842) (104) 44 (289) Total Equity Excluded Internal Addressable Equity Demand Demand Sources Demand Figure in brackets is in thousand crore Indian rupees Source: MSME Census, WBG - Intellecap Research 3.3. Segmentation of Addressable Equity Demand The 55.8 million MSMEs vary significantly in terms of lifecycle stage, size and sector of operation. Their equity requirements, challenges and their addressability also vary accordingly. This section attempts to segment the equity demand according to these characteristics. Figure 8: Segmentation of Addressable Equity Demand Early Micro Addressable Addressable Growth Stage Size Small Equity Demand Equity Demand Sector Mature Medium Manufacturing Services 3.3.1. Breakdown of Equity critical to identifying demand-supply Demand by Enterprise Lifecycle gaps and interventions needed. Stage Enterprises require equity for different Risk capital providers usually consider purposes at different stages in their the lifecycle stage of the MSME while lifecycle. In the early-stage, MSMEs rely making investment decisions. An almost exclusively on equity capital to analysis of the demand for equity from finance their setup cost and initial enterprises at various stages is thus working capital requirements. This initial 31 equity investment allows enterprises to In the growth and mature stages, generate revenues, establish profitability enterprises need to infuse additional and acquire assets that would enable the equity to make capital investments for enterprises to raise debt at later stages business expansion and fulfill the margin of the business. requirements in raising debt43. Figure 9: Reasons for Equity infusion44 Growth Early Stage Growth Stage Mature Stage Acquisitions Expanding supply chain Business expansion, Working capital addinional capital expenditure Intial cost of assets Working capital and workforce Business development cost Time As mentioned earlier less than 1 percent of enterprises in the MSME universe account for the addressable equity demand (i.e. have an annual turnover greater than USD 40,000 (INR 25 lac) and an annual growth rate higher than 25 percent). This proportion of enterprises is similar across enterprise lifecycle stages i.e. around 1 percent of early-stage enterprises, 1 percent of growth-stage enterprises and 1 percent of mature stage enterprises account for the addressable demand. The MSME universe comprises largely of mature enterprises45. As a result, more than half the addressable equity demand — USD 23.4 billion (INR 152 thousand crore)- comes from enterprises in the mature-stage (Figure 10). Figure 10: Addressable Equity Demand by Enterprise Lifecycle Stage, 43 Financial institutions, when 2017 (USD billion) providing debt, generally 53% require enterprises to partially fund their financing need Share of Demand through equity. This equity is called margin money. Generally, the margin money required by financial institutions is 15 to 25 percent 24% 24% 23.4 of the total financing need. 44 Early-stage enterprises have (152) been defined as enterprises having a tenure of 0–5 years, 10.5 10.5 Growth-stage as 6–10 years (68) (68) and Mature-stage as >10 years. Please refer to Table 7 in Chapter 2. Early Growth Mature 45 Please refer to Table 8 in Figure in brackets is in thousand crore Indian rupees Source: MSME Census, WBG - Intellecap Research Chapter 2 – Overview of Risk Capital Finance 32 3.3.1.1. Early-stage Enterprise • Intermediaries such as business Segment networks, entrepreneurs' associations, incubators and accelerators have Enterprises that are five years old or less mushroomed to assist first time have been considered early-stage entrepreneurs. These intermediaries enterprises in this report. Early stage provide support in terms of mentorship enterprises account for roughly a quarter and connections with investors and of the MSME universe. angel networks46. • Early stage enterprises account for around 24 percent of the addressable 3.3.1.2. Growth-stage Enterprise equity demand, amounting to Segment USD 10.5 billion (INR 68,000 crore) Enterprises having a vintage of more (Figure 10). than five, but less than 10 years, are • Analysis suggests that the average considered growth-stage enterprises. annual demand for equity per Almost a quarter of the MSME universe enterprise from early-stage enterprises consists of such enterprises. is roughly USD 93,000 (INR 60 lac). • Growth-stage enterprises account for • Since early-stage enterprises find it about 24 percent of the addressable harder to access debt finance, they equity demand, amounting to tend to depend more heavily on equity. USD 10.5 billion (INR 68,500 crore) • Equity is often provided by informal (Figure 10). sources in the early stage of an • Growth-stage enterprises incur higher enterprise. Friends and family or capital expenditure for business allied/similar businesses in the expansion and have an increased community or social group often working capital requirement. Such provide initial equity with little or enterprises tend to have relationships no formal arrangement. with financial institutions which allow • There is, however, a growing class of them to raise debt more easily than entrepreneurs who are trying to access early-stage enterprises. formal external equity in exchange for • Primary research indicates that there is dilution of stake, although they often a mismatch in the investors' and typically prefer to retain operational promoters' perception of the valuation and strategic control of the business. of an enterprise in the growth stage. Such mismatch causes delays in the The average annual assessment process and is a challenge demand for equity from while investing in growth-stage an early stage enterprises. enterprise is roughly • Intermediaries such as boutique advisory firms and chartered USD 0.09 billion accountants are often engaged by growth-stage enterprises to assist 46 Please refer chapter on them in raising capital. Enabling Environment for details 33 3.3.1.3. Mature-stage Enterprise • Research shows that entrepreneurs Segment running established MSMEs, especially ones that are family-run, are less Enterprises having a vintage of more willing to cede control of their business than 10 years are considered mature- by giving equity stake to financiers. stage enterprises. Almost half the MSME universe consists of mature enterprises. 3.3.2. Breakdown of Equity • Mature-stage enterprises account for Demand by Enterprise Size around 53 percent of the addressable (Micro, Small and Medium)47 equity demand, amounting to The MSME universe is usually described USD 23.4 billion (INR 152,400 crore) according to the definitions laid down in (Figure 10). the MSMED Act, 2006. This section aims • Analysis reveals that a typical mature- to provide an understanding of equity stage enterprise demands less external demand, segmented according to the equity infusion as compared to a MSMED definition. As seen earlier in this growth-stage enterprise. This is chapter, MSMEs that exceed a turnover because mature-stage enterprises of USD 40,000 (INR 25 lac) and have an tend to have a larger pool of internal annual growth rate of 25 percent are accruals, and are able to access debt considered potential enterprises for capital more easily. However, given external equity infusion. that mature-stage enterprises account for a large majority of the MSME sector, Accordingly, although micro enterprises this segment accounts for more than form about 95 percent of the MSME 50 percent of the addressable equity universe48, they account for only about demand at an aggregate level. 42 percent of the addressable equity demand (Figure 11). Analysis suggests More than 50 percent of that the average demand for equity per enterprise from micro enterprises was the addressable equity close to USD 0.05 million (INR 33 lac) demand comes from in 2017. These ticket sizes are typically mature enterprises perceived as too low by equity investors, as investing such small amounts • Enterprises that have been in operation increases their transaction cost. for more than 10 years and have a However, an opportunity exists in this history of raising formal external debt segment for newer models of raising tend to have their financial books equity such as crowdfunding. Such much more organized as compared to models can be supported by automated early and growth-stage enterprises. procedures to appraise enterprises for This ensures transparency in financial investment suitability by leveraging data dealings, which is an important aspect from sources such as social media and 47 Please refer to Table 3 in for equity investors. However, growth filings with the Ministry of Corporate Chapter 1 (MSME Landscape) for definitions of enterprise rates of mature-stage enterprises tend Affairs. size to be lower as compared to early and 48 Please refer to Table 4 in Chapter 1 (MSME Landscape) growth-stage enterprises, which make for split of MSME universe by mature-stage enterprises less enterprise size attractive to equity investors. 34 Small enterprises for equity investors. Small enterprises constitute 50 percent of the addressable constitute 50 percent of equity demand, although small the addressable equity enterprises comprise only around demand, although the 5 percent of the MSME universe51 MSME universe (Figure 11). comprises of only Medium enterprises have an average ~5 percent small turnover of around USD 7 million (INR 45.5 crore)52. The average demand enterprises from medium MSMEs is estimated to be about USD 0.8 million (INR 5.2 crore). Small enterprises have an average Medium enterprises considered turnover of around USD 1 million addressable are mostly manufacturing (INR 6.5 crore)49. The average quantum enterprises. However, medium of demand per enterprise from small enterprises make up only about enterprises tends to be more than three 0.2 percent of the MSME universe times that of micro enterprises50. The and account for around 8 percent of larger quantum of demand makes small the equity demand. enterprises a more attractive segment Figure 11: Addressable Equity Demand by Enterprise Size, 2017 (USD billion) Share of Demand 42% 50% 8% 22.0 3.7 18.8 (143) (24) (122) Micro Small Medium Figure in brackets is in thousand core Indian rupees Source: MSME Census, WBG - Intellecap Research 49 MSME Census, WBG – 3.3.3. Breakdown of Equity plant and machinery. On the sales side, Intellecap Analysis Demand by Enterprise Type these enterprises are heavily dependent 50 WBG – Intellecap analysis on traders who often buy on liberal 51 Please refer to Table 4 in (Manufacturing and Services) Chapter 1 (MSME Landscape) terms of credit, which increases their for split of MSME universe by Although only about 21 percent of working capital cycles. Additionally, enterprise size 52 MSMEs are manufacturing enterprises53, informal employment patterns call for MSME Census, WBG – Intellecap Analysis they account for almost 75 percent of short cycles of cash flows as workers the addressable equity demand54. 53 Annual Reports of Ministry of are often paid on a weekly or even MSME, GoI 54 Manufacturing sector enterprises tend daily basis. These characteristics of Enterprises classified as manufacturing/services based to have higher finance requirements manufacturing enterprises tend to on the NIC 2-digit industry classification followed by the than service enterprises owing to the increase their requirement for working MSME Census high cost of their fixed assets such as capital. The annual average equity 35 demand from manufacturing enterprises Thus, although a larger proportion of is estimated to be USD 0.1 million manufacturing enterprises clear the (INR 65 lac). Around 60 to 70 percent turnover and growth rate filters used of the equity demand is for capital in this study to identify potential expenditure while the balance is needed enterprises for equity infusion57, resulting for working capital requirements55. in manufacturing sector MSMEs On the other hand, the service sector accounting for a majority of the equity (which accounts for about 79 percent of demand, they are generally less preferred the MSME universe) comprises a large by equity investors because of a number of micro enterprises engaged in perceived lower scalability as compared activities related to wholesale/retail to service sector MSMEs. Manufacturing trade, legal, educational and social enterprises also find it easier to obtain services, hotels and restaurants, debt from traditional lending institutions transport, storage and warehousing56. owing to their inherent capital-intensive Such enterprises tend to have lower nature. Plants and machinery are finance requirements as there is almost tangible assets that traditional lenders no recurring capital expenditure. accept as collateral. Interactions with Over 90 percent of such businesses commercial banks have revealed that have a turnover of less than INR 25 lac they are more likely to finance (~USD 40,000). manufacturing enterprises, even in their early stages, than service enterprises. Figure 12: Addressable Equity Demand by Enterprise Type, 2017 (USD billion) Share of Demand 75p 33.1 25p (215) 11.3 (73) Manufacturing Services Figure in brackets is in thousand core Indian rupees Source: MSME Census, WBG - Intellecap Research 55 WBG – Intellecap Analysis 56 Ministry of MSME, Annual Report, 2014 - 15 57 Please refer to Section 3.2 – Addressable equity demand from the MSME sector 36 Equity Demand by Geography, 2017 Low income states and northeastern states account for roughly 30 percent of the addressable equity demand from the MSME sector in India, although about 42 percent of MSMEs in the country are located in these geographies58. As mentioned earlier, less than 1 percent of MSMEs in India account for the addressable equity demand. In the low income and northeastern states, the share of enterprises accounting for addressable equity demand is barely around 0.6 percent. This indicates that fewer enterprises in these geographies exceed the turnover and annual growth rate thresholds considered to estimate addressable demand. It is estimated that the average turnover of enterprises in these states is roughly 80 percent of those in the rest of the country, owing to a number of factors, including a greater lack of infrastructure, lack of access to technology, and talent gap among other things. Geography Equity Demand ($ billion) Share of Demand Low income states 12.7 (83) 28.6% Northeastern states 0.9 (6) 2.1% Rest of India 30.8 (200) 69.3% Total 44.4 (289) 100.0% Figure in brackets is in thousand core Indian rupees Source: WBG - Intellecap Research 3.4. Demand for Other Risk record of profitability. Since such funding Capital Products mechanisms may carry a higher element of risk, there is a growing need for MSMEs often have short-term working sources of capital that have a higher capital requirements for which raising risk appetite and that can structure equity capital not only often takes too debt according to the risk profile of long, but may also not be the most cost- the enterprise. effective mode of financing. At such times, entrepreneurs prefer to access Venture debt and unsecured debt debt that can be availed more quickly (business installment loans) from and does not lead to dilution of stake. financial institutions have emerged Since access to bank debt, even though as products that help meet such needs. it has been growing, is relatively limited, Such debt-based risk capital products there is a need for alternative forms of can potentially meet some of the MSME debt financing that are more aligned to funding needs for working capital, for an MSME's lifecycle stage, specific need, which equity has traditionally been repayment ability and other factors. sought. It is also estimated that working capital accounts for 30 to 40 percent In particular, MSMEs are increasingly of the addressable equity demand59. demanding debt funding that is linked to A portion of this demand can be business prospects, which can adapt to potentially addressed by other risk future cash flows and is flexible enough capital products (discussed in detail to take into account variations in in Chapter 4). business models, rather than relying 58 Please refer to Table 1 in solely on traditional debt that requires Chapter 1 – MSME Landscape in India tangible assets as collateral and a track 59 WBG – Intellecap Analysis 37 Case Study: Funding lifecycle of an MSME This box presents the financing journey of an MSME engaged in manufacturing technological solutions for the dairy sector in India. Across the lifecycle stages, the MSME has accessed multiple forms of risk capital from from different sources: Early-stage In the initial years, the enterprise relied on internal financing through equity contributions from the promoters. This strategy is called bootstrapping. As the scale of operations was small, the MSME did not want to incur any cost of borrowing from external informal sources. “Having our skin in the game at the start gave us the motivation and flexibility to plan operations well,” says the promoter of the enterprise. Growth-stage As the MSME reached stable cash flows and established a strong brand among local customers, it felt the need for long-term growth funding to make capital investments and replicate its model in other regions. Although dilution of equity was a concern earlier, the promoters believed that bringing in an institutional equity partner would bring financial disciple into the business. Hence, the enterprise raised equity funding a venture capital fund. Besides capital, the enterprise received advice and mentorship from the VC firm, but continued to retain control of strategic and opertional decision-making. “VC equity would give us visiblity inthe market, which is important for future listing in the capital markets,” says the founder. Mature-stage The VC funding enabled the enterprise to scale up rapidly. To continue the pace of growth and gain further market share, the enterprise raised a private equity funding through a hybrid of convertible also accessed a revolving working capital loan (cash credit) from a public sector bank with equity stocks and promoter’s personal property as collateral. This helped the enterprise to build a banking relationship for easier access to secured debt funding in the future. Lessons learnt by the enterprise • Equity funding is a long-drawn process and should be planned well in advance. Else, it may be difficult to sustain the business until the closure of the deal. • Shareholder agreements are complex and may be difficult for entrepreneurs to comprehend fully. Hence, the advice of CAs, lawyers or investment banking advisors should be sought while raising equity. 38 Chapter 4 Supply of Risk Capital Finance to the MSME Sector Supply of Risk Capital Finance to the MSME Sector Key Takeaways • The overall equity investment in the MSME sector in 2017 was estimated at USD 1.05 billion (INR 6.85 thousand crore). • Almost 70 percent of the amount was invested in early stage enterprises. • Quality of management team, alignment with investor mindset, industry outlook and market access are the key qualitative factors considered by investors while making investment decisions. • Venture debt can provide short-term capital to early-stage MSMEs without equity dilution. The supply of venture debt in 2017 was estimated at USD 140 million (INR 910 crore). • Unsecured debt from banks and NBFCs is useful for asset-light MSMEs in raising small ticket size loans. The supply of unsecured debt in 2017 was estimated at USD 6.5 billion (INR 42,000 crore). • Lately, crowdfunding and merchant cash advance have emerged as new risk capital funding models for MSMEs. 4.1. Supply of Risk Capital to MSMEs There are different forms and sources of risk capital supply in India. The matrix below shows the various sources of risk capital and the corresponding modes of financing that are covered in this chapter. Figure 13: Sources and modes of risk capital financing Sources Bank NBFCs SIDBI Angels VC/PEs Secured debt Unsecured debt Modes Risk Capital Venture debt Equity 40 4.1.1. Equity Investments Equity investments in India peaked at over USD 23 billion (INR 150 thousand crore) in 201760. The global financial crisis substantially reduced private equity investment in India from its earlier peak of roughly 17 billion in 2007 in the subsequent couple of years; however, the investment trend has been upwards since 2012, breaching the USD 20 billion mark for the first time since 2015, with a moderate dip observed over 2015-2016, when total investments went from USD 21 billion to USD 17 billion, to swing back to USD 23.61 billion in 2017 (Figure 14)61. Although the investments in 2016 are still the second highest since 2010, the dip was largely due to a slowdown in large consumer technology deals62. Industry sentiment has been positive in India in the last few years and there has been optimism in the investor community. Figure 14: Overall Private Equity Investment in India, USD billion 22.9 23.6 17.1 16.8 14.8 15.2 14.1 11.8 9.5 10.2 4.5 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Source: India Private Equity Report, 2017, Bain & Company, Inc., Venture Intelligence, WBG - Intellecap Analysis 4.1.1.1. Equity Investment in community. For this study, two filters MSMEs have been applied to the overall equity investment to estimate the flow of The bulk of equity investment goes into equity capital into MSMEs: 60 India Private Equity Report, large deals in a few sectors and asset • Investment filter: Investments in 2017, Bain & Company, Inc. light enterprises that have a high 61 Includes PE and VC MSMEs typically have a deal size less potential to scale. New age businesses investments than USD 10 million (INR 65 crore)64. 62 India Private Equity Report, engaged in IT/ITES, BFSI, healthcare and 2017, Bain & Company, Inc. life sciences have accounted for more • Investee turnover filter: Enterprises 63 Venture Intelligence, WBG - with a revenue of less than Intellecap Analysis than 60 percent of the equity 64 Based on primary interactions investments made in India since 2012, USD 15.4 million (INR 100 crore)65. with multiple investors and and over 70% since 2013. In 2017, the sector experts Applying these two filters reveals that 65 Based on primary interactions three sectors combined contributed about USD 1.05 billion (INR 6,825 crore) with multiple investors and 77 percent of the total equity were invested in MSMEs in 2017. This sector experts; and analysis of the MSME census investments in the country63. accounts for roughly 4.5 percent of the corroborates that an overwhelming majority of MSMEs that require comparatively overall equity investments in 2017 MSMEs have a turnover of less smaller investments garnered only (Figure 15)66. than this amount. WBG - Intellecap analysis limited interest from the investor 66 WBG - Intellecap analysis 41 Figure 15: MSMEs’ Share of Equity Investment in 2007 All Equity Investments (USD 23.6 billion, INR 153.4 thousand crore) Investment size filter Filter based on primary > USD 10 million inputs (INR 65 crore) Investee turnover filter Filter based on analysis of > USD 15.4 million MSME Census (INR 100 crore) Investments in MSMEs (US $ 1.05 billion, INR 6,825 crore) Source: Venture Intelligence, WBG - Intellecap Analysis Among MSMEs, service sector innovation in the service sector as enterprises account for a majority of the compared to the manufacturing sector, equity investments. Analysis shows that coupled with success stories of high - as much as 86 percent of the total equity value exits, has attracted more equity invested in the MSME sector in 2017 went to service enterprises. to service sector enterprises. This is Additionally, manufacturing enterprises partly because of the sector focus of the tend to be asset heavy and as a result funds involved. As mentioned earlier, find it relatively easier to raise traditional funds typically raise money from debt as compared to service investors with a mandate for investing enterprises68. The median investment in certain preferred industry sectors. size in the manufacturing sector 67 Apart from traditionally preferred service (USD 2.23 million or INR 14.5 crore) – was, Primary Research 68 Primary Research indicates sectors such as IT/ITES, BFSI and health however, higher than that in the services that banks are willing to lower care, enterprises leveraging mobile sector (USD 1 million or INR 6.5 crore) in margin money requirements for manufacturing enterprises based technologies are increasingly 201769. having adequate financial finding favor with equity investors, history to as little as 10 percent especially with the proliferation of 69 WBG - Intellecap analysis; e-commerce67. A higher degree of Investments classified as manufacturing/services based on industry and sector classifications as per Venture Intelligence deal database 42 Figure 16: Share of Equity Investment to MSMEs in 2017, 100 percent = USD 1.05 billion Services 86% Manufacturing 14% Source: Venture Intelligence, WBG - Intellecap Analysis Equity Investments by Geography, 2017 Low income states accounted for roughly 4 percent of the equity invested in MSMEs in India in 2017, whereas northeastern states saw no investments. Within the former group, more than 89 percent of the investment went to enterprises in West Bengal. Primary research indicates that investors often prefer to focus on enterprises near their own physical location – which is often in metros. A lack of adequate enabling infrastructure such as incubators/accelerators in low income states and a lack of awareness of formal external equity as a source of finance also inhibit investment in these geographies. The high concentration of investors near metros is also indicated in the Rest of India figure, with the states having metros – Karnataka, Maharashtra, Delhi NCR and Tamil Nadu — accounting for almost 78 percent of the equity investment. Equity Investment Share of Investment Geography ($ billion) (as a % of total) Low Income States 0.04 (261) 4% Northeastern States 0 (0) 0% Rest of India 1 (6,590) 96% Total 1.05 (6,850) 100.0% Figure in brackets is in thousand core Indian rupees Source: Venture Intelligence, WBG - Intellecap Analysis. 