Most of the challenges faced by SME’s are also known news. Lack of adequate and accurate information about the SME borrower is a crucial input for decision-making by banks in the lending process. This information asymmetry proves to be a major hurdle. The grading system at banks could be inadequate to have the requisite capability to discriminate between good and bad risks. Often providing an adequate collateral offering to bankers is a challenge.
There is already much known information through the World Wide Web apart from articles, journals and papers if you research the topic. So what perspective can we share that differentiates this article from the rest? The question raised above lingers in our mind as we write this article. Our attempt is to share some of the grass root challenges we have experienced during the process of fund raising for Indian SME’s.
There are two broad sources of fundraising for SME ’s – debt and equity. Banks provide debt. Friends and family, angels, venture capitalists and private equity funds provide equity. We have kept aside internal reserves and any quasi instruments out of this topic. For the purpose of this article we will be discussing the aspects of fund raising through debt.
A large part of the fund raising for SME’s takes place through debt. Banks are mandated primarily to assess the SME’s assets and collateral. Business assessment takes a backseat. Loans are largely disbursed based on collateral strength, not business strength. There are several reasons for this. The primary aim behind the nationalization of banks in 1969 and 1980 was to spread the banking infrastructure and make economical finance available to Indian businesses.However, as time has passed, the truth has become more and more evident. It is a known fact that the business doings and Financials for SME’s are not necessary what gets reported. In such a case, what can a banker do? A banker is trained to look at the numbers, and in such case numbers do not necessarily reveal the entire story. One can also argue that the due diligence capability of some banks to assess the business strength is also weak. So amidst this murkiness, the onus on the basis on which disbursements takes place is based on the SME assets and collateral. Lack of adequate collateral translates to lack of adequate funds (required for working capital and/or capital expansion) that translates to lower growth rate. The causality dilemma then comes into play: which came first, the chicken or the egg?
However, in the recent years, bank (especially private sector banks) has focused on the cash flow projections offered by the SME’s. However, most SME’s fall short of the projections made to the bank. Hence, bankers tend to discount the future projection that makes the proposal look weak forcing them to deny credit. It is imperative that SME’s approach this with sincerity. One must seek professional help if the accountant is not skilled in such projections.
Let us assume a new business initiative with no credit history comes to the bank. The project size is Rs.100 million. The bank will expect the promoter to bring in equity worth Rs.35 million and the rest will be financed through debt. Of the Rs.65 million to be financed through debt, the bank asks for a collateral of ~40% beyond the primary security (that of land/building). Mr.Promoter has no additional collateral than the primary security (where he plans to put up the manufacturing unit for which he is taking a loan). So the bank asks Mr. Promoter to provide his residence as a collateral (for some reason, residence as collateral gives a bank great psychological comfort in our opinion).
Mr.Promoter has come to a crossroad. To start his business initiative, he has to bring in equity, provide his existing land as security, and provide his house in the city of Mumbai as collateral. I’m guessing this should be just about sufficient or not, depending upon where he stays. Let us assume for a moment that the Mr Promoter has arranged the collateral and is raising debt. Next up is the bank loan agreement. I’m guessing William Goldman came up with his quote (“Life isn’t fair, it’s just fairer than death, that’s all”) right after reading a bank loan agreement. Pardon the weak attempt at humor. But it’s really that way. It’s one sided. It favors the institution lending the funds. After all, everybody wants strong borrowers. Such is the difficult journey borne by Mr. Promoter to raise debt. However, this is one part of the story.
The other challenge faced by Indian SME ’s during fund raising stems from their own backyard. In India, even today, hierarchy is respected more than wisdom/intelligence.
What can one do when the business head of the family who founded the business and has grown it over the years makes a decision? The second/third generation has their hands tied, respect for hierarchy you see.
