An alley to escape ‘capital’ punishment

Font Size

Print

Feedback

Email

Discuss

Small & Medium Enterprises (SMEs), though they account for more than 40% of domestic production, 50% of exports and 45% of industrial employment, have a weak capital base. The limited resources at their disposal make them susceptible to external and internal business shocks.

A key obstacle in SMEs development is their non-access to timely and adequate finance. Here, venture capital (VC) funding could be of help.

In fact, VC becomes an alternative way for financing SMEs when banks cannot intervene, and stringent collateral requirements cannot be met. It is also the only source of alternative finance when firms have outgrown their start-up phase, but have not yet reached full development. Private-equity financing for SMEs is still an underdeveloped market.

VC is a type of private equity capital typically provided to immature, high-potential, growth companies in the interest of generating a return through an eventual realisation event such as an IPO or trade sale of the company.

VC investments are generally made in cash in exchange for shares in the invested company. The financing typically comes from institutional investors and high net-worth individuals, but pooled together by dedicated investment firms.

During the 1960s and 1970s, VC firms focused primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data processing technology. This made VC almost synonymous with technology finance.

The investors are typically selective about where to invest in; as a rule of thumb, a fund may invest in one in 400 opportunities presented to it. Funds are mostly interested in ventures with exceptionally high growth potential, because of their ability to render high returns.

As investments are ‘illiquid’ and require three-to-seven years to harvest, venture capitalists carry out detailed due diligence prior to investment.

VCs also are expected to nurture the companies in which they invest, in order to increase the likelihood of reaching an IPO stage with attractive valuations. VCs are typically active at four stages in a firm’s development: idea generation; start-up; ramp-up; and exit.

The need for high returns makes venture funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt.

That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven.

In turn, this explains why VC is most prevalent in the fast-growing SMEs.

Successful venture funds are extremely selective in their choice of projects, and export-oriented enterprises are usually preferred.

In these cases, deals are chosen after a thorough field analysis because documentary evidence is not enough in itself. Finally, returns must exceed average market expectations.

Alternative financing is advantageous to SMEs, since they face challenges in raising adequate financial resources to sustain international competitiveness. This is often due to non-availability of suitable and tested credit appraisal models, repayment records and the market credibility of SMEs.

Alternative financing helps SMEs obtain quicker and improved cash flow; flexible terms and quicker sanctions and better, easy returns on funds deployed, besides matching the seasonal needs of finance.

To attract VCs, the project should get ahead of the conceptual stage and cross the pre-production stage, since no one would like to take a risk on conceptual framework until its configuration.

However, VC ‘finance’ may be available to the entrepreneur at the early stage in the form of seed capital; for financing research & development, as start-up capital at the take-off stage; or in the form of collaboration.

Meanwhile, the Abid Hussain committee, the study group appointed by the Planning Commission, recommended introduction of VC for small industries by setting up a special VC type fund of Rs 500 crore to be named as Laghu Udyog Nirman Nidhi for equity support. Followed by such recommendations, Small Industries Development Bank of India (Sidbi) has introduced VC funds for software and IT industries.

VC finance has made a powerful impact not only in South Asian countries but also in the US and UK. However, in India, we are still at a stage of infancy mainly because of non-involvement of the resource personality and partly because of low awareness among the small industries fraternity to the existence of such schemes and their inability, if not their inertia, to tap the potential.

The IITians and NRIs are enthusiastic about venture finance, but what is needed is the involvement of IITs. And this is the exclusive job of the small industries’ associations.

That apart, such associations should tap pensioners and retired intellectuals to be involved in such projects.

At the launch of the SME Rating Agency of India Ltd (Smera), the then finance minister P Chidambaram highlighted the three major benefits that would accrue to the rated SME units; adequate and timely credit; low collaterals; and a lower rate of interest. The finance minister said his confidence in Smera’s long-term success stemmed from the fact that major public and private sector banks would be stakeholders in the rating agency.

The finance minister also delineated a few strategies adopted by the central government to promote the SME sector: doubling the flow of credit to the small industry sector in five years; and enactment of a SME Bill. Currently, a draft of the Bill is under consideration. The Micro, Small and Medium Enterprises Act, 2006 is a legal framework for more capital investment in the SME sector. However, the implementation of the Act would need more precision and investing authority with different agencies.

The way forward would be to create an environment of risk-taking by the government by providing start-up capital to SMEs and to facilitate technology transfers and training in skill development.