4.1.1.2. Breakdown of Equity 2017 was in early - stage enterprises Investment by Lifecycle Stage (Figure 17). This share is almost 20 percentage points higher than the As already highlighted, equity investors share in 2012, as the total amount place greater emphasis on the lifecycle invested increased from USD 0.79 billion stage of the MSME to guide their in 2012 to USD 1.05 billion in 2017. investment decisions. Almost 70 percent of the total equity invested in MSMEs in 43 Figure 17: Equity Investment by Enterprise Lifecycle Stage, 2017 (USD billion) Share of Investment 69pe 19pe 12pe 0.73 (4,718) 0.20 0.41 (1,292) (841) Early Growth Mature Figure in brackets is in thousand core Indian rupees Source: Venture Intelligence, WBG - Intellecap Analysis While there is more risk associated with from the demonstrated performance early-stage investments in MSMEs with of the enterprise in using investments relatively less proven business models, received in earlier rounds over a number the growth prospects, as well as the of years. These factors lower the ability of the equity investor to influence perception of risk in investing. Investors the business model, are much higher. are willing to put in larger amounts in As a result, many equity investors prefer such MSMEs. The average deal size of investing in early-stage MSMEs. In the an investment in a growth-stage MSME early stages, the amount of finance was more than twice that in an early- required also tends to be smaller. The stage enterprise in 201770. average deal size of investments made Mature-stage MSMEs often need equity in early-stage MSMEs tends to be smaller to expand their business offerings, enter than those in the growth and mature new geographies or make acquisitions. stages. However, given their longer vintage and MSMEs that progress to the growth business experience, mature-stage stage display greater understanding of MSMEs also tend to have an the business and have an established institutionalized business model and financial track record. Investments in exhibit lower growth prospects. As a growth-stage MSMEs tend to be the result, they attract limited investment. third or fourth round of institutional funding and investors draw comfort Table 9: Average Investment in MSMEs, 2017 (USD million) Enterprise Lifecycle Stage Average Investment, 2017 Early 2.0 (13.0) Growth 4.1 (26.9) Mature 4.0 (26.3) Figure in brackets is in thousand core Indian rupees 70 WBG - Intellecap analysis Source: Venture Intelligence, WBG - Intellecap Analysis 44 Service sector MSME are preferred by equity investors in all three lifecycle stages – with IT/ITES, healthcare, life sciences and BFSI accounting for the bulk of the equity invested in 2017 (Figure 18). Figure 18: Share of Equity Investment by Industry Group (2017) Early Stage Growth Stage Mature Stage IT & ITES 72% 60% 32% IT & ITES BFSI BFSI 4% Food & 11% IT & ITES 21% Food & Beverages 4% Beverages Shipping & Healthcare & 4% Energy 6% 19% Logistics Life Sciences Healthcare & 3% Life Sciences Healthcare & 5% Shipping & 8% Life Sciences Logistics Education 3% Media & Textiles & Agri-business 2% 4% 7% Entertainment Garments Source: Venture Intelligence, WBG - Intellecap Analysis This is partly because of the wider and care and life sciences. This has resulted stronger supporting infrastructure in such MSMEs receiving stronger available to technology based MSMEs mentorship and direct exposure to in the country. The vast majority of potential investors as compared to other business incubators and accelerators in sectors such as manufacturing, India focus on sectors such as IT, health engineering and construction. Angel Investments as a Portion of Early-Stage Investments, 2015-2017 Analysis reveals that there is increasing investor interest in pre-revenue, proof-of-concept stage enterprises. This is partly due to the emergence of a new class of investors — such as HNIs, family offices and successful professionals. Such investors have a larger appetite for risk and are often associated with incubators/accelerators, and provide professional advice and mentorship along with financial support to the investee company. Additionally, with a start-up culture developing rapidly in India, especially in Bangalore and other metro cities, there is a larger breed of young entrepreneurs willing to start a business. Consequently, the capacity of the start-up ecosystem to absorb angel investments has also increased. The share of angel investments, i.e. investments in pre-turnover enterprises, as a portion of investments in early-stage enterprises, has increased at a compound annual growth rate of over 27.2 percent from 2015 to 2017. 92% 86% 87% Other early-stage Angel 8% 14% 13% 2015 2016 2017 Source: Venture Intelligence, WBG - Intellecap Analysis 45 4.1.1.3. Equity Raising Process Equity investors identify and finance MSMEs either through their own sourcing mechanisms or collaborate with intermediaries such as incubators, accelerators and angel networks. Other intermediaries such as chartered accountants and investment banking advisors also help the process. The typical fund raising process can last a minimum of 18–2071 weeks once an MSME has been identified for evaluation (Figure 19). Figure 19: Typical Equity Raising Process Weeks 1-4 Weeks 5-10 Weeks 11-14 Weeks 15-18 Weeks 18-20 Preparation Interaction and Negotiation and Detailed preliminary Deal Preparation of pitch of pitch due-diligence signing term sheet due - diligence closure The pitch document is the first Once the pitch is successful, the equity introduction of an enterprise seeking investor carries out an initial due equity from a potential investor. In most diligence in which he evaluates the cases, the investor decides whether to business plan and financial viability of further engage with the enterprise on the enterprise. This is followed by the basis of the pitch document. negotiations on the deal parameters and Preparation of the pitch is thus the the signing of the term sheet. The term critical first step of the equity raising sheet establishes the intent of both process. The pitch document clearly parties to continue the process. defines the business opportunity, A detailed due-diligence follows, which describes the MSME and its offering, includes assessment of not only the provides an overview of the industry and financials and legal status of the MSME, the competition, lays out the sales and but also other soft aspects such as the marketing strategy, defines roles of extent of alignment of the entrepreneurs management and advisers, details risks with the investor's mindset. Investment and indicates a funding plan. The funding decisions are made based on several plan typically includes detailed allocation factors: of the funds being sought under various heads such as sales, operations, human resources and capital expenditure. Figure 20: Key considerations for equity investors Quality of management team Robustness Alignment of business with model Key investor considerations for equity investors Growth Industry prospects outlook Market 71 Primary and secondary access research 46 • Growth prospects of the firm: It is the risk of being disrupted by important to understand the valuation regulatory changes. Hence investor of the company. The return expectation due diligence includes a detailed by equity investors typically exceeds assessment of the market and 25 percent. regulatory landscape of the concerned • Quality of management team: This is sector, an assessment of market size, a key consideration. Investors tend to intensity of competition and key look for entrepreneurs with either drivers and restraints that affect or substantial experience in the sector could affect the industry. Such an they are venturing into or a proven analysis allows investors to assess the track record of success, backed by long term viability of the business and strong educational credentials. potential exit options. Additionally, investors prefer • Market access: This is a critical enterprises driven by more than one component for an enterprise to promoter to reduce resource establish credibility and demonstrate dependency. the viability of the product or service • Robustness of the business model: offering. Equity investors encourage For investors, this is essential to ensure enterprises to go-to-market as soon as financial viability and sustained possible so as to incorporate feedback growth. They insist on a and tweak the offering if required. comprehensive business plan and Shorter cycles of testing and tweaking analyze its various components closely, the offering in the real marketplace such as value proposition, revenue help the enterprise to come up with a streams, cost structure, customer truly viable offering. This is especially segment, competition, partners and critical in the pre-revenue stage when distribution channels. an enterprise exists purely as a proof- of-concept and/or is associated with • Alignment with the investor: an incubator or angel investor. Investors prefer enterprises backed by promoters who are willing to accept However, as seen earlier, MSMEs investor interventions in management, accounted for only 4.5 percent of the if and when they occur. Investments overall equity invested in India in 2017. are typically made over a period of time Some of the key reasons for MSMEs in pre-decided tranches and such accounting for such a small share are: interventions are subject to mutually • Lack of awareness among traditional agreed upon targets laid out over the MSMEs about external equity as a investment period. Investors formal source of finance. This limits the themselves may themselves be sector number of enterprises actively seeking experts, or may bring in other experts out investments. MSMEs often rely on to protect their investments. informal sources such as friends and • Industry outlook: The state of the family to borrow money to be used as industry is also considered, both in equity in the enterprise72. As seen terms of size of opportunity and earlier, 87 percent73 of MSMEs either 72 Ministry of MSME, Annual regulatory developments. Innovative do not have access to finance or self- Report 2016-17 73 new age businesses often operate at finance their enterprises. Additionally, Refer to Table 5 in Chapter 1 – MSME Landscape the fringe of regulatory reach and run there is a lack of adequate 47 intermediaries such as financial • Inadequate management bandwidth advisers, investor-entrepreneur with MSMEs reduces investor platforms and freely available confidence in the enterprises' abilities information regarding equity investors. to adjust to changing market • High transaction cost is a disincentive conditions and maintain the growth for equity investors from investing in rate. Reluctance of the management MSMEs. Ninety five percent of the team to cede part control and strategic MSME sector consists of micro space to the investor is another barrier. enterprises. Equity investors assess Additionally, MSMEs often do not enterprises from the point of view of follow accounting best practices. This return on investment – which includes reduces transparency and increases the both the actual amount invested and perception of risk, discouraging equity the cost of due diligence. This results in investors. investors avoiding micro enterprises, • Lack of innovation in products and unless their growth prospects are very services offered by MSMEs result in high – which typically is the case only most enterprises operating in a highly with e-commerce start-ups and tech- competitive space. This reduces the based companies. Not all MSMEs are chances of achieving the scale of asset light and thus draw limited growth investors typically look for. interest from equity investors. Inefficient processes and limited market reach limit the MSMEs' growth prospects further. Common issues in the equity fund-raising process MSME perspective Investor perspective 1. Lenthy and cumbersome funding process: 1. Reluctance in ceding control: The Equity fundrasing is a long drawn out misalignment in vision and strategy between process. Many MSMEs lack the management the promoter and investor may affect the bandwith to engage with investors during investment decision. The inability to take that period or sutain their financial needs till investor’s inputs and maintain transparency the point of time that the deal is closed and in communication may also lead to a trust capital is received. deficit between the promoter and investor. 2. High inclination of VCs towards certain 2. Mismatch in valuation expectations: sectors: Most equity investors prefer to Sometimes entrepreneurs are over-confident invest in assest-light enterprises in the of the market opportunity in the sector they consumer technology, healthcare and BFSI operate in and discount the competiton, sectors. Hence, it is gettting increasingly regulatory environment and other difficult for other MSMEs, especially circumstances. manufacturing ones, to raise equity capital. 3. Lack of capacity to absorb capital: 3. Financial savviness of entrepreneur: The Investors prefer enterprises with promoters of tradional MSMEs find it difficult organizational maturity and proper internal to understand complex financial instrument systems and processes. Many MSMEs, and agreements on the term sheet. They especially family businesses, lack the ability also find it difficult to access trusted to deploy the capital productively. The ability intermediaries like CAs and lawyers, Hence, or intent to scale may be absent in the many promoters fail to close an equity deal. promoter, making it less attractive for investors. 48 4.1.1.4. SIDBI Venture Capital Ltd. Besides VCs and PEs, SIDBI Venture Capital Ltd., the venture investment arm of the Small Industries Development Bank of India, provides equity funding support to MSMEs through funds that have specific investment objectives and target sectors. SIDBI has invested in more than 88 venture capital funds, indirectly funding more than USD 873 million (INR 5,675 crores) to more than 472 MSMEs. SVCL, incorporated in 1999, has invested in around 90 MSMEs from diverse sectors. SVCL has generated an internal rate of return of 15 to 17 percent from the funds it has exited. Figure 21: SIDBI Venture Capital Ltd. Funds 1 2 3 4 5 6 7 India National Maharashrta West Bengal SME Growth Venture Fund for Samridhi Fund Opportunities TEX Fund Fund Fund Fund Software and INR 450 Cr. Fund INR 200 Cr. INR 200 Cr. INR 200 Cr. INR 500 Cr. IT Industry INR 450 Cr. INR 1,000 Cr. 1. Samridhi Fund: This fund invests in The fund has a life of seven years social enterprises in Bihar, Uttar and the average ticket size is Pradesh, Madhya Pradesh, Orissa, INR 1–3 crore. Chhattisgarh, Jharkhand, Rajasthan 4. Maharashtra State Social Venture and West Bengal. It is a closed-ended Fund (MS Fund): It identifies and fund with a life of seven years. The funds early-stage social ventures in focus sectors include water and Maharashtra that are profitable and sanitation, affordable healthcare, have an innovative and inclusive agriculture and allied services, clean business model. It is registered as a energy, financial inclusion, education, Category-I AIF and has a life of seven and skill building. The ticket size is – years. The holding period is four to INR 5-25 crore and the holding period five years and the ticket size is up to a is 3-5 years. The contributors to the maximum of INR 25 crore. fund are the United Kingdom's 5. West Bengal MSME VC Fund: It Department of International invests in enterprises that have Development (85 percent) and innovative business models, and high SIDBI (15 percent). potential to scale. The fund is a 2. India Opportunities Fund: It funds closed-ended one with a life of six high-growth MSMEs operating in years. The West Bengal government emerging sectors such as clean-tech, contributes 50 percent of the total light engineering, agro-based corpus. The investment in each industries, logistics, educational company is limited to INR 9 crore. services, and IT/ITES. It is a closed- The fund is sector-agnostic, but ended fund with a life of 10 years. preference is given to women 3. TEX Fund: It invests in early and entrepreneurs. growth-stage MSMEs engaged in textiles, power-loom and allied businesses such as production machinery, weaving and processing. 49 4.1.2. Venture Debt While equity financing is essential as long-term growth capital, venture debt Need may be a better alternative than equity Access to capital is now well-recognized for meeting transitory cash flow as a key challenge facing MSMEs. mismatches or making small capital However, as the evolution of risk capital investments. Some of the reasons for in India has shown, there is growing this include: recognition that access to capital has 1. The process of structuring equity two dimensions: (a) the amount of investment is an involved exercise and capital raised and (b) the characteristics generally takes a long time to close. (holding time, cost, ease of raising it) associated with the capital. Many 2. Cost of venture debt is generally MSMEs find it difficult to raise secured lower than cost of equity. debt and, at the same time, are not 3. Venture debt plugs the gap between willing to accept the dilution of control the investment capability of angel that additional equity raising entails. investors and average ticket size of Venture debt has emerged as an venture capital funds. additional source of risk capital supply 4. Equity financing to meet temporary for such MSMEs. working capital requirements leads to Venture debt providers typically target dilution of ownership, which may not venture equity-backed companies which be in the best interest of the MSME lack the collateral or other criteria entrepreneur. Even when venture required for secured debt financing, or debt is used to meet growth capital want greater flexibility in repayments74. needs, an entrepreneur may benefit Venture debt is generally structured as a by deferring the equity raise to a later 2-to-3-year loan with a limited equity date. kicker in the form of warrants of company stock. Figure 22: Key benefits of venture debt No collateral Optimization of requirement overall cost of capital Key Benefits Addresses immediate No equity liquidity needs dilution 74 In some cases, venture debt is also provided to early-stage MSMEs that have not raised external equity as well as to MSMEs that are in the growth or mature stages 50 Research by Kauffman Fellows indicates that enterprises which raise venture debt and deploy it to achieve critical business milestones benefit from increase in valuation in subsequent equity rounds. (Figure 23): Figure 23: Valuation curves with and without venture debt75 Valuation Equity only Venture debt plus equity Venture Equity Time debt round Source: Kauffman Fellows: Venture Debt: A Capital Idea for Startups Venture debt funding allows MSMEs to warrant or an equity kicker that allows accelerate business growth until there is the provider to participate in future a need for long-term equity infusion. profits of the MSME by converting a This creates the potential for greater portion of the debt into equity (generally valuation during the next equity round 2 to 5 percent). Repayment may also of funding. As shown in Figure 23, follow a tranche model wherein debt is enterprises can 'time' their subsequent repaid as certain business performance round of equity financing with venture metrics are achieved. The following debt funding. MSMEs can leverage this figure shows the common features 'extended runway' that venture debt across venture debt investments in India: provides to scout for and select the best- fit equity investors. This is important Figure 24: Features of venture debt76 because compared to a debt provider, an equity investor stays invested for a longer term and requires a higher return Interest Ticket Tenure on capital invested. Rate Size Venture debt is normally structured as 6 months to 18 - 24 % INR 1-10 crores 3 years a term loan, and both the tenure and repayment schedule are customized to the requirements of the MSME. Most venture debt investments also have a 75 The chart is for indicative purpose only 76 WBG - Intellecap research 51 Venture debt companies prefer to lend to Due-Diligence enterprises that are not served by banks Venture debt companies generally follow or NBFCs – in order to take on the role a due-diligence process that is more of senior lender. By doing so, they ensure extensive and ‘equity-like’ as opposed to that they get first preference in recovery that generally followed by banks and in the event of liquidation. Most venture traditional NBFCs. The average time debt providers also differentiate taken by venture debt providers to themselves from traditional lenders by assess an enterprise is two months. having fewer covenants and providing Generally, a venture debt provider flexible repayment schedules, giving funds 10 to 15 percent of the enterprises enterprises the room they need to make it evaluates78. During the due-diligence medium-term strategic investments. process, venture debt providers prefer For example, enterprises may be given the following characteristics in an extended moratorium periods at times of enterprise: large expenses, allowing the enterprise 1. A completed round of equity funding to remain focused on achieving business by angels or venture funds goals. In case an enterprise is about to go for an equity round of financing 2. Experience, education and delivery immediately after the venture debt capability of promoter(s) and tenure, the loan term may be structured management team such that a majority of interest 3. An innovative, viable and scalable payments are 'loaded' towards the end. business model As the chart below indicates, venture 4. Stabilized drivers of revenues, debt offers a good balance between expenses and cash flows return flexibility and equity dilution 5. Established path to profitability even of stake relative to other types of risk if the MSME is not profitable at the capital. time Figure 25: Return flexibility versus Equity dilution77 High Equity Return flexibility Venture debt Secured debt Unsecured debt Low No dilution High dilution 77 The chart is indicative and not Equity dilution drawn to scale 78 WBG - Intellecap primary research 52 Venture debt is best suited for In India, the venture equity ecosystem enterprises that are between two rounds has reached maturity level where many of equity investments. There is a need to innovative enterprises are attracting have more granularity in terms of ticket equity funding at an early-stage. This sizes in order for this type of capital to has created the necessary environment address demand from enterprises in to spur the development of the venture various growth stages. debt market to meet the funding gap Venture Debt in India between the angel and venture capital rounds. A total of about INR 910 crore, Global experience has shown that or about USD 140 million was available development of the venture debt market as venture debt to MSMEs in India over lags the venture equity market by a calendar year 2017. It is estimated that decade. In the West, venture debt began the venture debt market in India could in the mid-1990s and has now become a grow to USD 1 billion (INR 6,500 crore) mature asset class, comprising around by 202279. 10 percent of the venture capital ecosystem. Below are a few details of three major venture debt specialists in India – The venture debt IntelleGrow, Innoven (formerly known as supply in 2017 was Silicon Valley Bank) and Trifecta Capital: almost USD 140 million Table 10: Analysis of venture debt specialist companies in India IntelleGrow InnoVen (SVB India) Trifecta Structure NBFC NBFC AIF - Category II Cumulative loans disbursed (till Feb INR 1000 crore INR 7,290 crore INR 500 crore 2018) Total No. of disbursals 520 ~200 25 Ticket size INR 0.5-7 crore INR 5-20 crore INR 5-30 crore Average interest rate 19% 18% 16% Tenure 12-36 months 6-36 months 12-36 months Sector agnostic, Preference VC-backed technology Focus areas are education, is for impact sectors such enterprises in healthcare, Target sector / healthcare, financial as financial inclusion, consumer technology, companies services, digital media, healthcare, sanitation, logistics clean tech and analytics education and water Provide working capital Improve valuation for next Subscribe to senior secured Value proposition loan for early stage, high round of equity funding debentures of investees growth startups Lends independent of VC Co-Invests along with equity Invests in companies investment. Independent Investment timing infusion by VC funds. Lends that have raised Series cash flow analysis based 15-20% of equity investment A or B round of funding lending Projected cash flows, Warrants, partly-paid Comfort derived Cash flow generation and future equity raise and shares, equity kicker from warrants of 10% loan value equity kicker of 1.2% of 10%-20% of loan value Source: InnoVen Capital Press Release, Feb 2016, http://articles.economictimes.indiatimes.com/ 2015 - 12 - 01/news/68688492_1_venture - debt - saif - partners - rs - 500 - crore, 79 http://articles.economictimes.indiatimes.com/2015 - 12 - 01/news/68688492_1_venture - debt - saif - partners - rs - 500 - crore, IntelleGrow InnoVen Capital Press Release, May 2015 53 The success of venture debt in India, Under this plan, SIDBI funds MSMEs that inferred by the increasing number of have started generating revenues and startups raising venture debt for issues have a clear profitability roadmap, even from working capital requirements to though they may not be generating multichannel marketing for primarily profits right then. SIDBI also prefers ecommerce based companies, has led enterprises that have market-accepted to a number of new venture debt funds products, and conduct business with being announced. These include large enterprises. It targets asset-light INR 1,000 crore venture debt funds like sectors like web/mobile based solutions, Alteria Capital, started by ex-InnoVen biotechnology, and social ventures. SIDBI members, and new venture debt fund has also partnered with the IT industry announcements by Unicorn Ventures, body, the National Association of IvyCap Ventures, Anicut Capital, and Software and Services Companies and IntelleGrow80. Other organizations TiE for conducting due diligence and help offering debt funding to early stage investee enterprises with technical companies in India include Bengaluru- know-how, business mentorship and based Capital Float, Chennai’s IFMR other handholding support. Capital, and Lendingkart from Ahmedabad81. 4.1.3. Unsecured debt Besides these private sector players, Need SIDBI too offers venture debt through its As noted earlier, many MSMEs find it Start-up Assistance Scheme (SAS)82 for difficult to access regular secured debt early-stage enterprises. SAS aims at funding from banks due to lack of providing venture debt to early-stage collateral, strict financial covenants, MSMEs, between one and five years old. and the requirement of detailed Financing can be structured in a way documentation of their financial track that it has an 'equity kicker' component record. The risk-evaluation process of 1 to 2 percent equity on paid-up capital adopted in secured debt funding at par83. The financing is aimed at disqualifies many MSMEs which may enabling the MSMEs to scale up and reach operational stability. Such Unsecured debt is 80 MSMEs can then comfortably attract useful for asset - light http://www.business- standard.com/article/specials/ mainstream debt or equity finance. MSMEs in raising small from-capital-to-good- demand-here-s-what-is- The following figure shows the features ticket size loan driving-venture-debt-in-india- of SAS: 118020800065_1.html 81 have the cash flow to service the debt https://www.vccircle.com/ 84 venture-debt-firm-trifecta- Figure 26: Features of SAS by SIDBI but do not fulfill the other criteria. While capital-backs-agri-marketing- most banks have a cash - credit/ startup-ninjacart/ 82 The interest rate is overdraft facility, accessing it generally approximately 14 to 16 requires collateral (property or percent; it may vary Interest Maximum Tenure depending on the internal Rate Ticket Size inventory) and an existing relationship rating and due - diligence with the bank. Also, the debt tenure is 83 https://www.sidbi.in/sites/ Up to 7 years 14% - 16% INR 1 - 3 crore default/files/SIDBI_Ebrochure_ generally very short and the amount start_up_assistance.pdf allowed is restricted by the deposit that 84 Ibid. the enterprise has with the bank. 54 However, a few banks and NBFCs have The chart below shows the split of also started offering unsecured debt unsecured debt customers by their funding as an alternative collateral-free ownership structure: credit facility that is suited to the needs of MSMEs. Unsecured debt provides Figure 28: Ownership structure of MSMEs that access unsecured short-to-medium term funding to debt funding87 MSMEs for working capital needs, purchase of equipment, and business expansion. It is popularly known as 10% business installment loan or small 20% business loan. Features Unsecured debt funding has certain 40% advantages over secured debt funding, 30% such as no collateral, faster approval process and less documentation of financial history. The following figure shows the typical features of unsecured debt products by banks and NBFCs in Self-employed professionals India: Proprietorship 85 Figure 27: Features of unsecured debt Partnership Private Ltd. As can be seen, enterprises structured as proprietorships or partnerships, Tenure Interest Maximum Minimum which are not amenable to external Rate Ticket enterprise equity infusion, are the major customers Size age of unsecured debt. These include INR 0.1 - 1 traditional businesses such as 1 - 3 years 15% - 20% 3 - 5 years crore retail traders, distributors, small Banks have the option of covering a part manufacturers, restaurants and of their unsecured lending portfolio different service providers. under the Credit Guarantee Fund Trust Due-Diligence 86 for Micro and Small Industries plan. Most financial institutions providing This facility enables them to manage unsecured debt have a standardized their portfolio risk and also to reduce underwriting process as shown as 85 WBG - Intellecap research the risk premium for lending. NBFCs follows: 86 Please refer to the chapter on are not covered under CGTMSE and enabling environment for details on CGTMSE generally have an interest rate that is 87 The chart is prepared based on 2 to 3 percent higher than that of banks. primary interviews of a total of 14 banks and NBFCs and NBFCs, however, offer quicker may not be representative of turnaround time – around 4 to 10 days – the entire sector. Note that venture debt is included as a to sanction loans as compared to banks, subset of unsecured debt. which take 2 to 4 weeks. 