Designing credit products for micro-enterprises

By April 23, 2018blog

There is dearth of credit products for new and existing unorganized micro-enterprises. This post highlights the perils which micro entrepreneurs go through, even after being supported by last mile financiers like SHGs or JLGs.

CASE OF NEW MICRO ENTREPRENEURS

Potential candidates for micro entrepreneurship are mostly daily wage earners. Their risk appetite is low as they do not have alternate source of income like agriculture, livestock etc. They cannot afford to start-up a business on loan, since fixed installments increase their vulnerability.

In organized corporate sector, most popular financial instrument for start-ups is “Equity” – personal savings or funds from friends and relatives in exchange of Equity stake. In fact, Equity finance is most preferred and natural form of start-up finance. Typical financial arrangement is as follows –

In case of unorganized sector esp. micro- enterprises, the financial arrangement is as follows –

Absence of appropriate equity instrument in seed & start-up stage results in “Asset Liability Mismatch”. The ‘variable’ cash inflow from business or asset and ‘fixed’ cash outflow towards liability does not match.

What is required is a mechanism which makes financial arrangement of micro-enterprises as follows –

Therefore, there is need of financial instrument which has nature of ‘Equity’. Owing to lack of legal nature of unorganized micro-enterprises, micro scale of operations, absence of books of accounts, the most appropriate financial instrument for them turns out to be “Quasi-Equity” – which is hybrid of Equity and Debt. Quasi-Equity refers to structures of investment that take on the same win-win incentives of a normal equity investment but do not rely on a normal “exit” for investors. The most appropriate Quasi-Equity structure, which fits micro entrepreneur’s circumstances and challenges, is ‘Revenue Sharing’.

In Revenue Sharing arrangement, instead of purchasing ‘equity’ in a company, an investor agrees to receive a percentage of a company’s monthly revenues. Typically, there is a limit on this revenue-sharing agreement that is either a multiple of the original investment amount (say 2x the principal) or the revenue share is limited by a period of time (say 5 years). Where appropriate, it can be a blend of the two. In case of PPE enterprises, blend of investment amount (nX the principal) and limited period (nX years) is the appropriate repayment structure, which can easily be calculated using algorithm on Field Officer’s tablets.

Characteristic of Equity in Quasi-equity – Repayment is linked to sales revenue. If business succeeds, repayment continues. If business does exceedingly well, repayment is higher than expected. However, if business fails, repayment is discontinued. The financier shares the risk of failure of business. This considerably reduces the risk of individual micro-entrepreneur.

Characteristic of Debt in Quasi-equity – A regular monthly repayment (linked to sales) ensures that amount is repaid regularly to Financial Institution. The duration of repayment varies as per Expected Return on Investment (ROI) of Financial Institution – based on which nX of principal and nX of years is calculated. The borrower even has the option of buying back whole of equity stake and then stopping repayment.

CASE OF EXISTING MICRO ENTREPRENEURS

Businesses are seasonal in nature – be it an organized corporate or a PPE micro-enterprise in unorganized sector. Sales of businesses vary as follow (illustrative example) –

The working capital requirement mirrors the sales, as follows –

In corporate sector, banks have a standard product ‘Cash Credit Limit’ (“CCL”) for businesses. It is effectively a source of funds that can readily be tapped at the borrower’s discretion.  CCL provides instant credit to business but limits the maximum draw-able amount, which in most cases is pegged to working capital requirement in high season. Interest is paid only on money actually withdrawn. Businesses in organized sector, therefore, use CCL only when working capital is needed, as per seasonality. Once cash comes in, money is deposited back into CCL account, so that unnecessary interest does not accrue.

No such loan product exists in unorganized micro-enterprise space. Owing to lack of such product, micro-enterprises resort to Term Loan from SHGs and money-lenders for working capital needs. During low season, surplus credit from Term Loan gets used in unproductive activities.

Paying interest on credit, which is not used for business, is detrimental for a business. Situation gets worsened when money, stuck in unproductive activities, is unavailable for pulling out at time of high season, when working capital need is at its peak.

This is a mismatch between Loan Purpose and Loan usage. Loan for unproductive activity ends up being used in alternate (most likely, consumption) activity. On one hand, business fails to leverage and on other hand, it gets hit by fixed overhead interest cost. Therefore, there is urgent need of “CCL Product” for ‘individual’ micro-enterprises.

VULNERABILITY OF MICRO ENTREPRENEURS

Micro entrepreneur’s families and their enterprises are vulnerable to “Extraordinary Circumstances” like accidents, medical emergencies, death and business related exigencies like fire, cyclone, natural disasters etc. Experience shows that majority of delayed repayments and unwilling defaults happen due to Extraordinary Circumstances, in which working capital is put into alleviating the emergency. One such instance of Extraordinary Circumstance is sufficient to bring entrepreneur & its family to their knees and force shut down (or in some cases, drastic shrinking) of the business, which is major source of income & survival. Family is then gradually pushed into debt trap.

In corporate sector and even for tiny enterprises in organized sector, numerous insurance products exist for life, medical and business related exigencies. Products like life insurance (for immediate family), medical insurance (for immediate family) and enterprise insurance (for shop or factory, stock, machinery) provide a robust cushion to the insured, in case of any exigency. This results in continuity of business & earning for family.

There is an urgent need of a ‘composite’ insurance product specially customized to need of micro enterprises in unorganized sector. No such product exists in the existing ecosystem.

~ Pranay Bhargava

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IMV facilitates loans to MSME and small scale industries in India through partner microfinance institutions, NBFCs and SFBs. IMV’s sister concern, Enable Livelihoods Foundation which is a social enterprise, has vast experience of working in space of rural development, skill development and social entrepreneurship. The founders, themselves being social entrepreneurs in India, have authored several publications on microenterprise and entrepreneurship.