Let’s move on to another important member of the SME world – the chartered accountant. The lifeblood of every SME. Most decisions with regards to funds are run across to him. And as we understand, his role is to help the SME save tax. That’s his KRA (key result area/primary job responsibility). Mr. CA, how about helping grow the balance sheet over the years? What banker/equity partner wants to fund an SME whose net worth that has not grown in proportion to the business? Also good advice is not available to SME’s owing to its own revenue challenges. Should the advice be fixed or variable? Consultants would prefer fixed, while SME owners would prefer variable. The variable structure also has its challenges and then again as consultants, the soft advice that can go a long way in making a difference cannot really be measured.
Amidst all these challenges coupled by the Indian macro economic state and the world economic condition, Dalai Lama’s quote comes to my mind: “Choose to be optimistic, it feels better.” There is no denying that there is action-taking place on the ground in India – the implementation of the Micro, Small & Medium Enterprises Development Act 2006, schemes from the government, cluster formations, filling in investment gaps with FDI, providing strategic information such as benchmarking or trends, linking firms to training programs from local universities and fostering networking service centers and associations.As SME’s are not uniform, both in size and shape across the globe, it is difficult to make any direct comparison. However, one can take cues/inspiration from the government’s of South Korea, Taiwan, Japan, Trinidad and Tobago amongst others for the role they are playing in boosting the SME sector in their respective countries.
Let’s take the example of South Korea. Although Korea boasts a strong automotive and electronic sector, they are facing intense competition from similar goods coming from Japan. While the Korean SME’s used to supply to the chaebols (large conglomerates in Korea are called as Chaebols such as Samsung, Hyundai and LG), competition from China is forcing unproductive Korean firms to step up or step out. In such a competitive environment for the sector, the government has been channeling efforts to ensure the SME’s keep pace. Business incubators are there to guide innovative SME’s,efforts are underway to strengthen regional innovation clusters in Korea by decentralizing policy responsibility, and encouraging local linkages between universities, technology centers and companies.
An important organization for supporting SMEs in Korea is the Small and Medium Business Administration (SMBA). SMBA, a government branch has the primary task of encouraging, nurturing and growing new business startups and entrepreneurial spirit in Korea. Almost all areas of government policy for SME’s are dealt by SMBA. The Global Review of Innovation Policy Studies report shares that the annual budget for 2010 was 1.68 trillion won (1.4 billion USD). The report also mentions that in addition, SMBA had a SME promotion fund of 4.3 trillion won (3.6 billion USD)..
Another Korean policy focus is to turn around transforming traditional SMEsto high-growth SMEs through the “Inno-biz” and “Global Stars” programs. “Inno-biz” receives the support of business ventures through dedicated funds fuelled by domestic and overseas sources. One such Korean company that received the “Inno-biz” support was DongHwaEntec (manufacturer of heat exchangers for ships, power plants, food factories, agriculture).
The “300 Global Stars” program is significantly different program to Inno Biz. 100 SME candidates are selected yearly for the“300 Global Stars” program on the basis of their merits of management, business amongst others. These selected enterprises will be supported by a comprehensive support package of financing, mentoring, advice, networking, technology and marketing. The program sees the international championship for such SME’s. In recent years, Korea has been witnessing an emerging new group of young entrepreneurs who are developing start-up technology-intensive companies.
The “Inno-biz”, “Global Stars”, SMBA are examples of how the government is addressing the challenges faced by the Korean SME’s as well as assisting them across fund raising. The keywords today for SME policy in Korea are growth, global competitiveness and innovation. These key words should resonate in the Indian policy framework for SME’s as well. John Maynard Keynes has said “the difficulty lies, not in the new ideas, but in escaping from the old ones.”India needs to tread on such a path. Existing practices, institutions, policies, attitudes, and practices – even though they were successful in the past – have to change and evolve too.
The Indian SME space is witnessing change, no doubt. But can our framework and policies, keep up the pace? Only time can tell.
Mr. Milind Sarwate has contributed generously to this article.