55 Figure 29: Due-diligence process followed in unsecured debt funding Personal discussion Review of Assessment of Business metrics- by credit officers, repayment record, existing obligations product margin, KYC documents, bank statement, and cash outflows inventory etc. credit score business financials The eligibility criteria include review of Unsecured debt in India the borrower's tax records, credit bureau More than 20 financial institutions rating and business plan, with a focus on (banks and NBFCs) provide unsecured profitability track record and stability of debt to MSMEs in India. It is estimated cash flows. In some cases, the business that unsecured debt amounting to performance metrics are also evaluated USD 6.5 billion (INR 42,000 crore)89 against industry benchmarks. Financial was provided to enterprises in 2017. institutions place a significant emphasis on the debt service coverage ratio88 The supply of of MSMEs to assess the ability of the unsecured debt in 2017 MSME to adhere to the repayment was roughly schedule. The acceptable industry USD 6.5 billion norm is a DSCR of 1.5 to 2. The following table shows some of the major banks and NBFCs in India that provide unsecured debt: Table 11: Major financial institutions that provide unsecured debt90 Financial Ticket size Tenure Interest Minimum turnover Minimum Profitability Type Institution (INR)h (Years) rate (INR) enterprise age track record Up to 1-3 16.25%- 3 years 2 years HDFC Bank Bank 40 lac 15 lac 19.75% RBL Bank 10-35 lac 1-3 NA 1 crore 3 years 3 years Standard Up to 1-4 17.5% Bank NA NA NA Chartered 30 lac onward Deutsche 10-50 Base rate Bank 1-3 NA 3 years NA Bank lac + margin MAGMA 3 lac - Manufacturing: NBFC 1-4 15%-20% 5 years 2 years Fincorp 2 crore 40 lac; Services: 15 lac Bajaj FinServe NBFC 5-30 lac 1-3 15%-20% NA 2 years NA Tata Capital NBFC 3-50 lac 1-3 NA 40 lac NA 3 years 88 DSCR = Net operating income/ (Principal + Interest + Lease Besides banks and NBFCs, SIDBI also offers unsecured debt through its Growth payments) 89 WBG - Intellecap primary Capital and Equity Assistance Scheme (GEMS) for MSMEs. The debt is quasi-equity research in nature (subordinated to bank debt and with an equity component). It offers 90 The data has been sourced from the websites of the flexibility in debt repayment by providing a principal moratorium period up to three financial institutions listed in years and a one-time cure period91 of six months. The structures by which the the table 91 funding is provided under this scheme include: Cure period refers to a penalty- free timeframe offered in the event of default to the borrower to defer the payment of arrears and avoid legal recovery procedures 56 1. Subordinated debt: A debt of cash flow predictability instead of instrument that ranks lower than asset cover. The first lien on the assets bank debt (senior debt) with regard purchased from the funding belongs to claim on assets or earnings of the to SIDBI. enterprise in the event of bankruptcy. 2. Participatory debt: Royalty on sales 4.2. Emerging Models of Risk or convertible structures and equity Capital Financing warrants that enable participation in There are other forms of risk capital that future payoff. are emerging to meet specific demands 3. Convertible preference equity: of MSMEs. Two such products are Preference shares that earn regular discussed here: dividends and have the option to be converted into common equity 4.2.1. Merchant Cash Advance whenever a pre-determined event (MCA) is triggered. Need The objective of this scheme is to provide Working capital forms the major long-term funding to growth-stage financing need of MSMEs operating as MSMEs which are looking to expand, retail merchants. However, such MSMEs modernize their plant and machinery, find it difficult to access traditional or diversify into a new business line. banking products for working capital – The plan also aims to finance non-asset cash credit and overdraft – due to generating investments such as product collateral requirement, need for strong development, marketing, R&D and financial track record keeping and quality control. The funding is in the unpredictable nature of its cash flows. form of structured debt. The following The need for operational liquidity is often figure shows the features of GEMS: at relatively short notice (matter of days) and cannot be met by banks within the Figure 30: Features of GEMS by SIDBI92 required timeframe. Hence, there is need for an alternative form of risk capital characterized by relatively small ticket size, short duration and quick Interest Ticket Tenure Rate turnaround to help retailers meet Size up to 7 liquidity shortfalls. INR 1 - 15 15% years crores Over the past few years, Merchant Cash Advance has emerged as an innovative Under this plan, SIDBI funds MSMEs with solution for meeting the working capital at least three years of profitability and needs of retail merchants. MCA providers two years of satisfactory bank records. are NBFCs that offer merchants a short- Although SIDBI engages a third-party for term unsecured loan without a fixed due-diligence, it prefers funding MSMEs repayment schedule. The repayments which have had a previous round of are linked to future sale receipts that equity funding by a venture capital firm. are generated when customers transact 92 SIDBI Growth capital and The credit evaluation is done on the basis using their debit/credit cards at the Equity Assistance Scheme brochure 57 merchant location. This mechanism Due-Diligence has the following advantages: MCA funders carry out a credit 1. A dynamic tenure, tailored to align assessment of retailers based on their with business cash flows. This PoS based transaction history over the provides a cushion to the merchant past 6 to 12 months, analysis of their during periods of low sales. bank account statements and tax 2. Merchants are able to build credit records. These inputs are used to predict history to access larger size debt future sales and determine both the from banks in the future. quantum of loan and its pricing. 3. Risk to the MCA provider is reduced Merchant Cash Advance in India because of the relatively high The major MCA providers in India are frequency of repayment NeoGrowth, IntelleCash and Capital (daily/weekly/fortnightly) and Float. The estimated supply of merchant availability of real-time sales data. cash advance in 2017 was nearly 4. The electronic collection mechanism INR 2,000 crore (USD 308 million), lowers the cost of cash management having grown almost 100% over 2 years. for the MCA provider. Apart from brick-and-mortar merchants, online merchants have also started Funding Model accessing loans from MCA providers. Repayment amount is defined as a pre- agreed share of transaction receipts Figure 32: Features of merchant cash generated at a merchant's Point-of-Sale advance in India93 machine. As and when a customer transacts at the merchant's PoS, the funds from the customer's bank are Interest Ticket automatically credited to an escrow Tenure Rate Size account managed by the issuer of the 6 months - 1 1% - 2% per merchant's PoS machine. Before these INR 50 lac year month funds are credited to the merchant's bank account, the pre-agreed percentage share (typically 5 to 10 4.2.2. Crowdfunding percent) is credited to the MCA lender. Need The basic model is illustrated below: Very early-stage enterprises, which have not yet started generating revenues, Figure 31: Merchant Cash Advance funding model may need a small amount of risk capital to develop a product prototype or pilot Funder for the business idea. Such enterprises often find venture capital or even angel ce % funding unsuitable, because of van Cu to difficulties in access and the long time Ad fS h Cas al es taken for deal closure. The funding requirements of these start-up Sales on PoS enterprises may also be below the radar 93 WBG - Intellecap research Merchant of these investors. Moreover, the Escrow account 58 enterprise is less likely to receive bank without the intervention of debt following lack of a tangible asset traditional financial institutions such base and relatively short existence. as banks and NBFCs. There are around An alternative funding mechanism, 30 P2P lending platforms in India95. popularly known as crowdfunding, Some are involved in the microfinance has emerged to address this funding business with the stated primary opportunity in early-stage enterprises. goal of social impact and providing These platforms enable enterprises to easier access to credit to small solicit funds from multiple investors entrepreneurs. They provide a web- through a virtual platform. based platform to bring lenders and Crowdfunding provides a new borrowers together. One of the main investment avenue and portfolio advantages of P2P lending for diversification for investors. borrowers has been lower rates than Crowdfunding is an innovative way those offered by moneylenders and to provide low-value funding to budding the unorganized sector in general. entrepreneurs who need seed capital The advantages for lenders are or rapid-growth enterprises in their higher returns than those offered early stages. by conventional investment opportunities. Interest rates and the Models methodology for calculating those The following figure shows the different rates vary among P2P lending crowdfunding models being used platforms. They range from a flat globally. Among the three models, peer- interest rate fixed by the platform to to-peer lending, also called P2P lending, dynamic interest rates as agreed upon and equity crowdfunding, fall under the by borrowers and lenders to the cost domain of risk capital funding. plus model (operational costs plus 1. P2P Lending: Online P2P lending margin for platform and returns for companies work as marketplaces lender). The interest rates vary from that bring individual borrowers and 16 to 24 percent, while ticket size lenders together for loan transactions varies from 10,000 to INR 25 lac96. Figure 33: Various models of crowdfunding94 1 2 3 Donation-based Equity-based P2P Lending crowdfunding crowdfunding To raise fund in exchange To raise fund in exchange for To raise fund as a debt Objective for tax exemptions or owernship in the project/ instrument from individuals intangible rewards organization 94 IOSCO Staff Working Paper- Crowd-funding: An Infant Global Industry Growing Fast, 2014, examples WBG-Intellecap research 95 http://articles.economictimes .indiatimes.com/2016 - 01 - 28/news/70150353_1_peer-to- India EVERY % COUNTS Beta peer-lending-moneylenders- examples borrowers 96 Ibid 59 It is estimated that around 20 crore P2P Lending platforms in India are Indian rupees of risk capital have been classified as NBFCs and need to be provided through P2P platforms in registered as such. In most of the cases, India97. There is a growing demand for crowdfunding is sought online on the raising funds through P2P platforms basis of future projections rather than in India because of its ability to a viable business model in operation, provide small ticket size debt funding which increases the risk for investors. at the seed stage in a cost-effective This exposes investors on crowdfunding manner by leveraging technology. platforms to risks from default, fraud and 2. Equity crowdfunding: This is a information asymmetry. Some relatively new concept in India and mechanisms have been put in place to has very few market players so far. reduce such exposure to risk – such as a It refers to fund-raising by an cap on the amount that can be lent by enterprise, particularly early-stage one lender (across platforms), and a cap funding, by offering equity interest on the amount that can be borrowed in the business to investors through (across platforms). This is further to an online platform. Enterprises that consultation papers100,101, put out by the seek to raise capital through this SEBI and RBI to understand the existing mode typically advertise online on systemic risks, elicit views of various a crowdfunding platform website, stakeholders, and assess various which serves as an intermediary business models in crowdfunding that between registered investors and have emerged globally. Some of the the early-stage enterprises. The guidelines for regulating P2P lending process of raising capital on equity include102: crowdfunding platforms takes around 1. Registration: Lending platforms to three to four weeks; the average be classified as NBFCs and shall be number of investors on each platform allowed to operate only after is 60 to 100. Crowdfunding platforms procuring the Certificate of 97 charge listing fees, fund raising Registration. Every company seeking Ibid 98 commission (2 to 6 percent) and registration as an NBFC - P2P shall http://economictimes. indiatimes.com/small- sometimes equity participation in have a net owned fund of at least biz/money/crowd- control- sebi-warning-turns-off- the range of 0.5 to 1 percent. It is INR 2 crore (USD 300,000). crowdfunding-tap-for- estimated that around 200 2. Permitted activity: The platform startups/articleshow/542027 02.cms enterprises have raised around shall act as an intermediary providing 99 http://articles.economic USD 53 - 70 million (INR 350-450 an online marketplace or platform to times.indiatimes.com/2016- 01-14/news/69765628_1_ crore)98 on equity crowdfunding the participants involved in P2P crowdfunding-angellist - platforms in India, with ticket sizes Lending. It cannot raise deposits nor investors 100 ranging from USD 38,400 to lend on its own. http://www.sebi.gov.in/cms/ sebi_data/attachdocs/140300 USD 0.9 million (INR 25 lac to 5615257.pdf 3. Prudential requirement: NBFC-P2P 6 crore)99. 101 https://rbidocs.rbi.org.in/ shall maintain a Leverage Ratio not rdocs/Content/PDFs/CPERR2 Regulatory Framework for exceeding 2. A lender can only lend up 80420162D5F13C3A2204F4FB6 A2BEA7363D0031.PDF Crowdfunding in India to INR 50,000 to the same borrower 102 https://www.rbi.org.in/ Crowdfunding is at a nascent stage in (aggregated across multiple scripts/NotificationUser.aspx? Id=11137&Mode=0 India, though it is fast gaining traction. platforms). An upper cap has been 60 placed on the aggregated investment the platform shall be through escrow by a single lender across all P2P account mechanisms which will be platforms at INR 10 lac. Similarly, operated by a trustee. At least two a borrower can borrow up to an escrow accounts, one for funds aggregate INR 10 lac across received from lenders and pending platforms. disbursal, and the other for 4. Operational guidelines: The collections from borrowers, shall company will put in place a Board of be maintained. Directors for setting out the eligibility 6. Submission of data to CICs: An criteria, determine the pricing and NBFC-P2P shall become member of formulating non-discriminatory rules. all CICs and submit data (including The outsourcing of any activity by historical data) to them. NBFC-P2P does not diminish its 7. Fair practices: an NBFC-P2P shall put obligations and it shall be responsible in place a Fair Practices Code, adhere for the actions of its service providers to transparency and disclosure including recovery agents and the requirements and put in place a confidentiality of information grievance redressal mechanism. It pertaining to the participant that is shall also protect data privacy of the available with the service providers. participants and report to the RBI as 5. Fund transfer mechanism: Fund and when directed. transfer between the participants on Regulation of Crowdfunding — Global experience P2P lending is approached differently by different regulators in different regulatory jurisdictions. In countries such as Brazil, China, Egypt and South Korea, P2P lending does not have a separate regulation or legislation. In countries such as Australia, Argentina and New Zealand, P2P platforms are regulated as financial intermediaries and subject to related legislations. In countries such as France, Germany and Italy, P2P platforms are regulated as banks, while in Israel and Japan, both P2P lending is prohibited. In case of Equity Crowdfunding, most countries have enabled it as an exemption to general requirement regarding public solicitation through prospectus/offering memorandum. While in some jurisdictions such exemption is given only to offer made to ‘accredited/informed/wealthiest’ investors, others specifically exempt solicitation made through ‘crowdfunding platform,’ capping the amount that can be raised or the amount that can be invested by each investor. Many countries have adopted ‘regulatory sandboxes’ to deal with existing grey areas in regulators, particularly the FCA in the United Kingdom, the Monetary Authority of Singapore and Bank Negara Malaysia, have proposed and are currently in the process of implementing a regulatory sandbox. This is a novel approach through which regulators allow experimentation with the fintech ecosystem to test financial products within a very restricted and limited framework. The sandbox allows participant fintech enterprises to offer their products, testing their outcomes and allowing regulators to understand and monitor first-hand how a particular their outcomes and allowing regulators to understand and monitor first-hand how a particular product or service works. This approach has three benefits: (i) lower costs in time-to-market for innovation, (ii) faster and better access to investment in innovative enterprises taking part in the sandbox, and (iii) increased encouragement for innovation. In India too, the concept of regulatory sandbox could be implemented by RBI in consultation with SEBI and the Government to address lack of clarity in regulations related to crowdfunding and encouraging innovative ideas to pilot their offerings. 61 The following table presents the broad advantages and disadvantages of the various modes of risk capital discussed. Risk Capital Modes – Comparative Advantages and Disadvantages Risk capital Advantages Disadvantages mode • Protracted processing time for raising • High repayment flexibility equity (18–20 weeks) Equity • Access to mentorship and other • High cost of capital (>25%) support from investors' network • Partial relinquishing of ownership-equity dilution required • Customized repayment schedule • Lower cost of capital as compared • Protracted processing time (4–8 weeks) to equity (18 to 25 percent) Venture debt • Fixed repayment schedule at rates higher • Limited equity dilution than bank rates may lead to cash burn • Suitable for working or short-term capital • Lower cost of capital as compared Unsecured to equity and venture debt debt • Fixed repayment schedule, irrespective of (15-20 percent) (Business business cycle. Growth trajectory allows • Shorter and simpler process as installment for little flexibility compared to equity and venture loan) debt (1–3 weeks) • Very short process time (< 1 week) Merchant • Repayment schedule synched to • Very high cost of capital (>30 percent) cash advance business cycle • Short process time (2–4 weeks) Crowdfunding • Indirect validation of product/service • High cost of capital (16–25 percent) at the idea stage 62 Chapter 5 Assessment of the Demand - Supply Gap Assessment of the Demand - Supply Gap Key Takeaways • Less than 2.5 percent of the equity demand from the MSME sector was fulfilled by formal external investors in 2017. • The demand-supply gap is most pronounced in mature stage enterprises. • The sheer size of the MSME sector, the limited sectoral and geographical focus of investors, and information asymmetry regarding extent of opportunity are the key reasons for the large demand - supply gap. 5.1. Demand - Supply Gap by USD 1.05 billion (INR 6,851 crore) against 103 Enterprise Lifecycle Stage an estimated addressable demand of USD 44.4 billion (INR 289 thousand Although organized VC/PE funds have crore). Since investors' focus was been investing in India for over 20 years, primarily on early-stage enterprises, the MSME sector continues to be the demand supply gap was marginally underserved by formal external equity. lower in the early-stage enterprise The sector is heavily dependent on segment as compared to growth-stage informal sources for equity financing. and mature-stage segments. The Not only do informal arrangements investment was roughly 6.6 percent of constrain the ability of the sector to raise the addressable equity demand from adequate funds for its growth, they often early-stage enterprises, whereas for expose entrepreneurs to unscrupulous growth-stage enterprises it was about lenders. 1.8 percent and as low as 0.5 percent At an overall level, equity invested in for enterprises in the mature-stage MSMEs was only around 2.3 percent of (Figure 34). the addressable demand from the MSME sector in 2017. The total investment was Figure 34: Gap in Equity Investment by Enterprise Lifecycle Stage, 2014 (USD billion) Enterprise Lifecycle Addressable Equity Equity Gap Stage Demand104 Investment105 Early 10.5 0.7 9.8 Growth 10.5 0.2 10.4 Mature 23.4 0.1 23.3 103 Early-stage enterprises have been defined as enterprises having a tenure of 0–5 years, Growth-stage as 6–10 years and Mature-stage as >10 years. Please refer to Table 7 in Chapter 2 104 Please refer to Figure 10 in Chapter 3 105 Please refer to Figure 17 in Chapter 4 64 Equity Supply 7pe 2pe 1pe 10.5 0.7 10.5 9.8 0.1 0.2 10.4 23.3 23.3 Addressable Equity Early Growth Mature Demand Source: MSME Census, WBG - Intellecap Research 5.1.1. Early-stage Enterprise This suggests that early-stage investors Segment are providing ticket sizes that are much more than what a typical early-stage Equity investment in early-stage MSME demands. enterprises in 2017 was around USD 0.7 billion (INR 4,477 crore), which As a result, numerous early-stage was 6.6 percent of the estimated MSMEs that do not easily lend demand of USD 10.5 billion themselves to high valuations – owing (INR 68 thousand crore). Although the to either their location or industry – equity invested in early stage enterprises get neglected by investors108. accounted for almost 70 percent of the Investments in early stage enterprises total equity invested in MSMEs106 in 2017, are made both by VC funds and it is evident that a large demand-supply individuals. While organized investors gap still exists in this segment. The gap such as VC funds often have dedicated comprises both unfunded and sourcing mechanisms, individual underfunded enterprises. investors such as HNIs depend on word The typical quantum of demand per of mouth and angel networks to identify enterprise from MSMEs tends to be companies for potential investments. much lower than the average ticket sizes While there has been a burgeoning of that are being invested currently. enabling infrastructure for start-ups and Investments are often made based on early-stage enterprises in the country, valuation and future prospects of the the penetration of information regarding enterprise, rather than with the express availability, utility and procedural purpose of fulfilling the equity demand requirements of availing external equity of the enterprise. From a purely is still limited. This results in numerous operational perspective, a typical early- enterprises seeking equity investments 106 Please refer to Figure 9 in Chapter 2 stage MSME demands an investment being unprepared to meet the terms set 107 WBG – Intellecap Analysis of roughly USD 93,000 (INR 60 lac)107, by the investor – both procedurally and 108 Report on the Expert whereas the average investment size in terms of business growth prospects. Committee on Innovation and Entrepreneurship, NITI of early-stage investments was around Investors typically look for enterprises Aayog, August 2015 USD 2 million (INR 13 crore) in 2017. that have the potential to disrupt the 65 market with a scalable business model. 