MSMEs stifled by funding challenges while start-ups soar: Is the lack of innovation the true barrier?

This sector contributes a chunk to India’s GDP and exports and employs the highest number of people outside farms. Yet, when it comes to companies in the sector raising money, it is an uphill struggle, with insufficient working capital stunting their growth. The sector is none other than the country’s micro, small, and medium enterprises (MSMEs)—the hidden heroes of the economy—where the current solutions, both from the government and the private sector, seem ineffective in addressing their funding needs.

Sample this: there exists a staggering $530-billion credit gap in the MSME sector, despite the number of enterprises nearly doubling each year, according to a report by Avendus Capital. While some credit schemes and policies offer some relief, stakeholders argue that loans only add to their burden. With an existing shortage of working capital, how can these enterprises afford to pay instalments, they ask.

While most SMEs that listed on the bourses in recent times have done well in the stock markets, unlisted companies in the MSME space have struggled to raise money from investors. And it’s not as if these companies don’t have strong fundamentals. For one, MSMEs are a resilient lot. And that was in ample display during the pandemic. When many other businesses were shutting down, most MSME players managed to survive, with nearly 47% of micro enterprises alone pivoting and adopting digital solutions to keep their businesses afloat, according to a CRISIL report. Despite this adaptability, the private investment ecosystem in particular remains sceptical of investing in the space.

What explains this? “Traditional businesses cannot scale up [fast]… And, venture capitalists (VCs) invest in companies that scale up very fast… they want technology and they go after tech areas with a chance of success,” says T.V. Mohandas Pai, former Infosys CFO and Chairman of Aarin Capital, a venture capital firm that has invested in tech-driven businesses such as Pepperfry, according to data intelligence firm Tracxn.

As Pai mentions, MSMEs need a boost in technology and innovation to be attractive to private investors. But this itself requires funding and a shift in the mindset of MSME players to a more dynamic way of doing business. Shashank Randev, Founder VC and Co-founder of early-stage investment firm 100x.vc, highlights a common sentiment among MSME owners: despite building legacy businesses and turning profits, they struggle to attract private investment due to a perceived lack of innovation.

“MSMEs often lack innovation. For instance, consider a cardboard manufacturer who has been profitable for decades but continues to operate without introducing new ideas. This lack of innovation makes it challenging for VCs to envision a lucrative exit,” explains Randev, who also serves on the investment committee at the Maharashtra State Innovation Society, a nodal government agency that aims to boost the innovation-driven entrepreneurial ecosystem in the state.

According to experts, VCs need a good internal rate of return (IRR) and a good exit, which is why they are more inclined to invest at the seed stage, right at the inception of a business.

Arjun Vaidya, Co-founder of VC firm V3 Ventures that invests in consumer-focussed businesses, highlights a crucial challenge with MSMEs: while they are profitable and steadily growing, their growth rate isn’t rapid enough to deliver the massive capital gains that VCs seek. “There are solid businesses achieving 15-20% profit after tax (PAT), but they don’t grow significantly enough for VC investments to multiply,” he explains. For MSMEs to attract private investors, they need to demonstrate potential for exponential growth, he says.

Vaidya should know. He founded D2C ayurvedic brand Dr. Vaidya’s in 2016 as an extension to the Ayurveda business founded by his grandfather. In around four years, he grew the company to 2 million customers across more than 16,000 pin codes, and in 2021, sold the business to RPSG Ventures, the VC arm of the `26,634-crore RP-Sanjiv Goenka Group.

Vaidya successfully transformed his small business to meet the demands of the modern market. Other examples include companies like Hocco Ice Cream, Veeba (VRB Consumer Products Pvt. Ltd), GRM Foodkraft, Suburban Diagnostics, and others that evolved beyond traditional models and attracted significant investment. But before they secured funding, these businesses had already scaled up to an annual turnover of Rs 100-200 crore or more. This, by the government’s definition for MSMEs, classifies them as medium enterprises—businesses that have an annual turnover of Rs 25-250 crore. This means that micro (annual turnover of less than Rs 5 crore) and small (annual turnover of Rs 5-25 crore) enterprises are likely to face challenges in attracting investments.

The way ahead

According to Krishnakumar Natarajan, Managing Partner at VC fund Mela Ventures and Co-founder of IT services firm Mindtree (that was acquired by L&T in 2019), the VC industry in India is based on a US-centric model. In simple terms, he explains, the attractiveness of a tech business is that “it is created once and then reused so that the pace of growth can be substantive” and that VCs are focussed on companies that can grow 3x every year. “Now it’s been scaled down to at least doubling revenue every year… which cannot happen in the traditional SMB segment of India,” he says.

Since the VC model in India and its evolution was heavily influenced by the US model, where VCs rarely invest in the about 3 million small enterprises in America, says Natarajan. “Instead, they (the VCs) focus on tech companies, from digital equipment to modern start-ups. This is due to the reusability of technology, where an initial investment in a product or technology can be leveraged multiple times without significant additional costs,” he says.

However, a new trend is emerging. Randev says state governments are introducing funds for SMEs in collaboration with VCs, such as the Maharashtra Innovation Technology Fund, “which is a `200-crore fund by the state government and there is a clear mandate to invest 50% of the capital in start-ups and MSMEs based out of Maharashtra,” he says.

Yash Dholakia, Partner at Sauce.vc, an early-stage VC fund, notes that exciting MSME businesses can attract investments if they offer strong distribution, supply chain efficiency, and competitive procurement costs. By launching new-age brands catering to modern consumers and leveraging e-commerce platforms, these businesses become appealing, say experts. However, traditional MSMEs without differentiation hold little value to investors. What then should MSMEs in manufacturing or B2B businesses do?

One solution could be a special fund for them. Pai asserts that there is a need to create a special fund because SMEs, when scaled up, generate more jobs than large companies. Industry watchers say that this mechanism is crucial as finance and capital are the biggest hurdles for SME growth globally. While VCs might not be suited for this task, it falls within the realm of private equity (PE) funds or similar entities to establish a dedicated fund category for SMEs.

For instance, Foodkraft, a subsidiary of GRM Overseas Ltd that was founded in 1974, found success through this approach. Sauce.vc, primarily focussed on VC investments, acquired a 3% stake in Foodkraft, according to reports. Foodkraft Founder Atul Garg describes this investment as resembling a PE investment for them.

“We have greatly benefitted from shifting our mindset since partnering with Sauce.vc,” says Garg. “Traditional businesses like ours are often hesitant to dilute stakes when raising funds, which stems from our background. However, embracing professionalism is crucial for driving business growth, making this step necessary.”

In addressing mindset shift, Natarajan emphasises the urgent need to combat delayed payments from large enterprises to small businesses—a practice perpetuating a negative working capital cycle among MSMEs. According to Pai, the predominant challenge for SMEs lies in delayed payments from both big corporations and the government, resulting in constrained working capital and a constant struggle to recover funds. While the government has taken steps to resolve the issue of delayed payments, these moves have complicated things further. This financial strain poses a significant barrier to growth and investor attraction.

As a potential solution, there’s anticipation that the new government may collaborate with private investors to inject funds and stimulate the MSME sector, offering hope for change. MSME players will have their fingers crossed.

@PalakAgarwal64