5.1.2. Growth-stage Enterprise Since equity investors take the risk of Segment investing at an early stage, they tend to Equity investment in growth-stage prefer enterprises that hold the potential enterprises in 2017 was about for very rapid growth. The rapid growth USD 0.2 billion (INR 1,225 crore) – rates sought by early-stage investors can 1.8 percent of the estimated addressable often be multiple times the benchmark demand of around USD 10.5 billion growth rate of 25 percent considered by (INR 68.5 thousand crore). Although this study for demand estimation109. It is demand for equity from the growth- not uncommon for early-stage investors stage enterprise segment was roughly to expect a growth rate of almost 100 equal to that from the early-stage percent in the initial period of the enterprise segment, the demand-supply lifecycle of an enterprise. It is estimated gap was larger in the former. Lower that enterprises growing at such high equity investments in growth-stage rates account for roughly one-third of MSMEs is due to various reasons, such the addressable demand at this stage110. as lower willingness of entrepreneurs This indicates that there exists a demand to cede control, a mismatch regarding of USD 3.5 billion (INR 23 thousand crore) valuation of the enterprise from the from early-stage enterprises that equity demand and supply sides, and an investors will find especially appealing. investor perception of lower growth prospects for the enterprise as compared Figure 35: Share of Demand from to the early stage. Very Rapid Growth MSMEs, Early-Stage (100% = USD 10.5 billion) However, it is estimated that enterprises that are able to maintain a rapid year-on- year growth rate of 50 percent or more111 in this stage of their lifecycle account for over 60 percent of the addressable demand from this segment – amounting to about USD 6.7 billion Demand from Very Rapid (INR 44 thousand crore). Growth MSME, 34 percent Figure 36: Share of Demand from Rapid Growth MSMEs, Growth Stage Source: WBG - Intellecap Analysis (100 percent = US 10.5 billion) A wider reach of intermediaries such as incubators and accelerators and increased awareness among business enablers such as CAs about external equity as a source of financing will help 109 Please refer to section 3.2 – to improve visibility of such MSMEs for Demand from Addressable equity demand Rapid Growth 110 WBG – Intellecap Analysis investors. MSMEs, 111 Taken to be ~50percent for 64 percent enterprises in the growth stage, based on WBG - Intellecap research Source: WBG - Intellecap Analysis 66 There is thus a demand of about Creating awareness among mature USD 10.3 billion (INR 67 thousand crore) stage enterprises via business from early and growth stage MSMEs intermediaries such as CAs, audit firms that can be considered an especially and advisory firms will help introduce attractive subset of the addressable formal external equity as a viable source demand. This presents a promising of financing. Additionally, building opportunity for equity investors to advisory expertise among equity widen and deepen their sourcing investors in one or more business mechanisms and tap into this demand. segments such as HR, sales and marketing or supply chain management, 5.1.3. Mature-stage Enterprise will help them collaborate with MSMEs Segment on a wider level, apart from providing Equity investment in mature-stage equity financing. enterprises in 2017 was around USD 0.1 billion (INR 798 crore) – which 5.2. Demand-supply Gap by was roughly 1 percent of the estimated Nature of Enterprise demand of about USD 23.4 billion (Manufacturing and Services) (INR 152 thousand crore). Although a Investors often focus on a few preferred typical mature-stage enterprise industry sectors because of various demands less external equity infusion reasons such as fund-raising mandate, than a typical growth-stage enterprise, industry growth rate and prospective at an aggregate level, most of the high valuations. This practice often addressable equity demand came from excludes enterprises in other sectors. the mature-stage enterprise112 segment, Investor preference for certain sectors is thanks to its sheer size in the MSME rarely in sync with the demand from that sector113. Lower supply of equity to this sector. The skew in investor perception segment has resulted in the largest of the opportunity as compared to actual demand-supply gap. The gap is driven demand is very apparent from the larger by the perception among equity gap in demand and supply of equity in investors that mature-stage enterprises the manufacturing sector as compared have comparatively lower growth to the services sector. prospects and are unable to provide Equity investment in manufacturing the expected return on investment. sector enterprises in 2017 was Additionally, it is estimated that more USD 0.15 billion (INR 950 crore) – than 50 percent of the mature-stage which was close to 0.4 percent of the enterprises that account for the estimated addressable equity demand of addressable demand have been in about USD 33.1 billion (INR 215 thousand operation for more than 20 years114. crore). In contrast, investment in the This suggests that they have a long services sector was about 8 percent of 112 Please see Section 3.3.1.3 history of using traditional methods of the addressable demand. The supply 113 Almost 50 percent enterprises in the MSME financing. Such enterprises might be to services sector enterprises in 2017 sector are mature unwilling to avail formal external equity was USD 0.91 billion (INR 5,901 crore), enterprises. Please see Table 8. as a source of financing, or to cede stake the estimated demand being about 114 MSME Censuzs, WBG- in their long-held enterprises. USD 11.3 billion (INR 51 thousand crore). Intellecap Analysis 67 (Figure 37) Widening the target sectors growth rates to be considered for equity considered for equity investments will investments. help traditional MSMEs with high Figure 37: Gap in Equity Supply by Enterprise Type, 2017 (USD billion) Demand Fulfillment 0.4% 8% 0.2 33.1 33.0 0.9 11.3 10.4 Addressable Equity Manufacturing Services Demand Demand-Supply Gap of Geography, 2017 The low income and northeastern states accounted for around 31 percent of addressable equity demand; however, less than 5 percent of the equity invested in 2017 went to these geographies. This is indicative of both the lack of awareness among entrepreneurs in these states about formal external equity as a mode of financing, as well as the limited reach of equity investors outside of metro areas and large cities. Although there has been a mushrooming of enabling infrastructure for start-ups in India, it has been limited to metros such as Mumbai, Bangalore, Delhi and Hyderabad. Equity investors often lack the wherewithal and the mandate to explore geographies outside their physical locations for identifying MSMEs for investment. Equity Demand Equity Investment Geography Fulfillment ($ billion) ($ billion) 12.7 0.04 Low Income States 0.3% (83) (0.261) 0.9 0.0 Northeastern States 0% (6) (0.0) 30.8 1 Rest of India 3.2% (200) (6.59) 44.4 1.05 Total 2.4% (289) (6.85) Figure in brackets is in thousand core Indian rupees Source: MSME Census, Venture Intelligence, WBG - Intellecap Analysis 68 5.3. Factors Influencing investment despite having funds to Demand-supply Gap invest. It is noteworthy that a demand-supply • Low degree of financial literacy gap of close to 98 percent exists across among MSMEs: Entrepreneurs are early, growth and mature-stage often unaware of formal external enterprises. This stems from various equity as a source of finance. As a factors: result, they do not seek such equity investment and their demand remains • Sheer size of the MSME sector: 'unaddressed'. Additionally, MSMEs Although the turnover and growth rate often lack proper guidance and links filters used in this study to identify with investors for them to avail of potential enterprises for equity equity financing – especially in Tier II infusion disqualify more than 99 and Tier III cities and rural areas. percent of enterprises in the MSME The lack of effective intermediaries sector115, the sheer number of contributes to the demand–supply enterprises still remaining makes gap. the equity demand very high. • High prevalence of informal finance: • Limited sector and geography focus MSMEs are often reluctant to approach of equity investors: Investors typically formal equity investors owing to raise money with a mandate of complicated documentation investing in certain industry segments procedures. Informal finance has – which tend to be limited to service become the norm for a large number sector industries such as IT/ITES, BFSI of MSMEs owing to their chronic and healthcare. However over dependence on it and the ease of 75 percent of the addressable access and more timely nature of this demand comes from manufacturing type of finance. Thus a large portion of enterprises. Primary research has addressable demand remains outside revealed that the manufacturing sector the reach of formal equity investors. as a whole receives less attention from investors, and this contributes to the • Non-transparent accounting large demand-supply gap. Additionally, practices of MSMEs: MSMEs often do equity investors tend to be located in not follow accounting best practices. a few large metropolitan areas such as Primary interviews with equity Bangalore, Mumbai and Delhi NCR. As investors suggest that this increases a result, demand from Tier II and Tier III the perception of risk and such demand cities and non-urban areas often remains unfulfilled. remains unaddressed. Although the gap described above refers • Lack of information regarding extent to the gap in demand and supply of of opportunity: Investors are often equity, it presents an opportunity for unaware of the large amount of alternative structures and sources of addressable demand from the sector – finance, especially in fulfilling the portion especially from mature-stage of demand that is used to fund working 115 enterprises. As a result, investors often capital requirements. Alternative Please refer to Section 3.2 – Addressable equity demand struggle to identify enterprises for structures may include patient capital, from the MSME sector 69 blended finance and returnable capital116, of enterprises. Other interventions all of which are growing in popularity in such as developing the skills and global markets. Additionally, the gap outlook to lend without collateral and presents an opportunity for traditional strengthening the enabling environment lenders such as banks and NBFCs to for MSMEs can also be initiated, by both develop innovative products and private lenders and the government. methods of credit assessment to enable Please refer to Chapter 7 for further them to cater to this specific niche details. demand. These may include unsecured lending of smaller loans and credit assessment based on transactional data 116 Please refer to Chapter 7 70 Chapter 6 Enabling Environment for Risk Capital Finance to MSMEs Enabling Environment for Risk Capital Finance to MSMEs Key Takeaways • The enabling environment for risk capital financing to MSMEs has three key pillars: 1) Regulatory framework and taxation, 2) Government schemes, 3) Supporting infrastructure. • SEBI AIF Regulations, 2012 govern on-shore funding, and SEBI FVCI Regulations 2000 and FDI (TISPRO) Regulations govern off-shore funding to enterprises in India. • CGTMSE and MUDRA are two flagship government schemes to support financial institutions such as banks, NBFCs and MFIs that lend to MSMEs. • Recent government initiatives to boost risk capital supply to MSMEs include a fund-of-funds called India Aspiration Fund and the SIDBI Make in India Loan for Enterprises (SMILE). • Various intermediaries such as incubators, accelerators, angel networks and SME exchanges support risk capital providers and MSMEs seeking capital. These intermediaries enable MSMEs to access finance and help ease the funding process. 6.1. Overview of the Enabling financial intermediaries such as Environment incubators and angel networks. Designing a favorable enabling policy ccess to suitable and timely financing framework and creating adequate options is critical to promote growth, infrastructural support have a positive innovation and commercialization of impact on both the supply of risk capital ideas in the MSME sector. Apart from the and the ease of access to such capital for internal readiness of an enterprise, its MSMEs. ease of access to risk capital is governed by external factors such as MSME- The different elements of the enabling focused investors, government policies, environment are shown below: regulatory and tax regimes, and various Figure 38: Enabling Environment for the supply of risk capital Enabling Environment Regulatory Government Supporting framework and schemes infrastructure taxation • Investmentregime for • Credit Guarantee • Incubators and onshore funds Scheme accelerators • Investmentregime for • Refinance scheme • Angel groups offshore funds • Government- • SME Exchanges promoted funds • Taxation of investors • Taxation of investors 72 These elements of the enabling environment can impact either the supply-side or the demand-side or both. The matrix below provides a classification according to the direct impact of each element: Figure 39: Impact of the elements of enabling environment on supply-side and demand-side players Key elements of the Enabling Supply-side Demand-side Environment enabler enabler Investment regirne for framework and onshore funds Regulatory taxation Investment regirne for onshore funds Taxation of investors Credit Guarantee Scheme Government schemes Refinance of non-bank MSME lenders Government-promoted funds Incubators and Accelerators infrastructure Supporting Angel groups SME Exchanges 6.2. Regulatory Framework and 6.2.1. Investment Regime for 117 Taxation Onshore Funds The equity investment process is In 1996, SEBI announced the SEBI Venture complex and time consuming, involves Capital Funds Regulations to regulate significant capital commitment and investments carried out through onshore lacks liquidity due to limited exit options. pooled vehicles in early-stage ventures. A stable and consistent regulatory and In due course, however, pooled vehicles tax regime enhances investors' with different investment themes and confidence and reduces risk aversion118. objectives, such as private equity funds, The equity investments in Indian hedge funds, and infrastructure funds, enterprises by privately pooled capital, all started using VCF as an omnibus both onshore and offshore, are regulated investment vehicle. Hence, to align rules, 117 Only for equity investments by SEBI and RBI. The following sections concessions and restrictions with the by funds discuss the regulatory framework and different types of emerging funds, it was 118 SEBI Alternative Investment Policy Advisory Committee taxation norms governing equity necessary to make clear regulatory (AIPAC) Report, 2015 investments in India. distinctions among the different 119 SEBI Concept paper on AIF investment vehicles119. Thus, in 2012, Regulations 73 the SEBI VCF Regulations were replaced AIF refers to any fund established in India by the SEBI Alternative Investment (onshore fund) in the form of a trust, Funds Regulations that lay down a company or limited liability partnership, comprehensive regulatory framework for which is a privately pooled investment the different categories of investment vehicle and is not covered by SEBI's funds. Mutual Funds Regulations or Collective Investment Schemes Regulations. AIFs Onshore funding is have been divided into the three regulated by SEBI AIF categories based on their investment Regulations, 2012 objectives and strategies as shown below: Table 12: Categories of Alternate Investment Funds120 Category Description Types of funds Funds that invest in early-stage enterprises and are perceived Infrastructure Fund, SME Fund, Social Category I to have postive spillover effects on the economy Venture Fund, Venture Capital Fund Funds that are categorized as neither Category AIF nor Category II Debt Fund, Private Equity Fund Category III AIFs Funds that empoly complex or diverse trading strategies and Category III Hedge Fund high amount of leverage SEBI's AIF Regulations, 2012, have helped bring all types of investment funds domiciled in India under a single umbrella, thus recognizing AIFs as a distinct asset class. Most of the AIFs in India are structured as trusts because the regulatory framework governing trust structures is stable and taxation rules are favorable121. While the AIF Regulations permit a Limited Liability Partnership as a fund structure, the Registrar of Companies overseeing the registration of LLPs does not permit LLPs to be used simply as 'investment vehicles'. In view of this, both SEBI and the Registrar of Companies discourage the LLP structure for AIFs122. 6.2.2. Investment Regime for 1. Foreign Direct Investment route: Offshore Funds Investment through the FDI scheme (Schedule 1 of the Foreign Exchange Investment by offshore funds in private Management TISPRO Regulations) 120 enterprises in India is governed by the SEBI AIF Regulations, 2012 2. Foreign Venture Capital Investor notification Foreign Exchange Management 121 Fund Structures & route: Investment through SEBI (Transfer or issue of Security by a Person Operations, Nishith Desai Foreign Venture Capital Investor Associates, 2015 Resident outside India, or TISPRO) Regulations, 2000 (Schedule 6 of 122 There seem to be no Regulations, 2000 issued by RBI (in restriction on the legal Foreign Exchange Management structure of investee in terms keeping with the Consolidated FDI Policy TISPRO Regulations) of LLP or private limited of the Department of Industrial Policy company, although most enterprises receiving and Promotion). The regulations allow Offshore funding is investments are the latter. an offshore fund to invest in India Interactions with investors regulated by SEBI FVCI seem to suggest that if all through the following two routes: other details can be agreed Regulations 2000 and upon, legal remedies exist to amend the status of an FDI regulations investee. 74 To invest via the FVCI route, an offshore 1. Pure offshore structure: In a pure fund has to register with SEBI and offshore structure, the pooling vehicle receive approval from RBI. The FVCI is domiciled outside India and the route has relaxed some requirements of foreign investor makes investment the FDI route, such as entry/exit pricing directly to an enterprise in India. norms imposed by RBI, the lock-in 2. Unified structure: In a unified requirement following an initial public structure, the offshore fund vehicle offering, and the need for approval from invests in an onshore fund (AIF) that the Foreign Investment Promotion draws funds from domestic investors Board123 among others. But it also as well. restricts the scope of investments (for 3. Co-investment structure: In a co- example, FVCIs can invest in only nine investment structure, funding into a sectors specified by RBI124) and mandates private enterprise flows from foreign reporting of investments and disclosure and domestic investors through an of strategy. As on March 2018, there were offshore fund and an onshore fund 240 FVCIs registered with SEBI with a respectively. Although these funds are cumulative investment of over independent, they typically maintain INR 46,000 crore (USD 7.1 billion)125. a ratio while investing and have Offshore funds can invest in Indian management teams that closely private enterprises either directly or interact with each other. through onshore funds (AIFs). The following figure shows the different structures that a foreign investor may adopt: 123 Despite the introduction of Figure 40: Modes of Investment by FVCIs in Enterprises in India126 the AIF Regulations, the corresponding RBI Pure offshore Unified Co-investment regulations governing foreign structure structure structure investment have not been amended to specifically allow investments in AIFs by FVCIs under the automatic route, and hence FVCI route requires Foreign Foreign Domestic Foreign Domestic Government approval too. Investor Investor Investor Investor Investor 124 The nine sectors are: nano- technology, information technology of certain Offshore qualifying forms, seed fund research and development, Offshore Offshore biotechnology, AIF fund fund pharmaceutical research, production of bio-fuels, AIF construction and operation of certain hotel/convention centers having more than 3,000 seating capacity, dairy Enterprise Enterprise Enterprise and poultry industries. 125 SEBI Consultative Paper on Amendments to FVCI Regulations 126 Fund Structures & Operations, Nishith Desai Associates, 2015 75 6.2.3. Taxation of Investors and small enterprises. The extent of guarantee cover is capped at 75 percent The taxation system in India is set by the of the loan value, and the maximum Ministry of Finance, Department of loan size that can be guaranteed is Revenue, and income is taxed as per INR 1 crore130. India's Income Tax Act, 1961. The tax on FVCI investments is determined by the Figure 41: Achievements of CGS 131 ITA alongside the Double Tax Avoidance Agreement that India has signed with a number of countries – whichever is more beneficial to the investor. Prior to the AIF Guaranteed Claims Member Regulations, 2012, venture capital funds) loans settled lending institutions were granted tax pass-through127 status INR 125,000 150,000+ 119 under the provisions of Section 115U of crore the Income Tax Act. To rationalize the taxation of other forms of AIFs, the 6.3.2. Refinance scheme Finance Act, 2015 extended the pass- through status to Category I and A large part of the MSME sector, 128 Category II AIFs as well . especially sole proprietorship firms, has limited access to the banking system due 6.3. Government schemes to limited geographical penetration of banks, and perception of higher credit The government has taken several risk of the enterprises. Many small initiatives to promote the supply of risk manufacturing units, traders, vendors capital to MSMEs and collaborate with and artisans are unregistered and belong risk capital providers to reduce their risk. to the informal sector, but are critical for It has two flagship programs – the Credit employment generation and local Guarantee Scheme and the Micro Units economic development. They often Development and Refinance Agency – to struggle to access institutional micro- promote the supply of unsecured debt to loans due to low interest-bearing MSMEs. In the case of equity, the capacity, and difficulty in meeting the government promotes several funds at collateral requirement and other the center and state levels. 127 Tax pass-through implies that eligibility criteria of financial institutions. income from investments is 129 MUDRA132 has been constituted by the taxable only in the hands of 6.3.1. Credit Guarantee scheme unit holders i.e. investors government to refinance last-mile (after distribution) and the Non-availability of debt funding from fund vehicle is exempted from financial institutions that provide income tax banks due to inadequate collateral has unsecured debt funding to MSMEs. 128 The Finance Act 2015 calls the been a major obstacle to the growth of Category I and Category II MUDRA Bank will help address capital MSMEs. To address this challenge, in July funds as 'Investment Funds' constraints of such MSMEs as face 129 For further analysis of CGS, 2000, the government established the please refer to Section 7.1.3 difficulty in accessing external equity Credit Guarantee Fund Trust for Micro 130 CGTMSE Website; As per funding from VCs. Most sole Budget 2017-18 and Small Enterprises, in partnership proprietorship firms, especially traders, announcement, the loan limit with SIDBI. CGS provides a guarantee is expected to increase to INR are not amenable to receiving equity 2 crore cover under which member banks can 131 financing, and have to borrow from CGTMSE Website give unsecured debt funding to micro 132 private moneylenders at interest rates as http://www.mudra.org.in/ 76 high as 25 to 40 percent. MUDRA refinancing scheme can incentivize banks and NBFCs to increase their portfolio allocation to such micro entrepreneurs. MUDRA will also lay down policy guidelines for lending to micro businesses to minimize the risk of lending. Under the refinancing scheme, financial institutions can extend loans up to INR 1 million to micro enterprises. These loans have been categorized in three buckets – Shishu, Kishore and Tarun, corresponding to early, growth and mature stage respectively – and are disbursed according to the lifecycle stage and funding needs of the micro-entrepreneurs. MUDRA is also in the process of rolling out a Credit Guarantee Scheme to reduce the credit risk for member lending institutions of the MUDRA scheme. The following figure captures the major offerings of MUDRA: Figure 42: MUDRA offerings MUDRA Refinancing to commercial Credit Overdraft Development Equipment banks / NBFCs / RRBs / facility guarantee and financial finance (MUDRA) Cooperative hanks / MFIs scheme literacy support scheme card) shishu Kishore Tarun (Upto INR (INR 50,000 (INR 5-10 50,000) -5 lac) lac) 6.3.3. Government Promoted early stage startups. In April, the state Funds owned insurance group and investment company Life Insurance In August 2015, the Government Corporation (LIC) signed an MoU launched two funds called India promising a contribution of 10% of the Aspiration Fund and SIDBI Make in fund size as co-investor. IAF aims to India Loan for Enterprises (SMILE) support VCs to channel investments through SIDBI133. towards a larger number of early- 1. India Aspiration Fund: Launched in stage start-ups. It will help increase August 2015, this is a fund of funds the pool of equity supply for with an initial corpus of technology start-ups that find it INR 2,000 crore. This fund has a total difficult to raise debt due to lack of corpus of USD 610 million. Launched collateral, by providing a cushion to with an initial corpus of domestic VCs which invest in seed- USD 305 million, the fund received stage start-ups and carry an element another USD 140 million in December of high risk. Sectoral allocations may 2015, and USD 150 million in April be built in to channel funds to 2016. The last investment was emerging areas with a high potential 133 http://www.livemint.com/ intended for 30 venture funds for impact and job-creation. Politics/9FaxOhSxGDqbjXLRv MrZcI/Arun-Jaitley-launches- channeling investment through the funds-for-startups-small- India Aspiration Fund, to invest in firm.html 77 2. SMILE: The government has also and soft loans respectively. It is launched a new loan program called structured in a way that on expiration the SMILE plan under SIDBI with an of 3 years from the date of first initial corpus of INR 10,000 crore. disbursement, the outstanding debt SMILE aims at providing soft loans134 amount with any dues thereon will be to MSMEs in 25 manufacturing converted into a secured term loan, sectors identified under the Make in with the entire loan carrying an India program. The loans can also be interest rate as per internal rating of utilized to establish new MSMEs, or the borrowers135. for projects related to expansion, 3. SAARC Development Fund: In April modernization, or upgrading 2016, SAARC Development Fund (SDF) technology at existing MSMEs. As and SIDBI signed an MoU envisaging a part of SMILE, SIDBI can collaborate co-funding partnership in MSMEs on with banks to co-finance projects for a risk sharing basis in shortlisted MSMEs so that banks are comfortable sectors for MSMEs in India as well as with the leverage and terms of the other SAARC countries. project's financing. SIDBI will also 4. ASPIRE Fund: Established in October work with other MSME-focused 2016, this fund aims to promote programs such as the Micro and Small entrepreneurship in rural India with Enterprises Cluster Development a total corpus of USD 9 million Programme (MSE - CDP) and the (INR 58.5 crore). Funds are Prime Minister's Employment administered by SIDBI with a focus on Generation Programme (PMEGP) to technology inclusive interventions, provide funding to MSMEs especially in agriculture, livestock, participating in these interventions. social impact, healthcare and life This fund has allocations for startups sciences through setting up various 25 priority sectors for startups under Technology Business Incubators PM Modi's ‘Make in India’ vision. It (TBIs). A total of INR 34.92 crore has provides quasi-equity and term based been sanctioned, while another INR short term loans, to MSMEs to enable 15.3 crore has been disbursed to nine them to continue meeting adequate TBIs. A total of 30 TBIs are in various debt-to-equity requirements as they stages of set up. Eligibility to access 134 Concessional interest rate of grow. Minimum loan size if INR 25 lac. around 10 percent norms focus on MSMEs with The loan financing is available 135 https://www.sidbi.in/files/ Entrepreneurs Memorandum (EM) SIDBI_Ebrochure_SMILE_new. through an affirmative action registration. Average ticket size is pdf oriented policy. A total of 10 percent 136 http://msme.gov.in/sites/ INR 10 crore 136. of the project cost (maximum of default/files/MSME-ASPIRE- FINALBOOK.pdf INR 20 lac) as the loan amount for 5. Fund of Funds for Startups: and general category, 15% for enterprises Approved by the Centre in 2016, the https://inc42.com/startup- promoted by Schedule Caste, FFS is a USD 1.5 million 101/startup-scheme-indian- government-startups/ Scheduled Tribes or Persons with (INR 10,000 crores) which was aimed 137 https://economictimes. Disabilities (PwD) representatives to boost the Startup India initiative. indiatimes.com/small - Under it, INR 500 crore was already biz/sme-sector/fund-of- (maximum of INR 30 lac). Payback funds-for-startups-sidbi- period is up to 7 years, inclusive of a released to the corpus in financial ramps-up-its-startup- year 2016, and another INR 600 crore funding-operations/ 1-1.5 years and up to 2 years' articleshow/52896311.cms moratorium applicable on term loans was earmarked for financial year 2017137. 78 Recent initiatives by the Government 1. ATAL Innovation Mission: The Government has proposed setting up an orgaization under NITI Aayog to promote innovation and entrepreneurship, called the ATAL Innovation Mission (AIM). The following are the goals of AIM: Short-term goal Medium-term goal Long-term goal • Incentivize early-stage • Address inadequacies in • Inculcate entrepreneurial startups through education, skilling and spirit and change cultural competitions and incubation infrastructure attitudes towards self- facilities employment. AIM would have four working groups to undertake different activities: 1) Idea and Networks, 2) Angel fund of funds, 3) Governance innovation, 4) Special Initiatives. AIM can help support entrepreneurship cells within institutes and help establish incubators in semi-urban and rural areas. AIM can also play the role of linking early-stage institutional investors with incubators and accelerators to source startups for funding. 2. Startup India Standup India Scheme Startup India is an initiative by the Government to nurture innovation and strengthen the startup ecosystem in India. As a part of the action plan, the scheme aims to provide various types of funding support and incentives to eligible startups (as defined). Some of the items include: • Startups having annual turnover less than INR 25 crore (~USD 3.8 million) and incorporated after April 1, 2016 eligible for getting 100% tax rebate on profit for a period of 3 years. • Startups will be exempt from long-term capital gains tax if the long-term capital gain is invested in a fund notified by Central Government within a periiod of six months from the date of transfer of the asset. • Carry forward losses to be allowed if certain conditions with respect to shareholding are met. Besides the various funds under SIDBI Venture Capital discussed earlier, there are some funds managed by other venture capital firms promoted by the Central and state governments. The prominent ones include: 1. IFCI Venture Capital Funds Ltd: IFCI was established around four decades ago as a risk capital foundation to provide equity-based financing. IVCFL is a subsidiary of IFCI and provides equity finance to manufacturing, health care, IT solutions and companies setting up new projects from scratch in India. IVCFL has the following funds operating at present: Figure 43 : IVCFL Funds 1 2 3 4 Green India India Enterprise India Automotive VC Fund for Venture Fund Development Fund Components Scheduled Castes Manufactures PE Fund INR 330 crore INR 250 crore INR 330 crore INR 200 crore 79 Under these funds, IVCFL has invested in 2. Gujarat Venture Finance Ltd. 29 enterprises so far138. It also rolled out (GVFL): GVFL is one of the first two new funds called Green India venture capital firms in India, jointly Venture Fund–II and Small and Medium owned by the Gujarat state Enterprises Advantage Fund. GIVF-II will government and private sector focus on enterprises in clean-tech and companies. It was established in 1990 renewable energy, while SMEAF will with the help of the World Bank to nurture MSMEs in auto components, provide financial assistance to chemicals and fertilizers, food innovative tech-driven enterprises. processing, fast moving consumer So far, GVFL has invested in more goods, leather, healthcare, than 90 tech-based MSMEs139. GVFL pharmaceuticals and textiles. has the following funds under its management, of which Golden Gujarat Growth Fund closed in February 2015: Figure 44: GVFL Funds 1 2 3 4 Golden Gujarat SME Technology Value Multiplier GVFL Startup Growth Fund-1 Venture Fund Fund Fund INR 426 Crore INR 500 Crore INR 600 Crore INR 600 Crore Please refer to Appendix E for details on other government schemes for MSME financing. 6.4. Supporting Infrastructure facilities that improve a start-up's chances of commercial success. While Various intermediaries such as incubators provide support in the incubators, accelerators, angel networks business model development phase of and SME exchanges support risk capital the ventures they serve, accelerators providers and MSMEs seeking capital. generally provide support at the business These intermediaries enable MSMEs to model execution phase. The key access finance and help ease their difference, though, is that the gestation funding process. period in an incubator (1 to 2 years) is longer than in an accelerator (3 to 6 6.4.1. Incubators and months). Accelerators Incubators and accelerators provide handholding support to entrepreneurs to help them transition from concept to 138 Source: https://www.ifciltd.com/ implementation. They provide a ?q=content/ifci-venture- structured environment and basic capital-fund-ltd 139 business resources and infrastructural http://www.gvfl.com/funds. html, WBG-Intellecap Analysis 80 Figure 45: Incubators and Accelerators Incubator Accelerator • Generally associated with • Post-incubation stage, university industry-led • Long term support • Mentorship • Shorter, intense period (1-2 years) • Seed funding (3-6 months) • Usually at ideation stage • Technical • Usually at POC/execution • Offers infrastructural assistance stage support • Management • Investment deck and • Aid in building B-plan and support financial model networking • Aid in executing B-plan and pilot Incubators: Incubators provide a test market-validated product or service. bed for entrepreneurs to refine their Entrepreneurs get access to a network of business models and build a market-fit mentors, business advisers and investors product or service. They are generally in exchange for 5-8 percent equity. set up in universities or backed by the Accelerators may also help connect the government, and offer shared working start-ups with service providers for space, mentorship, networking product development and design, opportunities, and basic services such marketing, inventory management and as IT, research labs and administrative recruitment of personnel. Generally, support. At the end of the incubation accelerators cater to technology start- phase, the ventures ideally graduate ups and other asset – light ones that with a clear business model and some can scale fast. traction in terms of revenue, user adoption, reach and partnerships. Accelerators: Accelerators have a standardized approach and offer a more structured program for start-ups to expedite the process of product/service deployment. They only support start-ups with a sound business model and a 81 Start-up Chile Startup Chile is an accelerator program directly funded by the Chilean Government to provide impetus to the local entrepreneurial ecosystem. It aims to attract entrepreneurs from all over the world to participate in the program and create job opportunities for the local population. The 6-month Startup Chile program provides entrepreneurs with office space, a temporary visa, mentorship opportunities and USD 40,000 of grant money. In return, the startups engage the local population through workshops, hackathons and other community outeach initiatives, thus promoting a startup culture in Chile. The Chilean Government has also created a follow-on fund called SCALE under the Startup Chile program. The fund is raised through a co-financed grant in which Startup Chile puts 70% and the investees put the remaining 30% themselves. Graduates from the accelerator program that have gained significant traction in the market and that are willing to stay in Chile for one more year are eligible to receive funding. In India, there are over 250 incubators The following figure shows the major and accelerators, of almost 100 provide incubators and accelerators across the financial support as well, through their country: own fund or their network of investors. Figure 46 : Major Incubators and Accelerators in India • Indian Angel • TBIU, IIT Delhi Network • Tlabs Incubator • GSF • The Hatch • Sideas • CIIE, IIM-A • NDBI, NID Abd. • Comm. TBI. • MICA Delhi Kolkata Ahmedabad Mumbai • IIMCIP • SINE, IIT-B • STEP, IIT KGP • Venture Nursery Bangalore • Seedfarm • GSF • Startup Center • UnLtd • RTBI, IIT-M • Villgro, IIT-M Kerala • TBI, Anna Univ • Startup Village • Technopark TBI • Microsoft • NSRCEL, IIM-B • TBI, NIT Calicut Accelerator • Kyron • Khosla Labs • Angel Prime 82 6.4.2. Angel Networks Angel networks play a vital role in the Angel networks early-stage financing ecosystem. They facilitate equity help organize angel investors on to a common platform, connect them with investment by HNIs entrepreneurs seeking seed capital, and into MSMEs facilitate the entire investment transaction. This helps address the Some of the major angel groups in India information asymmetry and reduce the include India Angel Network, Mumbai search and transaction costs of both Angels, Calcutta Angels, Chennai Angels, investors as well as early-stage Hyderabad Angels, Intellecap Impact enterprises. Investment Network and Spark Angels. Angel networks carry out an initial According to industry sources, there are screening and due-diligence before more than 1,000 angel investors in enterprises get to pitch their business India140. idea to potential investors. The common 6.4.3. SME Exchanges platform enables entrepreneurs to MSMEs in the growth and mature stages access a larger pool of investors to meet often find raising equity capital a better their funding requirement in a single option than raising debt capital due to round and helps angel investors diversify an over-leveraged balance sheet or their portfolio with a large deal flow. inability to bear interest expenses. Angel networks have well-defined However, raising capital from VC/PEs processes for deal-sourcing that make may not be always possible due to discovery of enterprises easier for them. mismatch between investors and Angel groups also assist entrepreneurs enterprises in valuation. Many such in preparing their business plans, refining enterprises wish to access funding from their projections and rearticulating their multiple investors in the capital markets. pitches. They provide administrative As public listing on the main exchanges support (documentation and legal is difficult due to stringent regulatory support) so that angel investors can norms and various compliance issues, focus on imparting mentorship. the concept of a dedicated SME trading Evaluation of start-ups by different platform has emerged. SME exchanges angel investors results in a more robust create a credible and efficient market valuation, thus reducing the risk of place to bring about convergence of adverse selection. Often, angel networks sophisticated investors and leverage their relationships with early- high-growth enterprises. stage VC funds to co-invest with angel The opportunity to trade securities with investors. Angel groups can also help other institutional investors also start-up enterprises join an accelerator provides an easy exit option to existing 140 program on the advice of angel VC/PE investors of an enterprise. WBG - Intellecap Analysis, http://www.livemint.com/Co investors. mpanies/tbJ0T8oH7nlR0XtO9 Globally, there are several examples tasAL/Domestic-VC-funds- of such exchanges such as Alternate proliferate-as-HNI-interest- in-startups-g.html Investment Market in the 83 United Kingdom, TSX Ventures in Canada, Growth Enterprise Market in Hong Kong, MOTHERS in Japan, Catalist in Singapore and Chinext in China. Along these lines, SEBI has also allowed MSMEs that fulfill certain criteria to list separately on the two major bourses in India – the Bombay Stock Exchange and the National Stock Exchange. Figure 47: Benefits of SME Exchange Easier entry and Higher visibility exit for investors Benefits of SME Exchange Market exposure Better price discovery The listing norms are designed specifically to suit MSMEs and are less stringent than those for an IPO. The following table shows a comparison of key listing requirements in the main exchanges and the SME exchanges: Table13: Key Listing Requirements SME Exchange Main Exchange Post-issue paid-up capital INR 10 - 250 million Minimum INR 100 million Lock-in period for promoter 1 year 3 years capital Net tangible asets: Minimum INR 30 Million Net tangible assets and BSE: Minimum INR 10 million for 3 years Net worth: Minimum net worth NSE Emerge: Positive networth INR 10 million in 3 years Time-to-market 3 months 6 months Reporting requirement Half yearly Quarterly 100% (with merchant banker Underwriting underwriting 15% from Not mandatory own account The MSMEs that list on the SME In 2013, SEBI also introduced the exchange, with a paid-up capital Institutional Trading Platform (ITP) to between 10 crore and INR 25 crore also facilitate capital-raising for early-stage have the advantage of easier migration enterprises in high-growth sectors such to the main exchanges after two years of as e-commerce, biotechnology and listing. Some additional requirements for analytics. This offers opportunities to listing on SME exchanges include a institutional investors and HNIs to minimum application size of INR 1 lac explore and invest in innovative and a minimum of 50 shareholders. The businesses models. The incentives for an SME exchanges also provide tax benefits enterprise to list on the ITP are relaxation such as zero long-term capital gains tax in disclosures, eligibility and other and 15 percent short-term capital gains compliance rules. The following are the tax, as compared to 20 percent and 30 eligibility norms for listing on the ITP: percent respectively, for unlisted shares. 84 Figure 48 : Eligibility norms for listing on ITP Minimum 1 year audited financial statements Vintage< 10 years Turnover< INR 1 billion Paid-up capital< INR 250 million The following table shows the growth of SME exchanges on the two bourses as of March 2017141: Table 14: SME Exchanges in India BSE SME Exchange NSE Emerge SMEs that have listed (excluding ITP) 231 7 SMEs migrated to main exchange 182 1 SMEs listed through ITP 21 21 The interplay of MSMEs and risk capital providers with the different elements of the enabling environment impacts the access and supply of capital. A clear and consistent regulatory regime, effective formulation and implementation of fiscal policies, and a well-integrated financial infrastructure are vital for MSME finance. The next chapter explores actionable ideas and suggestions to develop and implement multiple support mechanisms for both investors and MSMEs. 141 NSE, BSE websites 85 Chapter 7 Recommendations and Potential Interventions Recommendations and Potential Interventions Key Takeaways • Investment through onshore funds could be promoted to unlock domestic pools of capital from institutional investors and HNIs. • New funding models such as patient capital, returnable capital and blended finance could be explored to fund MSMEs. • Co-investment by government-promoted funds can help mobilize funds from private investors for financing high-impact MSMEs. • The use of technology and alternative data, coupled with stronger government schemes, can enable financial institutions to increase the supply of unsecured debt to MSMEs. • The supporting infrastructure of financial intermediaries such as incubators could be strengthened to cater to the growing entrepreneurial ecosystem. • Greater parity between onshore funds and offshore funds with respect to regulatory compliance, investment scope, operational flexibility and taxation could be beneficial for equity investors. • Harmonization and consistency in the investment regime for offshore funds can boost investor confidence. • Tax incentives and compliance relaxations for risk capital providers can stimulate early-stage investing. • Policies and infrastructure to enable easier investment exits can decrease the liquidity risk for investors. As discussed in the earlier chapters of process of bridging the demand-supply this report, there exists a significant gap gap. It is thus critical that interventions in the demand and supply of risk capital be made across the ecosystem to make to the MSME sector in India. This gap the supply of risk capital to the MSME presents an opportunity for risk capital sector in India more efficient and investors to help spur the latent growth effective. potential of the sector. At the same time The risk capital ecosystem in India can be MSMEs need to be better equipped to considered to comprise of providers of absorb more risk capital. Favorable risk capital, supporting infrastructure, policy and effective supporting and the enabling environment. infrastructure can help catalyze the 87 Figure 49: Risk Capital Ecosystem Providers of Risk Capital Supporting Infrastructure CAs Sources Commercial Banks Investment banks Intermediaries Guarantors NBFCs VC/PE funds Data suppliers Insurance firms Micro, Small and Medium Government schemes Pension funds Angel networks Enterprises (MSMEs) Endowments/ Foundations Incubators/ Accelerators Enabling Environment Development Fls Regulatory framework HNIs/Family offices Taxation Interventions across the ecosystem can boost the risk capital provided to the MSME sector. Some potential interventions to strengthen these elements are outlined below: Figure 50: Recommendations to enhance the risk capital ecosystem Reommendation to enhance the risk capital ecosystem Catalyze access to diverse Bolster the supporting Foster an investor-friendly risk capital providers infrastructure enabling environment $ • Unlock domestic pools • Strengthen incubation • Create a coherent of capital for MSME facilities regulatory and policy financing • Bridge information framework • Promote innovative asymmetry between the • Provide tax incentives funding models MSMEs, investors and to equity investors • Encourage debt-based other stakeholders • Ease exits for risk capital risk capital • Increase financial investor awareness among SMEs Broadly, the implementation of the and regulators. The following matrix above recommendations requires shows the ecosystem stakeholders that interventions by stakeholders such as have a role to play in each of the the government, risk capital investors, potential interventions: VC/PE funds, supporting intermediaries 88 Figure 51: Recommendations Matrix Recommendations/ Government Risk capitsl VC/PE funds Regulators Supporting Financial Potential interventions investors intermediaries institutions Unlock domestic pools of Catalyze capital for MSME financing access to Promote innovative diverse risk funding models capital providers Encourage debt-based risk capital Strengthen incubation facilities for entrepreneurs Bolster the Bridge information asymmetry supporting between MSMEs and investors infrastructure Increase financial awareness among MSMEs Create a coherent regulatory Foster an and policy framework environment Provide tax incentives to -friendly equity investors enabling environment Ease exits for risk capital providers Interventions across stage, size and type of MSME: Enterprise Stage Enterprise Size Enterprise Type Early Growth Mature Micro & Recommendations/ Medium Manuf. Service Stage Stage Stage Small Potential interventions Enterprises Enterprises Enterprises Enterprises Enterprises Enterprises Enterprises Unlock domestic pools of Catalyze capital for MSME financing access to Promote innovative diverse risk funding models capital providers Encourage debt-based risk capital Strengthen incubation facilities for entrepreneurs Bolster the Bridge information asymmetry supporting between MSMEs and investors infrastructure Increase financial awareness among MSMEs Create a coherent regulatory Foster an and policy framework environment Provide tax incentives to -friendly equity investors enabling environment Ease exits for risk capital providers These interventions are further detailed in the following sections. 7.1. Catalyze Access to Diverse funding structures that align the risk and Risk Capital Providers return characteristics of MSMEs to the risk appetite and return expectations of The investor base for MSME financing investors. can be widened by tapping diverse pools of capital available with domestic institutions and sophisticated investors. Access to large pools of risk capital can also be increased by devising innovative 89 7.1.1. Unlock Domestic Pools of smaller enterprises, increased availability Capital for MSME Financing of domestic capital augurs well for the MSME sector. A wider pool of domestic In 2015, SEBI established the Alternative capital would encourage more VC Investment Policy Advisory Committee investment in early-stage MSMEs. to recommend reforms in the regulatory and taxation framework of alternative 7.1.1.1. Commercial Banks investments in India. According to the committee, only 10 to 15 percent of In India, public sector banks have equity capital flowing to enterprises is allocated more towards VC/PE funds sourced domestically. Due to more than private banks145. Many large banks stringent regulatory restrictions on have created their own subsidiary VC/PE domestic institutional investors, most funds, and contribute to the fund pool VC/PE funds draw their capital from among other institutional investors. foreign investors. The foreign investors However, the allocation by banks to benefit from the Double Taxation VC/PE funds is low due to tight Avoidance Agreement between India and regulations and prudential norms. Indian their countries. However, foreign capital banks have to assign a very high risk is exposed to currency risk, country risk weightage towards investment in VC/PE and other global economic factors142. funds as an asset class while staying In contrast, domestically sourced capital within capital adequacy limits. is less volatile in nature. Domestic To boost the supply of risk capital from investors can better deploy capital banks, investments in certain AIFs, such towards the MSME sector due to strong as VCFs and social venture funds, could local networks and better understanding perhaps be excluded from capital market of the domestic regulatory context and exposure ceilings146. The government's entrepreneurship ecosystem. In turn, fund of funds could also commit a higher the domestic pools of capital can amount to the VC/PE funds created by benefit from the higher returns and banks to lower risk and incentivize larger diversification effects associated with commitments from the bank. At present, 'alternative investments' in MSMEs banks can invest only 10 percent of their through VC/PE funds. Also, domestic paid-up capital in AIFs or 10 percent of investors largely tend to reinvest in India, the total corpus of an AIF. These limits making a sustained pool of capital could be raised suitably. available for investment in the MSME Additionally, commercial banks can sector143. devise newer products such as venture There is a need to debt on the lines of SIDBI's Start-up Assistance Scheme which targets early- unlock domestic pools stage MSMEs less than five years old147. 142 Concept note prepared by TVS 143 Capital Funds Limited, 2014 of capital Since a lack of sufficient enterprise data India Venture Capital and Private Equity Report 2014 restricts the ability of commercial banks 144 Ibid Additionally, as opposed to foreign to lend to MSMEs, alternative data 145 Ibid investors, domestic investors have sources such as customer ratings, utility 146 SEBI Alternative Investment historically shown a higher preference Policy Advisory Committee payments, and projected cash flows (AIPAC) Report, 2015 for investing in VC funds than in PE could potentially be used to evaluate 147 Please refer to Section 4.2.1 funds144. Since VC funds invest mostly in creditworthiness. 90 7.1.1.2. Pension Funds Since alternative equity investment is a new domain for pension fund managers, Globally, over 40 percent of the they can be provided initial handholding aggregate investments in VC/PE funds in terms of what strategies to adopt and flow from pension funds148. Pension funds exit options available153. AIFs that raise in developed countries have been domestic capital can potentially build increasing their percentage allocation collaborations with pension funds to in equity and VC/PE funds since 1995149. understand the investment preferences, However, in India, pension funds have risk appetite, liquidity needs, taxation traditionally preferred investing in fixed and other issues of pension fund income debt instruments. The managers. Investment from the liberalization of the investment pattern government sector pension fund corpus of pension funds in India can unlock a could also be opened up to AIFs, since huge amount of equity capital for government pension comprises the private enterprises150. majority (almost 90 percent) of the In India, until recently, pension funds total corpus154. were not allowed to invest in alternative Since 2015, a small but growing number asset categories. In February 2016, the of overseas pension funds and pension regulator of India, the Pension endowments have been looking to invest Fund Regulatory and Development in the Indian consumer internet sector155. Authority, allowed 2 percent of the Pension funds such as Ontario Teachers' private sector National Pension System Pension Plan, Canada Pension Plan and corpus to flow into Category I and II global aerospace and defense major AIFs151. This move is likely to make Lockheed Martin's pension fund, are 148 TVS Capital INR 800–1,000 crore (USD 120–150 million) among those that have invested or are 149 PFRDA Annual Report, 2013-14 available for investment in AIFs annually. 150 Report of the Committee on currently scouting for avenues. This regulatory amendment is expected Investment Pattern for Endowments of major US universities, Insurance and Pension Sector, to enhance the domestic fund-raising G.N. Bajpai, 2013 including Harvard University and environment, given the huge corpus of 151 PFRDA Chairman, IVCA Columbia University, have also expressed Annual Conclave, March 2016 pension funds under the NPS152. Pension interest in investing in consumer 152 The total corpus as of 2015 funds could be a significant source of was INR 1.1 lac crore (USD 17 internet enterprises. billion) out of which private long-term and steady capital for onshore sector portion is INR 12,000 funds in India. crore (USD 1.8 billion) according to PFRDA data 153 PFRDA Chairman at an Investment by pension Funds in VC/PEs – Global Experience ASSOCHAM conference on 'Budget Proposals and Role of Globally, pension funds are one of the largest investors in the VC/PE asset class due to their long Private Equity: The Road term liabilities and low need for liquidity. Pension funds account for the greatest proportion of Ahead,' April 2015 capital billion to VC funds in 2015 (PitchBook Data). Generally, pension funds invest in mature- 154 http://www.livemint.com/ stage enterprises that have achieved scale, are profitable, carry lower risk of investment and Industry/vZvDQhmmGyqwvX require a large amount of capital. Pension funds globally have long-term horizon (holding fOFHPyAK/PEVC-fund- managers-cheer-move-to- periods of around 8-12 years) and add a lot of credibility for future investments. allow-pension-funds-to- inv.html 155 http://articles.economic times.indiatimes.com/2015- 11-06/news/68071750_1_ pension- plan-debt-funds- venture- capital 91 7.1.1.3. Endowment Funds insurance regulator, the Insurance Regulatory and Development Most endowment funds in India are Authority159. Some of the reasons for this structured as charitable trusts set up for include lower risk appetite of insurance different purposes, such as construction companies, limited ability to commit to of hospitals, of educational institutes, VC/PE funds, the illiquid nature of VC/PE religious establishments, and the investments, and a relatively weak promotion of social causes. These domestic VC/PE industry160. charitable trusts have an investible corpus of more than INR 5 lac crore156 Regulatory changes allowing insurance (USD 77 billion) and expect relatively low companies to invest in both Category-I risk-adjusted returns. There is potential and Category-II AIFs provide a huge for capital from such endowment funds opportunity for domestic VC/PE funds to flow towards angel funds or early- to raise funds from insurance companies. stage focused funds that carry a high A stable domestic regulatory element of risk. environment and greater impetus to investment through onshore funds (AIFs) In the US, investment in VC/PE funds can help attract capital from domestic represents a significant portion of the insurance companies, especially life investment portfolios of endowments insurance companies which have a (funds generated from donations)157. long-term investment horizon. For example, the endowment fund of Yale University has an equity-oriented Investment limits in AIFs for insurance portfolio and an allocation of companies could be increased from 10 to USD 3.6 billion in venture capital funds158. 20 percent of the total corpus of an AIF. Capital from endowment funds is well- Also, investments in AIFs could be aligned for investment in VC/PE funds included in the list of approved due to their long-term horizon and low investments by amending the Insurance need for liquidity. Investment Regulations, 2000161. The Ministry of Finance could put in 7.1.1.5. High Net-worth place enabling regulations to channel Individuals 156 India Venture Capital and capital from these trusts into the Private Equity Report 2014 entrepreneurial financing ecosystem and High net-worth Individuals are wealthy 157 Preqin Special Report: North allow professional deployment of the individuals with significant investible American Endowments as Investors in Private Equity corpus. For example, the regulatory capital, which is often managed through Funds: June 2012 framework could be amended to permit family offices in case of inheritance 158 Yale University Website, September 2015 these trusts to invest a portion of their across generations. In India, there has 159 Overall exposure limits to assets in AIFs. been a steady growth of HNIs over the AIFs are 3 percent and 5 last decade. Less than 1 percent of the percent of total investment for life insurance companies 7.1.1.4. Insurance Companies HNI wealth in India has been invested in and general insurance alternative assets162, out of which only companies, respectively Globally, insurance companies serve as 160 India Venture Capital and about 15 percent allocation is towards large pools of capital for VC/PE funds. In Private Equity Report 2014 VC/PE funds. A stronger collaboration 161 SEBI Alternative Investment India, however, the allocations made by between the VC/PE fund industry and Policy Advisory Committee life insurance and general insurance (AIPAC) Report, 2015 HNIs or their family offices, could be companies to VC/PE funds are far below 162 India Wealth Report, Karvy beneficial to both stakeholders. Wealth the regulatory limits specified by the 92 Increasingly, many successful guidelines for angel investors: minimum entrepreneurs in India have begun to investment requirements were changed invest through their own venture capital from INR 1 crore to INR 25 lac for AIFs funds (family offices) in early-stage registered with SEBI, while lower enterprises. The expertise and regulatory fee and lower fund size norms experience that such entrepreneurs were instated. SEBI also relaxed the bring can be leveraged by VC/PE funds regulation for minimum investment in deal generation and validation of requirement by an angel fund in a investment opportunities. Such venture capital undertaking from entrepreneurs can provide access to their INR 50 lac to INR 25 lac. The lock-in networks and give sector-specific advice period of these investments was also to the funds. In several cases, HNIs reduced to one year from three years, source enterprises and co-invest with besides the legitimization of angel the funds they have invested in. This can schemes (funds) to invest 25 percent add greater value to the fund than the of their investible corpus in startups more traditional passive funding by overseas. institutional investors. Accreditation could also be an effective Many HNIs invest as angels on their own tool to recognize and incentivize such or through angel groups. SEBI guidelines early-stage investors. Qualified investors for angel investors state that individual including HNIs, corporate houses and investors should have early-stage others could be given incentives such as investment experience, or experience tax credits, exemption or rollover of as serial entrepreneurs, or should have capital gains tax and reinvestment been senior management professionals benefit to invest in VC/PE funds. Wealth with at least 10 years of experience. management companies and family Additionally, the investor is required to offices can form stronger relationships have tangible net assets of at least with the VC/PE industry and channel a INR 2 crore (USD 0.3 million) excluding higher proportion of personal capital the value of investor's primary across VC/PE funds with different stage residence163. Although these regulations and sector focus. This will help achieve are made to ensure that investments are diversification and better risk-adjusted made by only such individuals who are returns for the HNIs. able to absorb the risk associated with VC/PE investments, they are substantially restrictive for participation of retail investors164. In 2016, SEBI relaxed 163 SEBI Memorandum to the Board – Amendments to SEBI (AIF) Regulations, 2012 164 India Venture Capital and Private Equity Report 2017 93 Growth in investment by HNIs According to the Asia-Pacifit 2016 Wealth Report, India has around 2,36,000 HNIs. HNIs have traditionally invested in asset classes as real estate, gold, commodities and capital markets. However, post the 2008 global financial crisis, as foreign investors started scouting fo rnew opportunities in emerging markets. As more capital started to flow in India, it had a cataytic effec t on the growing entrepreneurial ecosystem, attracting higher investment from domestic HNIs. The 50–60 percent returns realized in this space has made MSMEs an attractive investment avenue for HNIs. MSMEs that bring technological innovation have seen rapid traction and exponential financial growth in india. Higher risk-adjusted returns, combined with favorable Government policies, have encouraged domestic HNIs to increase their allocations to this asset class. Many of the ultra HNIs have established family offices that work with MSMEs closely to understand their business models and co-fund with VC/PE investsors. Mojority of HNIs go via the angel network route or collaborate with incubators/accelerators to make their investments. 7.1.2. Promote Innovative of investment in new-age businesses Funding Models that exhibit very high growth rates. This results in most investments going Apart from increasing the availability of to only a few sectors. Bridging the investible capital, it is critical that mismatch between return expectations funding models other than traditional of the current breed of equity investors equity be devised to address the gap in and the typical growth rates experienced the demand and supply of risk capital by MSMEs is a challenge that needs to to the MSME sector. These models may be addressed. include what are often termed 'mezzanine' structures – with elements Patient capital refers to capital that has of both debt and equity – or pure-equity- been raised specifically to be invested for like investments, albeit with different the long term – with the recognition that expectations of returns. certain businesses need time to scale. Such capital has evolved out of 7.1.2.1. Patient capital philanthropic giving and as such has a high tolerance for risk. Creation of such Equity investors typically expect a return funds that will pool philanthropic capital of more than 25 percent, while the from institutional and individual donors average holding period of investments could be encouraged. Such funds could by VC/PE funds is roughly five years. This be given explicit recognition within translates into fund managers looking the existing AIF norms, and target for quicker returns and investing in new sectors/geographies can be identified age enterprises that present a high to direct such capital. potential to scale. Traditional MSMEs are often unable to scale at such high rates. VC/PE funds source capital from investors on the basis of assurances 94 Evergreen funds Typically, VC/PE funds have a life of 5-10 years, after which investors draw all the returns and the funds have to initiate the process of capital raise again. Evergreen funds are funds with indefinite life and wherein the realized investment returns are recycled back into the investment strategies focused on longer-term hold periods, often with a greater emphasis on yield generation, are the key drivers for evergreen funds. When investors find enterprises with a high future potentional but long gestation periods, they would prefer to remain invested. However, due to the tradional closed-ended structure of funds, investors have to sell their stakes and restructure their protfolio. Alternatively, the lifespan of enterprises in capital-intensive industries (eg. manufacturing, infrastructure) is simply too long to fit in the traditional fund model. The evergreen fund structure allows investors to take a very long-term view on companies in a way that can’t be done with regular funds. The open-ended structure also gives the fund the liberty of investing in enterprises at various stages without the pressure of exits. Because evergreen structures have no specifit time frames, enterprises can also set the growth rate and business strategy that is best for their business, not necessarily a strategy imposed by fund level restrictions. Pension funds, insurance companies, university endowments and foundations have a long-term horizon and are ideal investors into an evergreen fund. Category-I and Category-II AIFs, that are required to be closed-ended, could find innovative ways to create longer life funds that have liquidity intervals for investors and lowers their reinvetment risk. 7.1.2.2. Returnable Capital for about 20 percent of the total ODA provided165. DFIs typically invest such Returnable capital refers to money capital to achieve ‘pro-poor’ raised to be invested with low or no development impact – which includes expectation of returns, beyond the MSME finance, apart from other sectors investment amount itself. Such capital such as health and education. Such expects to create impact in terms of overseas capital can be supplemented poverty alleviation, skill development with domestic sources to specifically and employment generation. target the MSME sector. Constituting such funds can be considered to augment the supply of 7.1.2.3. Blended Finance capital to MSMEs located in remote regions of the country. Such capital can The term blended finance refers to ‘the also be used to support enterprises in deliberate use of public funds to attract politically unstable or disaster-prone private capital towards investments geographies. Returnable capital can be delivering development impact in especially useful for enterprises engaged emerging and frontier markets.’ Typically, in capital intensive sectors such as in such arrangements, public investors manufacturing – where high upfront primarily bear the risk while enhancing costs and long gestation periods returns for private investors. Although dissuade equity investors from this concept was originally floated to venturing. create development impact, it can be 165 Social Sector Applications of used as a guiding philosophy for Development finance institutions are Returnable Capital by deploying capital from guarantee funds Development Financial increasingly using returnable capital as Institutions, Evans School and MSME-focused corpuses set up by a method of channeling their official Policy Analysis and Research the government. (EPAR), University of development assistance – accounting Washington 95 Blended finance can be used to pool capital from traditional investors, impact investors and public funds to create credit guarantee funds and/or to provide concessional debt at interest rates lower than market rates166. Such pools can be raised with the specific purpose of creating an impact in a particular geography, MSME cluster or sector that has been traditionally underserved by financial institutions. Financing through Masala Bonds Masala bond is a term used to refer to a financial instrument through which Indian corporates, especially financial institustions, can raise capital from overseas markets in rupee denomination. These are Indian rupee denominated bonds issued in offshore capital markets. The rupee denominated bond is an attempt to shield issuers from currency risk and instead transfer the risk to investors buying these bonds. Issue of Masala Bonds can ease access to capital for financial institutions as they would widen the investor pool. Such a structure can be used by FIs to raise finance specifically for lending to MSMEs in India. A masala bond has the advantage of diversifying funding sources and hedging the currency risk, which may result in a lower cost of borrowing for FIs. This benefit could be passed on to MSMEs as lower interest rate or relaxation of collateral requirement. RBI has allowed FIs to raise Tier-1 and Tier-2 capital by issuing Masala bonds for financing infrastructure and affordable housing. This move could potentially also be extended to MSME sector financing so that the proceeds from the bond serve as unsecured debt capital for MSMEs, increasing the total pool of finance available to the MSME sector. 7.1.2.4. Government–Private private investors. For example, a 'fund of Sector Co-investment funds' set up by the government could invest in a portfolio of VC/PE funds, with The government, through its various the requirement that such funds invest ministries, already plays a key role as a in MSMEs that typically do not attract provider of funds through grants, seed venture capital funding. Funds like the funds and other schemes to MSMEs. TEX Fund, Samridhi Fund and National Increasing the scope and scale of direct Venture Fund for Software and IT funding by the government in MSMEs Industry operated by SIDBI could be may 'crowd out' the potential for encouraged to target specific sectors innovation by private risk capital or geographies167. providers. In addition, private fund managers have the ability to bring in- Globally, there are also examples of depth sectoral knowledge, a systematic co-investment plans wherein due-diligence process and operational government matches the capital know-how to the MSME sector for more provided by private investors by either efficient capital deployment. grant or equity, to provide either upside leverage or downside protection to the International experience shows that private investors (see box on the government intervention in the following page). Such a model is an financing of early-stage MSMEs in low effective way to leverage private capital 166 Blended Finance Vol. 1: A income states and high impact sectors Primer for Development and can also drive the building and Finance and Philanthropic can mobilize greater private investment professionalizing of the seed and early- Funders, OECD, World for such MSMEs. The government could Economic Forum, September stage investment market by providing a 2015 thus consider pursuing co-investment more structured investment process. 167 Please see section 4.2.2 strategies that involve participation of 96 An 'asymmetric' model of funding could also be adopted whereby the fund allocates a higher proportion of the returns to private sector investors or bears a greater part of the losses. Schemes can also be formulated to provide safety nets for investors in MSMEs that are engaged in non-traditional businesses which have a high inherent risk of failing. For example, guarantee schemes can be introduced for certain sectors to cover risk of failing partially. This provides a premium to private sector investors to compensate for the risk and long-term nature of seed and early-stage investments. Global experience – Co-investment between Government and private funds United States: Under the Small Business Investment Company (SBIC) program, the SBA supplements the capital that the VC funds raise from private investors with low-cost, government-guaranteed debt. SBIC operates as a fund of funds, investing up to 75 percent in a VC fund’s capital. Israel: The government has set up a fund, YOZMA, to invest directly and also to operate as a fund of funds. Its objective is to promote private venture capital in the technological sector. It can invest up to 40 percent of the total fund size and has invested around USD 200 million. It has led to 164 start-ups receiving funding, more than 50 percent successful exits and breakeven in 5 years. New Zealand: The New Zealand Venture Investment Fund (NZVIF) invests with VC funds and angel investors to support technology companies with start-up growth capital. It invests through 2 vehicles: 1) A USD 260 million VC fund of funds, 2) A USD 40 million Seed Co-investment fund. Singapore: SPRING SPEEDS Capital, a Singaporean government agency, co-invests in Signapore-based innovative startups along with independent angel/VCs, matching dollar-to-dollar, and taking an equity stake proportionate with the investment. Turkey: The Treasury of Turkish Government has started a system for accrediting angels. There is a joint mutual funds system, which is run by the government, which can match investments made by business angels. The Department of Industrial Policy and entrepreneur to scale the business. At Promotion (DIPP) is in the process of present, banks provide unsecured debt setting up a Credit Guarantee Fund of funding based on factors such as INR 2,000 crore. The fund will provide revenue, profit, business vintage, credit partial risk cover for collateral-free credit rating and audited financial statements. by banks to start-up enterprises168. Often, banks also demand personal guarantees from promoters for these 7.1.3. Encourage Debt-based loans. MSMEs find it difficult and costly Risk Capital to meet these requirements and furnish Apart from equity capital, a venture the paperwork for small ticket size loans. also needs debt for working capital. More banks could have pure cash-flow Due to limited formal sources of debt, based lending products for MSMEs by 168 https://www.vccircle.com/ the entrepreneur is often compelled to analyzing transactional data to assess dipp-to-move-cabinet-note- use equity capital as working capital, risk and pricing the loan accordingly. on-credit-guarantee-fund- for-startups/ which limits the ability of the This will especially enable service sector 97 enterprises with low tangible asset bases Credit Guarantee Scheme to access debt funding more easily. Over 2017-18, only about 17.4 percent of Based on their risk appetite, banks can total credit disbursed by banks went to fund early-stage enterprises through a MSMEs, while 82.6 percent of credit was dedicated ‘start-up cell.’ Besides disbursed to large enterprises170. As of financing, this cell could also provide March 2017, CGTMSE guaranteed loans advisory services to entrepreneurs on formed approximately 10 percent of the 169 Please refer to Chapter 3 for taxation, investment planning, legal total outstanding debt to MSMEs by details consultation, maintaining proper banks171. While there has been significant 170 https://economictimes. indiatimes.com/small- financial statements, details of CGTMSE, increase in recent years, there is biz/sme-sector/ economic- determinants of credit rating and other potential for further increases. Some survey-large-businesses- corner-82-6-of-credit- msmes- issues. ways of doing so are set forth below: get-a-paltry-17-4-/ articleshow/62693254.cms There is a dearth of short-duration and 1. Expanding the CGTMSE corpus172: 171 MSME Committee Report, small ticket size unsecured debt funding A significant rise in claims in the past 2015 172 to MSMEs in India for their working three years has resulted in over- According to CGTMSE Annual Report 2014-15, the corpus as capital requirements. The potential extension of the CGS corpus. The ratio of March 2015 was INR 2,400 demand-supply gap is over USD 10 of guarantees approved to overall crore 173 IFC - Intellecap Primary billion169. MSMEs often need such finance corpus is as high as 36 times. research, MSME Committee on an immediate basis, while the current Increasing the CGTMSE corpus would Report, 2015 174 credit assessment process can take up help in widening the coverage of the According to a research titled 'Innovative Credit Products to two weeks. Globally, many NBFCs plan. Keeping in view the existing for MSME sector and to evaluate the Credit are beginning to mine alternative data over-extension of guarantees by the Guarantee Mechanism under sources such as customer ratings on CGS, niche guarantee agencies can be CGTMSE and compare with Credit Guarantee Mechanism ecommerce platforms, social networks, established that can provide credit of Japan' undertaken as part daily sales and bill payments for quicker guarantees for specific sectors. of the IIBF Diamond Jubilee and C H Bhabha Banking credit scoring and disbursal. As the 2. Reducing procedural delays in case Overseas Research online presence of MSMEs in India of default173,174: Right now, the Fellowship project, an assessment of the CGTME increases, financial institutions could realization process for claims under against Principle 13 (relating to the efficiency and leverage technology and use such CGTMSE is slower than desirable. transparency of the claim proxies to screen MSMEs faster and A mechanism for quicker settlement management process) reveals that the biggest concern widen the pool of potential borrowers, of the guaranteed sum would be faced by banks [sic] is slow simplifying the application and beneficial. A step towards achieving realization of claims. Faster settlement of claims under underwriting process. Tapping this has already been taken by the the CGTMSE scheme would alternative sources of data will allow help foster confidence Ministry of MSME as part of the amongst the member lending lenders to advance venture debt or recent policy changes in the scheme. institutions (MLIs). Given the alternative products based on projected The Ministry announced that it will legal issues and procedural delays involved, the number cash flows. be enhancing the IT infrastructure of cases for which full settlement of eligible claims The existing government schemes – of the Trust to improve operational (2nd instalment) gets CGTMSE and MUDRA – can also be efficiencies and reduce turnaround completed is negligible. Source: strengthened to encourage the banks time for claim settlement175. http://www.iibf.org.in/docu ments/IIBF-report-Final- to increase the supply of unsecured 3. Introducing risk-based pricing: CGS 12.06.2018.pdf debt to the MSME sector. caps the downside risks for lenders by 175 https://www.cgtmse.in/ news_and_features.aspx?arti offering guarantees. However, some d=301. 98 private banks consciously enter the increase the use of the plan by member high-risk zone of unsecured loans for lending institutions176. higher returns. To encourage private Refinance scheme (MUDRA) banks to lend to MSMEs under the The target customers for MUDRA Bank plan, a high-risk-high-reward belong to the informal sector. Thus, the approach must be adopted and member lending institutions may face interest rate caps should be made higher NPAs if proper risk management flexible according to the risk of the systems are not in place. There is an borrower. opportunity for MUDRA to periodically 4. Implementing better risk rate NBFCs and microfinance institutions mitigation practices: The scheme on the basis of recovery performance and should adopt better risk mitigation promote responsible lending practices. measures such as a fee-based, robust, This could be extremely beneficial in independent and periodic credit reducing the risk of adverse selection health assessment of both the on the part of NBFCs and MFIs. MSMEs and of the lender portfolios. There is an opportunity for banks too Some plan changes are already to introduce venture debt as a risk underway, such as increasing risk- capital product. DBS Bank in Singapore, sharing among member banks to for example, was one of the first banks 50 percent of the loans exceeding to provide venture debt to growth-stage INR 50 lac, and differential pricing of technology-based enterprises to loans based on historical non-performing complement venture capital, as an assets as recorded by banks. These alternative source of finance. changes are expected to significantly Venture debt by banks Venture debt is an instrument that is increasingly being promoted by banks too. In Singapore, for example, there is a popular venture debt loan offered by commercial bank OCBC (and other Singapore banks) that enjoys backing of SPRING Singapore, a government body established to promote financing to technology startups for meeting working capital needs, buying fixed assets and project financing. DBS has partnered with a few venture capital firms and funds only those enterprises that have raised funding from one of these VC firms. Similarly, in india, Dena Bank is one of the few banks that has stepped into Venture Debt funding by launching a specialized branch called ‘smallB’ to offer term loans to early-stage MSMEs that have innovative and asset-light business models. Although the loans are collateral-free and guaranteed under the CGTMSE scheme, they require a personal guarantee from the promoter. SmallB finances only those MSMEs that have raised an equity round of funding from an angel network or a SEBI-registered venture capital fund. An advantage for the MSMEs that raise venture debt from smallB is the access to the parent bank for larger loans at a later stage. 176 As of Financial Budget 2017- Total size: INR 50 lac to INR 1 crore | Tenure: 5-7 years | Interest rate: 12.5% p.a. 18, other changes such as increasing the corpus by an Federal Bank, too, has introduced a dedicated startup fund worth INR 25 crore. This fund is additional INR 5,000 crore to housed within specialized louges called Lanchpad in the bank branch premises. These lounges a total of INR 7,500 crore, act as incubators and provide financial and advisory support to entrepreneurs. increasing the loan limit from INR 1 crore to INR 2 crore, and By acquiring startups as a client at the beginning of their business development journey, including NBFCs in the banks are able to build relations with growing enterprises. member lending institutions are also underway. Source: Livemint, Dena Bank smallB blog, Times of India, DBS Bank website, Innoven 99 7.2. Bolster the Supporting building market readiness can Infrastructure substantially increase the probability of success for a new venture. A platform The extent and efficiency of supporting for successful entrepreneurs to interact infrastructure plays a critical role in and mentor the youth about different ensuring investment in the MSME sector. financing options can help increase 'Supporting infrastructure' here refers to awareness and streamline the flow various enabling intermediaries that of finance. assist both demand side and supply side entities in facilitating investments – Increasing ecosystem support from ranging from incubation support to the government: The Ministry of MSME MSMEs, to data suppliers and insurance could explore building outcome-based providers, to investors. This section looks financial support mechanisms for at such ecosystem players and suggests incubators. One of the ways to achieve interventions to strengthen them. this could be by holding competitions and theme-wise challenges with prizes 7.2.1. Strengthen Incubation to provide incentives to entrepreneurs Facilities for Entrepreneurs who develop innovative products and There has been a burgeoning of solutions with a high potential for social incubators and accelerators in the impact. The ministry could support country following increased interest impact investors who invest in early - in investing in start-up enterprises. stage ventures and establish a However, incubators are mostly located standardized system of impact in a few metro cities and are relatively assessment. A common platform could inaccessible to new entrepreneurs from be created to register various angel Tier-II and Tier-III cities. Additionally, networks and individual angels to share incubators are often unable to provide best practices. The ministry could also end-to-end hand-holding to link early-stage institutional investors entrepreneurs. Incubators can facilitate with incubators and accelerators to value creation for new enterprises by source start-ups for funding. addressing the critical support needs of entrepreneurs throughout various Government could junctures in the early stages of the augment private sector enterprises' existence. in providing incubation On-boarding of business experts: support to MSMEs Incubators and accelerators can bring business and market experts on board, apart from subject experts, to provide mentorship to new enterprises. Primary research with incubators and angel investors has revealed that most new enterprises fail at the go-to-market phase of their business despite having a technically sound and subject-expert- vetted offering. Early intervention in 100 Self Employment and Talent Utilization (SETU) Scheme The governent has announced the Self Employment and Talent Utilization (SETU) scheme, especially for technical, financial and other important aspects of self-employment activities, especially for technology-intensive startups. Presently, various startup ecosystem actors such as investors, incubators, universities and service providers operate in silos. SETU scheme aims at strengthening the network among these players to accelerate the growth of MSMEs. The funds allocated to the SETU scheme could be used to build capacity of incubators and accelerators that focus on supporting startups that require a high initial capital outlay. For example, in the healthcare products space, entrepreneurs often do not have adequate infrastructural facilities for building and testing prototypes. SETU scheme can encourage incubators to induct such startups by way of cost-sharing or allocation of earmarked funds. SETU scheme may also connect local government departments and civic bodies with incubators in universities to involve the youth in developing solutions to local issues. To this end, ‘Tinkering labs’ could be set up in engineering institutes and polytechnics for providing students with hands-on experience in creating innovative products and prototypes. Corporates can also be looped in to partner with universities and fund such labs. Developing sectoral expertise: capability, infrastructural support and Incubators could build expertise in market network required to compete particular sectors by creating relevant in the national market. Incubators too mentorship teams with industry are usually located in large metro cities connections. Incubators need to look or within academic institutions. As a beyond popular sectors such as IT/ITES, result, new enterprises in non-metro BFSI and healthcare. Additionally, locations are often unable to access the a database of incubators and their sector mentorship they need. Thus there is a focus would help entrepreneurs find the need to nurture talent, especially in the right incubator. rural areas, where over 45 percent of Launching innovation labs: Innovation MSMEs are located177. Incubators should labs could act as intermediaries that expand their sourcing mechanisms to liaise between industry experts and new non-metro geographies to be able to enterprises to design and execute pilots support such enterprises. The concept that validate market feasibility of the of virtual incubation has emerged as an product/service in question. Incubators effective mechanism to enable could partner with such innovation labs entrepreneurs from non-metro areas to to shorten the failure cycles of new access incubation support. StartupWave entrepreneurs and ensure that they are is one such virtual incubator that allows developing a scalable product or service. entrepreneurs to connect with mentors online and receive incubation support Expanding geographical reach: Rural remotely. enterprises typically find it difficult to access institutional finance and incubation facilities because of their small size and localized operations. They also lack the management 177 MSME Census 101 StartupWave: A virtual incubation platform StartupWave is a virtual incubation platform developed by Intellecap in partnership with DFID and GIZ. It caters to entrepreneurs and early-stage interprises with sector-specific support. It works in collaboration with existing incubators, accelerators and investors, and complements their efforts. In partnership with incubators and acelerators, business support service providers (legal, marketing, technology support) and a vast network of investors (angels and Vcs). StartupWave provides personal mentoring and access to content on building a business model around their startup idea. Incubation-ready startups are taken through a customized journey involving sector and theme-based mentoring, pitch preparatory support, and connections to corporates / startups based on synergies. For startups that are at a sufficiently advanced stage. StartupWave slso conducts periodic ‘demo days’ (virtual and physical). Getting incubators and industry start-ups is low. Contributions of stakeholders to collaborate: Engaging corporate houses to this sector as part with industry stakeholders such as large of their Community Social Responsibility corporate houses, regulators and market commitment, is low as well. Incubators research agencies to identify market approved by the Department of Science gaps can help incubators provide specific and Technology can put in place robust inputs to entrepreneurs. This will help outreach mechanisms, better in any course correction required for governance structures and reporting the enterprise and/or to expand the frameworks to encourage corporate enterprise's offering to address related houses to fund incubators. Initiatives opportunities. Moreover, relationships such as SIDBI's StartupMitra could be built with industry stakeholders can be useful platforms for entrepreneurs to beneficial to the enterprise in the long connect with mentors and apply to run. Currently awareness among suitable investors178. corporate houses about MSMEs and SIDBI StartupMitra platform SIDBI has recently launched an online platform to enable entrepreneurs in the start-up community to get connected with various stakeholders, namely incubators, angel investors, and venture capital funds. The launch of the platform is in line with the objective of the government in forging innovation-led entrepreneurial growth through various measures. The portal also shares other information such as government schemes and allows entrepreneurs to apply to different investors and schemes. The one-stop shop platform has already on-boarded 2254 enterprises, 79 investors, 80 incubators and 88 venture funds. 178 https://www.sidbistartupmitra.in/ 102 Global experience- Government driven initiatives focused on incubation Singapore: There are various business incubation schemes as well where government bodies such as the Media Development Authority, SPRING and National Research Foundation partner with incubators and provide them grant support based on the condition that the incubators take equity stake of 10-25% in the startups they support. Israel: The government has entered into public-private partnerships with incubators to focus on domestic capacity building for products manufactured in Israel. The program has created 1,600 companies in a decade with the government funding leveraged six fold by funding from private sources. New Zealand: Incubators are supported under the Incubator Support Program (ISP), launched in 2001. The government has launched a Repayable Grants Programme wherein it contributes a certain portion of repayable grants to technology-focused incubators that incubate startups commercializing complex intellectual property in these incubators. Brazil: The Brazilian innovation agency called FINEP sponsors a program called PRIME to fund business incubators that incubate innovative startups. South Korea: Korea’s National IT Industry Promotion Agency (NIPA) provides training and support for startups as well as provides policy research. NIPA sponsored the K-Global Startup Engine which was designed to help place 40 Korean startups into global accelerators. The government has launched the Tech Incubator Program for Startups (TIPS) to identify promising startups for funding and expansion. Germany: The Federal Ministry of Economic Affairs and Energy runs startup funding programs called EXIST. The INVEST programme provides subsidy up to 20% of investment to private investors to acquire shares of ‘Innovative’ companies and hold them for three years. The ‘EXIST business start-up’ grant supports the preparation of innovative start-up projects at universities and research institutions. ‘The EXIST transfer of research’ complement the ‘EXIST business start-up’ by promoting technology-based start-up projects in the pre- start-up and start-up stage. BMWI also promotes various Business Membership Organizations (BMOs) to provide consultancy service to MSMEs. 7.2.2. Bridge Information Asymmetry enterprise data and financial records between MSMEs and Investors according to standard criteria. In the Most MSMEs in India are structured as absence of information required by sole proprietorships or partnerships. traditional methods of credit analysis, Such enterprises are required to file financial institutions are often hesitant minimal financial records with the to provide unsecured debt to MSMEs. government and often lack proper Financing constraints tend to be more documentation. This makes the acute for early-stage enterprises because availability of credible data on such they have limited internal funds and lack MSMEs a challenge for risk capital a track record to give confidence to providers. While equity investors investors. When information generally perform an independent and asymmetries are large, a 'missing- thorough due-diligence before funding, market' problem may emerge, implying debt providers generally require that many of the innovations associated 103 with early-stage firms may never be to assess creditworthiness in the commercialized179. In addition, early- absence of historical financial and stage financing often involves long-term business records. Banks and other investments, which carry a premium. financial intermediaries, credit rating The information asymmetry increases agencies and credit bureaus, could be the transaction cost, posing difficulties encouraged to develop and use new for investors in devising the appropriate tools for risk assessment using such contract. There is a need, therefore, to alternative sources of data. Analytics establish a stronger database of relevant and algorithms can be applied to such data for a wider pool of MSMEs – either data to arrive at an aggregate credit by credit information companies or by score. Psychometric evaluation has also a separate body set up with the express been experimented with as a means of purpose of collating data for MSMEs. credit assessment. Such non-traditional Globally, many models have emerged and innovative frameworks for credit where alternative data points are used rating would facilitate a greater flow of to underwrite and provide MSMEs with risk capital to MSMEs. Increased easier access to funding. Utility bill digitization of government processes in payments by MSMEs, demographic and different sectors can increase access to social network data and cluster-level information and expedite approvals. information are all being used as proxies eBiz G2B Portal For an entrepreneur, setting up a new business currently requires several compliances to be met and clearances to be obtained from multiple government departments. The information about these government services is scattered across different acts and platforms. An entrepreneur has to apply and pay for each service individually before receiving the statutory clearances. Such a fragmented service delivery is one of the major causes for India’s low ranking in the ease of doing business. To provide a one-stop shop solution for various regulatory sanction and licenses required while starting up a business, DIPP has launched the’e-Biz Portal’. e-Biz web portal aims to provide a single-window clearance of various G2B services from the Central, State and local governments. The centralization of services under the e-Biz umbrella would be done in a phased manner. As of 2015, fifteen pan-India services are available in the e-Biz portal. The Government is planning to centralize services from specific state departments under the e-Biz portal too. Services from Andhra Pradesh and Delhi have already been integrated in the portal. It is envisaged that over the next 10 years, around 200 services for investors and businesses will be rolled out. The e-Biz portal will enable businesses to submit a consolidated application for several licenses and clearances. This concept of a universal gateway for e-governance application would help in reducing delays due to numerous approvals required from different departments at the time of incorporation. The online payment mechanism for the delivery of services through e-Biz would enhance security, increase transparency, and facilitate a fast, convenient and secure way of obtaining information and accessing services related to licenses, permits and clearances. While setting up the e-Biz portal is a step in the right direction, its usefulness could potentially be enhanced if it can be linked with the DCMSME portal which presently facilitates online registration for MSMEs on national-level. 179 Policy lessons from financing young innovative firms, OECD 104 Credit reporting and rating agencies can Additionally, in order to reduce play a key role in enhancing MSME data dependence on immovable collateral availability and quality since banks and such as land, property and plant, a NBFCs rely on credit reports and framework for using movable assets as registries to make lending decisions. collateral can be devised. Movable assets The robustness of the data becomes such as machinery, stock, receivables or even more important in the case of livestock often account for most of the unsecured debt funding, to evaluate the capital stock of MSMEs. Such movable willingness and capacity of the MSMEs assets can be more easily pledged as to repay. An effective commercial credit collateral to obtain debt. A sound legal reporting system could reduce reliability and regulatory framework is essential on 'soft' information and encourage to allow movable assets to be used as financiers to better engage with MSMEs collateral. Without a well-functioning for lending. registry for movable assets, even the It can also enable the financiers to design best secured transactions laws could new financial products by customizing be ineffective180. Recognizing this, the the tenure, repayment schedules, Ministry of Finance and RBI are in interest rate and other relevant advanced stages of setting up a 'movable elements. asset registry' in association with IFC Credit insurers, which typically cover and Central Registry of Securitization short-term accounts receivables, can Asset Reconstruction and Security be a rich source of trade data for credit Interest of India, which provides a facility bureaus. Financiers could also increase for registering charge on immovable transparency of their credit policies, property. The registry will enable MSMEs create awareness about proper book- to borrow from banks, especially for keeping practices, and provide working capital requirements. actionable feedback to MSME borrowers so as to enable the MSMEs to take corrective measures and increase their credit-worthiness. Collaboration and data–exchange (as legally permissible) among the different credit bureaus could also strengthen the depth of enterprise data for financiers. 180 https://blogs.worldbank.org/ allaboutfinance/does- introduction-movable- collateral-registries-increase- firms-access-finance 105 Global experience – Movable assest registry China: After the enactment of the Property Law in October 2007, the People’s Bank of China Credit Information Center has created a national online registry for security interests in receivables. The percentage of moveable asset-based lending in China went up from 12% pre-reform to around 20% post-reform. Of the USD 3.5 trillion in new financing facilitated that year, approximately USD 1.1 trillion corresponded to SME financing. Ghana: In 2008, Ghana embarked upon a reform of its movable collateral legal framwork and registry. Before the reform took place, the use of movable collateral in Ghana was a key constraint for SME financing. Upon enactment of the ‘Borrowers and Lender Act’ 2008, the Bank of Ghana established a collateral registry. With IFC support, the Bank of Ghana updated the Borrowers and Lenders Act and redesigned the Registry system to align more with international best practice. Over 20,000 loans were reported to have been registered since March 2010. The total financing secured with movable used the registry in Ghana that year. The new secured transactions system led to the development of productive supply chain financing schemes in the mining and oil industry, benefiting more than 100 local SMEs and creating hundreds of new jobs. 7.2.3. Increase Financial activities, adhere to regulatory Awareness among MSMEs compliance, and execute a term sheet. The Ministry of Finance can engage CAs, Apart from devising new methods of banks, consultants and investment credit assessment, there is a need to banks to provide advisory services to concurrently create awareness among both MSMEs and financiers under a MSMEs about the importance of national scheme. This can ensure a adhering to accounting best practices smooth investment process and and regarding institutional risk capital as decrease transactional costs for MSMEs. a source of finance. Networks of industry Adherence to accounting best practices bodies and MSME associations such as will ensure transparency and help bring ASSOCHAM, FICCI, CII and FISME can be enterprises under the ambit of used to reach out to MSMEs. Awareness institutional finance. Access to can also be created through various institutional risk capital can help protect advisory services that MSMEs access. entrepreneurs from unscrupulous The equity raising process is complex and informal lenders in the short term. many MSMEs lack in-house capability to manage it. This is true especially of A system of professional credit advisers family-owned proprietorships and could also help MSMEs with weak credit partnership enterprises. Such histories and inadequate expertise in enterprises seek external support from preparing financial statements, as well business advisers such as CAs, banks, as assist banks in making better credit consultants and investment banks. decisions. A proposal to accord These advisers assist the MSME to accreditation to a few credit counselors 181 http://indianexpress.com/ maintain financial statements, prepare who would act as facilitators for small article/business/business- a detailed business plan, assess the tax entrepreneurs to access the formal others/collateral-for-msme- loans-monetising-non-land- implications of various financing financial system has been floated181. assets-2781436/ 106 7.3. Foster an Investor-friendly especially for knowledge-based Enabling Environment enterprises in the technology sector, such as e-commerce and software A well-functioning entrepreneurial and product development. The modified ITP, financial ecosystem is likely to have called Alternate Capital Raising positive spillover effects on the economy Platform, is similar in concept to in terms of job growth, self-sustenance London's AIM exchange or New York's and wealth creation. Policy intervention Nasdaq, and is aimed at providing can play a catalytic role both in relaxations on eligibility criteria to facilitating the functioning of the enable high-growth start-up companies ecosystem and targeting actions to to list on Indian bourses. Compared to trigger its further development. the present ITP, this proposed platform A framework of policies and procedures further relaxes the criteria on restriction that makes it easy for entrepreneurs to of fund-raising, promoter shareholding create and operate new ventures, take lock-in period, profit history and more. risks, and raise financing at different Such a platform could ease liquidity stages should be encouraged. While the concerns of early-stage investors in government is already taking several technology start-ups, and thereby initiatives in this regard, some more increase their risk appetite. are suggested below: Often, an enterprise may also fail and 7.3.1. Ease Exits for Risk Capital go bankrupt, forcing it to shut down. Providers Capital providers recover their investments by liquidating the assets of Extensive procedures and compliance the enterprise. However, shutting down requirements for mergers and a business is a time-consuming process acquisitions, and strict criteria for IPOs, in India. At present, it takes an average are key deterrents to exits for venture of 4.3 years to resolve insolvency in India capital investors. A well-integrated and the recovery rate of debt is very low financial services market allows compared with other countries, investors to realize returns on according to a report by Nomura. investments with a lower transaction Even asset-light enterprises take about cost, reducing their exit risk. An efficient six months on average to shut down. secondary market for VC/PE investors There are multiple laws dealing with enables higher liquidity and incentivizes bankruptcy (SICA, SARFAESI and the them to reinvest in the MSME sector Companies Act). As a result, four Efficient SME platforms can prove a vital different agencies – the high courts, source of capital for MSMEs. However, the Company Law Board, the Board for despite the presence of two SME Industrial and Financial Reconstruction, exchanges in India, many enterprises get and the Debt Recovery Tribunals have listed in Singapore or the United States overlapping jurisdiction, giving rise to because of the less stringent domestic ambiguities and complexities. Due to regulatory regime and lower compliance the number and expense of procedures, requirements in those countries. SEBI many entrepreneurs choose to keep their has recently proposed a modified version defunct businesses alive 'on paper', of the Institutional Trading Platform, which proves costly in the long-run. 107 Slow recovery proceedings also impact the ability of the investors of that enterprise to free up funds and feed them into other enterprises. To expedite the process of winding up businesses and subsequent sale of assets, the recently implemented Insolvency and Bankruptcy Code, 2016 proposes an institutional mechanism to deal with asset recovery and creates a time-bound process for insolvency resolution. The enforcement of this new legislation could potentially have a positive impact in promoting investments in the MSME sector182. Insolvency and Bankruptcy Code, 2016 The Insolvency and Bankruptcy Code, 2016 is a law aimed at speedy winding up of insolvent companies, lowering NPAs, and redeploying capital productively. It consolidates and amends the existing framework and create a new institutional structure. The Code creates time-bound processes for insolvency resolution of companies and individuals. These processes will be completed within 180 days. If insolvency cannot be resolved, the assets of the borrowers may be sold to repay creditors. Some of the key features of this Code include: • The new law creates a new class of insolvency professionals who will help sick companies and banks with a smooth takeover of the insolvent company and manage the liquidation proces. • It sets up a new entity, the Insolvency and Bankrupty Board of India, which will regulate insolvency professionals and information companies – those which will store all the credit information of corporates. • The National Company Law Tribunal will adjudicate cases for companies and limited liability partnerships, while the Debt Recovery Tribunal will do the same for individual partnership firms. 7.3.2. Create a Coherent Greater compatibility between rules for Regulatory and Policy domestic investors and foreign investors Framework in terms of taxation, investment and compliance could facilitate greater A transparent, clear and consistent onshore pooling of foreign investment. regulatory regime can incentivize risk At present, investment through onshore capital providers to create a steady funds constitutes only around 10 percent pipeline of long-term investments in of the total funds flowing into private MSMEs. Multiple regulatory jurisdictions enterprises in India annually183. The pure and agencies create grey areas that may offshore investment structure has discourage investors and hamper the historically been the preferred flow of funding to MSMEs. Regulations investment route of foreign investors. that are implemented must be Greater parity in investment matters coherently coordinated with the between offshore funds and onshore government policy on the subject. funds could be beneficial in encouraging This will reduce administrative and onshore pooling. compliance hassles for the investors and fund managers. Regulatory parity 182 http://blogs.wsj.com/briefly/ between domestic and 2016/05/12/what-indias-new- A clear and consistent bankruptcy-law-means-the- foreign investors could short-answer/ regulatory framework provide significant 183 SEBI Alternative Investment enhances investors' Policy Advisory Committee benefits Report, 2015 confidence 108 Similarly, as suggested by the SEBI may well be deterring foreign Alternative Investment Policy Advisory investors from investing through AIFs. Committee Report, 2015, there is a need This tax is applicable only to offshore to liberalize investment structures funds using the FVCI route. through the FVCI investment route and Elimination of this withholding tax for reduce sector restrictions. The report exempt income flowing through AIFs suggests that greater flexibility of can ease capital repatriation for 184 investment via the FVCI route can also foreign investors . incentivize foreign investors to direct 2. Pass-through of net losses: Net funds through an AIF. Onshore pooling losses at the AIF level are not allowed can potentially help SEBI and other to pass through for investors to be regulatory bodies to exercise better able to offset the losses against their control and monitor systemic risks. income. Consequently, in case of a net Greater flow of investments from foreign unabsorbed loss at the end of fund investors through AIFs could also life185, investors are unable to derive a encourage domestic investors to co- tax credit from the net loss. As a result, invest in the AIF, and hence increase investors are taxed on an amount that the total available risk capital to MSMEs. is greater than the 'real' taxable A localized ecosystem of onshore funds income derived by them from their can catalyze growth in the MSME sector investment186. A provision to allow by providing finance and mentorship pass-through at the end of the tenure to MSMEs. of the fund could further incentivize investors to invest through AIFs. 7.3.3. Provide Tax Incentives to Equity Investors 3. Section 56(2) (vii b) of ITA: In cases where the shares of a private limited Taxation is an important factor that enterprise are purchased at a premium shapes investment decisions and to the fair market value (FMV), the inconsistencies in taxation may pose difference is treated as taxable income a barrier to entrepreneurial funding for the enterprise under the Section activity. SEBI's Alternative Investment 56(2) (vii b) of the Income Tax Act. Policy Advisory Committee (AIPAC) Only investments made by the VCF Report, 2015 has made the following subcategory of Category I AIF are recommendations to iron out some exempt from this section. However, inconsistencies in the taxation rules many MSMEs also raise capital from for equity investors: private equity funds and angel 1. Withholding tax: Even though investors. The funding generally Category I and Category II AIFs have depends on future prospects of the tax pass-through status, a enterprise more than the present withholding tax of 10 percent is levied underlying tangible assets. on dividends and long-term capital Consequently, the fair market value 184 India Tax Insights, January – gains payable to investors. Although of such enterprises may be very low March 2015, EY India 185 Category I and Category II this tax is refundable in case of compared to the perceived enterprise funds are closed-ended i.e. investors who may have lesser tax value. Exemption under this section they have a limited tenure 186 liability or may benefit from the could possibly be extended to angel SEBI Alternative Investment Policy Advisory Committee Double Taxation Avoidance investors and other sub-categories (AIPAC) Report, 2015 Agreement, the withholding tax and categories of AIFs. 109 Tax incentives may be difficult to target In India, the Start-up India has exempted effectively, so careful design, monitoring tax being levied on investments above and evaluation are necessary to ensure the fair market value in eligible startups the intended results are achieved. Some – investments made by angel investors, countries provide tax incentives at the incubators, family or funds which are not regional level for a more geographically registered as venture capital funds. relevant policy. These include the United This will help augment funds available to States where tax incentives are Category - I AIFs, many of which invest in implemented at the state level and MSMEs. Also, the exemption from tax on Canada, where tax incentives are at the long-term capital gains on the sale of a provincial level, as well as some other residential property if such gains are countries. invested in MSMEs is now also extended to eligible startups. These incentives, Tax incentives can along with the ones described earlier, boost early-stage could significantly decrease the tax investing burden on entrepreneurs and investors. Global experience – Tax incentives United Kingdom: UK has 2 major tax relief schemes for startups: • Seed Enterprise Investment Scheme (SEIS): Caters to early stage companies which are usually funded by angel investors. 50% income tax relief with maximum investment of GBP 1 lac p.a. • Enterprise Investment Scheme (EIS): Caters to slightly mature companies which are funded by VCs. 30% relief with maximum investment of GBP 1mn p.a. Startups incur no capital gains tax on sale after 3 years of lock-in. For sale within the lock-in period, no capital gains tax is applicable in case the money is re-invested in an EIS/SEIS eligible company. United States: Many states give tax write-offs for angel investments up to USD 500,000 to startups. China: SMEs with revenue less than RMB 30,000 are given tax waiver of 50% and a tax grace period of 3 months. Turkey: Angels are allowed to deduct 75% of their investments from income tax. Israel: The government levies lower company tax of 10% for MSMEs operating in certain priority sectors compared to 15% for other sectors. 110 Focus on Low Income States and Northeastern States Roughly 45% of the MSMEs in the country are located in the Low Income States and the Northeastern States. However, less than 5% of equity investments in 2017 have been made in these geographies. Within these geographies too, there is a high concentration of investments in a few states, whereas most states have witnessed no equity investments. There is an urgent need for targeted efforts to bolster the supporting infrastructure in the LIS and NES to encourage more flow of capital to MSMEs in these geographies. Sufficient support for entrepreneurs is not available in these geographies, with less than 25% of all incubators and accelerators in the country located in these geographies187. A start has already been made in the direction of correcting this imbalance – with multiple Atal Incubation Centers coming up in these geographies as part of the Atal Innovation Mission. It is critical to keep the momentum going and ensuring that support is available to MSMEs in a sustained manner. While most of the recommendations listed in this Chapter would be relevant across the states/geography, some specific recommendations for Low Income States and the Northeastern States: • Sectoral expertise pertaining to the trades dominant in specific regions of the LIS and NES can be nurtured and augmented with appropriate business expertise, provided through regular programs executed by the incubators and accelerators. • A cluster-based approach can also be taken to support multiple MSMEs at the same time; and pooled structures can be explored. • Industry stakeholders and large retail businesses can be encouraged to collaborate with the Government in this effort and supporting MSMEs in these regions by prioritize sourcing from these regions. • Investors can be incentivized to invest in these geographies by providing them tax breaks. • Targeted programs for improving the financial awareness of MSMEs (on Risk Capital and more broadly) in the region can also be undertaken – with financial advisers, CA firms, retired bankers etc. being empaneled to provide support to MSMEs in the region. The Government's push towards digitization is expected to address the issue lack of availability of credible information about MSMEs, in the long run. It is hoped that increased digital transactions will enable alternate credit assessments all over the country, and especially in the LIS and NES where the level of formalization is low. 187 Source: WBG - Intellecap analysis, Inc42 111 Appendices Appendices Appendix A – Demand The methodology for estimating the Estimation Methodology equity demand from MSMEs draws from the methodology and assumptions used The principal sources of data for the during a similar exercise in 2012, the estimation of the equity demand from results of which were published in IFC's MSMEs are the Fourth All India Census 2012 report on MSME Enterprise Finance on MSME 2007 (MSME Census), Annual in India188. The assumptions used were Reports of Ministry of MSME, Central re-validated through both secondary Statistical Organization (CSO), and sources and primary interactions with Ministry Of Statistics and Program key stakeholders in the sector such as Implementation (MOSPI). Other sources SIDBI, public and private sector banks, include publications of the Reserve Bank venture capital firms and incubators. of India (RBI), Government of India, The estimation methodology involved Small Industries Development Bank of the following key steps: India (SIDBI), existing research literature, IFC publications, industry publications and primary interactions with various stakeholders. Key Steps in the Estimation of Equity Demand from MSMEs Estimate average finance Estimate overall equity Identify addressable subset Estimate addressable demand per enterprise and demand of MSME Universe equity demand overall finance demand Step 1: Estimating average finance demand per enterprise and overall finance demand The underlying data for estimation is derived from the MSME Census. Trends in key metrics such as gross output per enterprise and average enterprise asset turnover ratio were used to derive average enterprise finance demand in 2017. Average finance demand was estimated The key steps involved in estimation as the sum of the demand for capital of average finance demand included the expenditure and the demand for working following: capital of an enterprise. • Enterprises were segregated by their • The demand for capital expenditure lifecycle stage based on their vintage, was taken as the annual demand to as indicated in the table below. finance the increase in fixed asset Lifecycle stage buckets were based per enterprise on supply side categorization of • Demand for working capital was enterprises189 estimated as 25 percent (three months) 188 http://www.ifc.org/wps/ of operating expenses per enterprise wcm/connect/region_ext_ across manufacturing and services content/regions/south+asia/ publications/msme+report enterprises 189 Please refer to section 2.3 – Enterprise lifecycle stage framework in Chapter 2 113 Enterprise Lifecycle Stage groups was derived by extrapolating Framework the gross output per enterprise in Enterprise Lifecycle Vintage of 2007 (from above) using industry Stage Enterprise (Years) level growth rates from the Central Early <5 Statistical Organization (CSO), Growth 5 – 10 Ministry of Statistics and Program Mature > 10 Implementation (MOSPI) and industry Source: Venture Intelligence, WBG - Intellecap Analysis reports. • The value fixed asset per enterprise for • Enterprises were further segregated by 2017 (INR crore) corresponding to the type of industry i.e. manufacturing and above-estimated output in 2017 was services sector. Top industry groups in calculated as the gross output per each manufacturing and services enterprise in 2017 (INR crore, from sector were considered for demand above) divided by the asset turnover estimation at industry group level ratio for the industry group. • The key financial metrics to be used • The annual increment in fixed assets as inputs for estimating the overall (INR crore) corresponding to the finance demand were calculated from above-estimated output was the MSME Census 2007 raw data for calculated as the CAGR of the value of each of the industry groups: fixed assets per enterprise from 2007 w The gross output per enterprise in to 2017 for each of the industry groups. 2007 (INR crore) was calculated as - This CAGR was used to calculate the aggregate reported gross output annual capital expenditure (towards (INR crore) for the industry group the incremental fixed assets) for 2017. divided by the number of enterprises • The annual capital expenditure in that industry group. requirement per enterprise in 2017 w The value of fixed assets per was adjusted for depreciation. enterprise in 2007 (INR crore) was • The working capital expenditure calculated as - aggregate reported requirement per enterprise was value of fixed assets (INR crore) for calculated as the product of average the industry group divided by the operating margins in each industry number of enterprises in that (as estimated earlier) and gross industry group. output per enterprise in 2017. w The asset turnover ratio was • The demand for capital expenditure calculated as the aggregate reported was taken as the annual demand to gross output (INR crore) divided by finance the increase in fixed asset the aggregate reported value of fixed assets (INR crore) for each industry per enterprise. group. • Demand for working capital was • The operating margins for each of the estimated as 25 percent (three months) industry groups were estimated from of operating expenses per enterprise secondary research about the industry. across manufacturing and services enterprises. • The gross output per enterprise for 2017 (INR crore) for each of the industry 114 • Total finance demand per enterprise Step 3: Identifying addressable (capital expenditure + working capital) subset of the MSME universe thus estimated was multiplied by Equity demand from all MSMEs cannot number of enterprises in the MSME be considered amenable to external universe in 2017 for the respective equity infusion. Assessment of industry groups. Number of enterprises addressable equity demand requires in industry groups was estimated by enterprise level assessment as extrapolating numbers in the MSME conducted by the investors. External Census 2007 by growth rates from institutional equity investors use Annual Reports of the Ministry of multiple criteria to assess enterprises for MSME. investment. Primary research indicates Key assumptions in estimation of that demonstrated growth of an average finance demand enterprise and its turnover can be • Average finance demand in the considered as preliminary criteria to registered and unregistered assess the amenability of an enterprise enterprises is similar for investment, i.e. only MSMEs that • Asset turnover ratio of enterprises exceed certain thresholds of turnover remains constant over 2007–2017190 and annual growth rate can be considered as potential enterprises Step 2: Estimating overall for equity infusion. Based on this equity demand understanding, the following key steps were followed to identify a subset of the Discussions with financial institutions, MSME universe that would account for MSME associations and enterprises addressable demand: suggested that the share of finance demand met by debt varies across • Enterprise level data from the MSME MSMEs. Early-stage enterprises typically Census (2007) was filtered to retain tended to fulfil a lower share of the only such enterprises that fulfilled 190 Reserve Bank of India finance demand through debt as the following conditions (which were 191 Although angel investors compared to enterprises in the growth identified based on primary often invest in pre-revenue and mature stages. The following ratios interactions with equity investors) startups, for the purpose of demand estimation from the were used to disaggregate the finance w Enterprise turnover greater than MSME universe as a whole, certain minimum cut-offs demand into Debt Demand and Equity USD 40,000 (INR 2.5 million) have been assumed based on primary inputs Demand: w An annual growth rate of greater 192 Roughly 94 percent of MSMEs Disaggregation of than 25 percent191,192. are structured as Finance Demand proprietorships and • The number of enterprises that would partnerships and hence are Enterprise Lifecycle Debt Demand: not amenable for external account for the addressable demand Stage Equity Demand equity infusion. However, in 2017 was derived as: interactions with equity Early 3:1 investors suggest that legal Growth 4:1 w The share of enterprises that meet structure is not a major factor in evaluating an enterprise, Mature 4:1 the above criteria as a part of overall and conversion to a private number of enterprises was calculated limited enterprise is pre- Source: WBG – Intellecap Analysis supposed. Legal structure is for each industry group thus not considered a factor in determining the potential demand for equity. 115 w The share thus calculated was The equity demand was estimated applied to the number of enterprises at these segment levels – i.e. in that industry group in 2017 (which methodology outlined in Steps 1 and 2 was derived from the MSME Census was applied at the segment level and Annual Reports of the Ministry • Within the early-stage enterprise of MSME) segment, a further subset of • At an overall level, only 1 percent of enterprises having a growth rate the enterprises accounted for the exceeding 100 percent was identified addressable demand to estimate demand from enterprises • The addressable subset of the MSME demonstrating such hyper growth universe was segmented according to rates in the early stage. the enterprise lifecycle stage (Early, • Within the growth-stage enterprise Growth, Mature) for further processing segment, a further subset of enterprises having a growth rate Step 4: Estimating addressable exceeding 50 percent was identified equity demand to estimate demand from enterprises The finance and equity demand demonstrating such high growth estimation methodology outlined in rates in the growth stage. Steps 1 and 2 was applied to the subset of • Segregation of the addressable the MSME universe identified in Step 3. universe into manufacturing and The equity demand thus estimated is the service sector enterprises was used potential equity demand. A portion of to derive demand estimates for these this demand – 26 percent – is fulfilled segments. through internal sources193. Excluding • Equity demand was estimated from this portion, the remaining equity a strictly financials-based perspective demand is the addressable demand using the above methodology. It does for external investors. not take into account behavioral • The addressable subset of the MSME factors such as knowledge of and universe obtained from earlier Step 3 access to investors or willingness was segmented by size (Micro, Small to cede stake. and Medium) and by enterprise lifecycle stage (Early, Growth, Mature). Estimation of Addressable Equity Demand No. of Equity Share of Particular Enterprises Demand Enterprises (million) (USD billion) A MSME Universe 55.8 100 percent 283 (18.4) B Addressable Subset of MSME Universe 0.5 1 percent 60.4 (3.9) C Demand met from internal sources 16 (1.04) B minus C Addressable Equity Demand 44.4 (2.9) 193 Financing Firms in India, Figure in brackets is in INR lakh Cr. Allen, Chakrabarti, De, Qain, 2007 116 Outcome: Addressable Equity Demand by Various Segments: Equity Demand Segment (USD billion) Early 10.5 (0.7) Growth 10.5 (0.7) Mature 23.4 (1.5) Total Addressable Equity Demand 44.4 (2.9) Micro 18.8 (1.2) Small 22.0 (1.4) Medium 3.7 (0.2) Total Addressable Equity Demand 44.4 (2.9) Manufacturing 33.1 (2.2) Services 11.3 (0.7) Total Addressable Equity Demand 44.4 (2.9) Figure in brackets is in INR lakh Cr. Totals may not match due to rounding off. Appendix B – Supply Estimation • Investment filter: Primary Methodology interactions with equity investors including angel investors, venture There exist multiple databases of capitalists and PE firms indicate that private equity investments in India194. investments in MSMEs typically have a Such databases track information deal size less than USD 10 million (INR about deals that is available in the 650 million). public domain. Additionally, various publications report private equity and • Enterprise turnover filter: Analysis of venture capital investment in India the MSME Census reveals that more based on independent research and/or than 99.9 percent MSMEs had a proprietary databases. turnover less than USD 9.2 million (INR 0.6 billion) in 2007. This turnover Venture Intelligence deal database was cap was extrapolated to 2017 using the chosen as the primary source of data for GDP growth rate. In 2017, the resultant the purpose of this study as it provides revenue cap was calculated as segmentation of the reported deals USD 15.4 million (INR 1 billion). according to the lifecycle stage of the investee enterprise. Segmentation of The above two criteria were validated investments by lifecycle stage is a key by the research team via both primary framework adopted in this study as and secondary research. The research it reflects the typical investment team conducted a roundtable of key philosophy of equity investors. Deal respondents (in addition to individual data from Venture Intelligence was primary interviews) in partnership with benchmarked to data provided in WBG to re-validate the filters and authoritative research reports and subsequent outcomes. validated from both primary and Applying these two filters reveals that secondary sources. USD 1.05 billion was invested in MSMEs To identify investments made in MSMEs, in 2017. 194 Such as VCCircle, Venture the following two filters were applied to The annual supply of other risk capital Intelligence, Research PE India etc. the Venture Intelligence deal database: products (venture debt and business 117 installment loans) was estimated based on data gathered through primary research with key providers and reconciliation among them on a best-effort basis. The market for such products is still evolving and it is difficult to arrive at accurate estimates. Appendix C – Proposed Amendments to MSME Definition The existing definition of MSMEs was adopted under the Micro, Small and Medium Enterprises Development (MSMED) Act, 2006. The definition is based on the investment in plant and machinery for manufacturing enterprises and on the investment in equipment for services enterprises. The limits for each category of MSMEs are defined as below: Existing definition of MSMEs Manufacturing Services Categories (Investment in plant and machinery) (Investment in equipment) Micro < INR 2.5 million < INR 1 million Small > INR 2.5 million and < INR 50 million > INR 1 million and < INR 20 million Medium > INR 50 million and < INR 100 million > INR 20 million and < INR 50 million In due course, a need for revision of the According to the new definition, a micro definition was felt due to significant enterprise is a unit where the annual increases in the wholesale price index turnover does not exceed INR 5 crore, and cost of inputs since 2006. There has a small enterprise is one where annual also been a change in the business turnover is between INR 5 crore and environment with many MSMEs INR 75 crore, and a medium enterprises becoming part of domestic and global is where the turnover is more than value chains. Subsequently, in 2015, an INR 75 crore but does not exceed MSMED Amendment Bill was introduced INR 250 crore. In order to give this new to incorporate a new section on the MSME definition into effect, the Section 7 change in definition for MSMEs. of the Micro, Small and Medium The Union Cabinet in Feb, 2018 approved Enterprises Development (MSMED) Act, a proposal to change the definition of 2006 will be amended. Micro, Small and Medium enterprises. Proposed definition of MSMEs Manufacturing Services Categories (Investment in plant and machinery) (Investment in equipment) Micro < INR 5 million < INR 2 million Small > INR 5 million and < INR 100 million > INR 2 million and < INR 50 million Medium > INR 100 million and < INR 300 million > INR 50 million and < INR 150 million 118 Primary interviews reveal that the single In China and most European Union criterion of fixed assets for the purpose countries, the SME definitions are of defining MSMEs has some constraints: based on annual turnover, number of 1. It is difficult for most MSMEs to have employees and total assets197. The a precise estimate of investment in definitional segregation may also be fixed assets due to robust book- made flexible depending upon the end keeping practices. purpose. For example, in Malaysia, SMEs are defined on the lower of turnover and 2. In MSMEs structured as number of employees198. The MSME proprietorship firms, the line Committee Report, 2015 also suggests differentiating business assets and that a mechanism can be instituted personal assets is often blurred, whereby the definitional limits could leading to mismatches in calculation be linked to an appropriate inflation of investment in assets195. benchmark for automatic adjustment 3. The correlation between investment on a periodic basis. in fixed assets and size of the enterprise varies widely with the Appendix D – Details of Primary industry and business model. Research Global experience suggests that the This study draws on primary interviews MSME definition should also include conducted with various risk capital other factors such as turnover, providers, MSMEs and other key employment and industry benchmarks, stakeholders to understand the MSME to formulate targeted policies more financing landscape in general, validate effectively. estimates of data, and receive insights For example, in the United States, the on gaps and recommendations. The Small Business Administration defines interviewees are listed as follows199: a small business either in terms of the average annual receipts over the past three years or average number of employees over the past 12 months. Definitions also vary across industries to reflect different size standards. 195 The size standards take into account MSME Definition in India: The Present State and the the structural characteristics within Imperatives – FICCI Report individual industries, including average 196 U.S. Small Business Administration website firm size, the degree of competition and 197 MSME Definition in India: The federal government contracting trends Present State and the to ensure that size definitions reflect Imperatives – FICCI Report 198 Ibid current economic conditions within 199 Please note that the lists are those industries196. not exhaustive and does not contain the names of stakeholders who have requested anonymity and do not want their or their organizations' names to be disclosed. 119 Supply side Sr. No. Organization Type 1 Acumen Fund Venture Capital 2 Asian Healthcare Fund Venture Capital 3 Dena Bank Bank 4 Ask Pravi Venture Capital 5 Aspada Investment Venture Capital 6 Banyan Tree Finance Private Equity 7 Capital Float NBFC 8 Dr. Malpani Angel investor 9 Kotak Bank Bank 10 IDBI Bank Bank 11 IntelleGrow Venture debt 12 IntelleCash NBFC 13 Ivycap Ventures Venture Capital 14 Lighthouse Advisors Venture Capital 15 Magma NBFC 16 RBL Bank Bank 17 responsAbility Venture Capital 18 Samir Shah Angel investor 19 Sequoia Capital Private Equity 20 SIDBI Apex body for MSMEs 21 SIDBI Venture Capital Ltd. Venture Capital 22 Tano Capital Venture Capital 23 Indostar NBFC 24 Trifecta Capital Venture debt 25 Zephyr Peacock Private Equity Demand side Sr. No. Organization Type 1 A*****on Technologies Services 2 A***r Enterprises Services 3 A*****g India Manufacturing 4 B***a Delivers Services 5 C****e Salt Manufacturing 6 C*** Bakery Services 7 D***a Enterprises Services 8 Edu***** Services 9 G**** Enterprises Services 10 G**** Engineering Works Manufacturing 11 H***n Clockworks Manufacturing 12 H**** A** View Services 13 I*** Services 14 I******n Filters Manufacturing 15 K****k Instruments Manufacturing 120 16 M.R. M*****l Services 17 M*** C**** Guide Services 18 My***** Services 19 R****n Systems Manufacturing 20 S** A*** I**** Services 21 S** K******* Electronics Pvt. Ltd. Manufacturing 22 Su***** F******r Services 23 S**** P**** M**** Manufacturing 24 T********s Systems Services 25 T****r India Manufacturing 26 V**** S***** Services 27 W* N******* Manufacturing Other stakeholders Sr. No. Organization Type 1 National Stock Exchange SME Exchange Federation of Indian Micro and Small & 2 Association Medium Enterprises (FISME) 3 Foundation for MSME Clusters (FMC) Association Centre for Innovation, Incubation and Entrepreneurship 4 Incubator – IIM Ahmedabad 5 SIDBI Innovation and Incubation Centre – IIT Kanpur Incubator 6 MSME Board Ministry of MSME Appendix E – Government Schemes for MSME Financing Scheme Details Financial Terms Services • Fund of Funds Scheme - • LIC is a co-investor • Startup India Hub for corpus INR 10,000 crore • Max 50% contribution Startup queries and Start-Up India • Provide funding for of daughter fund size handholding support development & growth of • Daughter fund to raise • Online learning module innovative enterprises the balance 50% • Bank loans between • Composite loan (term loan + • Stand-Up India INR 10 lakh and INR 1 crore working capital) Connect Centers Stand-Up India to at least one SC/ ST • 75 % of project cost arranges for support borrower per bank branch • Repayable up to 7 years to trainee borrowers Technology • Applicable to All Existing & • Reimbursement of 50% of Acquisition and • Scheme technically new MSMEs technology transfer fee or Development & administratively • For Outright purchase of 20 lakh Indian rupees Fund (TADF) managed by the GITA Technologies and IPR for • In-direct acquisition: 50% Direct & In-Direct • TADF Helpline & large scale deployment of of the project value Technology Live Chat relevant technologies (max INR 20 lac) Acquisition • Subsidy up to 10% of capital TADF Subsidy for • Applicable to All Existing & expenditure incurred on new Manufacturing new MSMEs including those Plant & Machinery • Same as above Equipment / in the National Investment (max INR 50 lac); Technology and Manufacturing Zones • INR 25 lac to INR 50 lac 121 Credit Linked • Enable MSMEs to adopt • Scheme provided Capital Subsidy modern technology for • 15% capital subsidy up through concerned Scheme (CLCSS) improving their to a maximum of banks/ nodal agencies for Technology productivity, through INR 1 crore of eligible financial Upgradation technology upgradation institutions • Category I: • Category-I: Promoting • Support micro budget • Proof of Concept/ Prototypes/ • Provided by TePP Innovations in innovations. Models Outreach cum Cluster Individuals, • Initiate a promising • Max: INR 2 lac Innovation Centre Start-ups and development, prove • Category-II: (TOCICs) for promoting MSMEs (PRISM) functionality in a lab • Fabrication of working model and implementation of Phase I • Category II: • Max: INR 20 lac or 90% of PRISM in their regions Category I & II • Convert an original idea project cost into working prototypes • For scaling up technology • Subsidy of 50% of the project based innovations, PRISM Phase II - value (max INR 50 lac) including patenting/design Enterprise • Project cost more than • Same as above registration/technology Incubation INR 35 lac and up to transfer to develop a INR 1 crore marketable product 122 IN PARTNERSHIP WITH Creating Markets, Creating Opportunities GOVERNMENT OF JAPAN