High-growth startups are having to use expensive equity for their working capital because of the lack of venture debt availability
There has been some recent good news about the emergence of a more predictable regulatory environment for the microfinance sector in India. Banks are starting to lend again to cash-starved MFIs which have adapted to the new rules in order to start expanding their micro-lending operations again. This is good news as there continues to be a huge supply-demand gap for financial services amongst India’s 800 million BoP population.
As we interact with hundreds of seed-stage BoP Startups (businesses serving large low-income populations) in India, we continue to see another significant lending gap: loans for high-growth BoP startups. Instead these BoP Startups are having to fund working capital and asset purchases through very expensive equity capital. This significantly slows their growth and, therefore, the built-in positive social impact benefits they are delivering to low-income populations. The question is: where are the venture debt suppliers in India?
Working capital is the biggest gap
Almost every business that wants to scale-up requires working capital. Most small businesses generate insufficient surpluses to internally fund their working capital needs to take advantage of the business growth opportunities in front of them. These might include:
- Inventory carrying costs. They have to pay for inventory or supplies before they are fully paid by their customers — especially if they want the best prices from their suppliers — in advance of completing a sale.
- Providing credit to customers. Often their customers are also cash-strapped and can’t pay full cash upfront so they need to provide say 15 or 30 days of credit to their customers.
- Forward investing in people & capex. Most businesses have a stair-step vs. a linear cost for scaling up. They need to hire another sales or support person and train them before they can be fully productive and paying for themselves. Similarly they need to purchase equipment or place a deposit on a new facility lease upfront ahead of the profits that can pay for them.
Indian banks are not motivated to figure out small business lending
In the same way that the banking sector in India doesn’t know how to successfully lend to low-income individuals (microfinance), the banks don’t know how to lend to small businesses. Some of the same kinds of issues exist for lending to small businesses in India:
- Lack of credit history. Banks have a culture of lending to companies which have a history of repaying previous loans.
- Lack of operational history. Banks have a firm policy of only lending to businesses which have been profitable for 2+ years. Most high-growth businesses are forward-investing in order to capture market opportunity and so don’t have a consistent, profitable operating history.
- Lack of the right collateral. Banks look for appropriate collateral they could repossess if the small business defaults on loan repayment. Most small businesses do have assets, but not ones that can be easily liquidated.
- Require personal guarantees. Banks require business owners to commit to personal guarantees on their business loans. This sounds good for the bank, but with the typical over-reaching covenants in most Indian bank loan documents, this is a real concern for a small business owner. The reason they’ve gone through the effort to create a private limited company was to obtain some level of limit to their personal liability.
- Small loans not viewed as profitable. Banks generally view that even with somewhat higher interest rates on small business loans that there is still less or no profit to be made vs. larger loans to larger companies. It’s an opportunity cost situation.
- Nervous of bad debt ramifications. Banks in India are heavily penalized by banking regulators for bad debts on their books. This means that they are highly incentivized to NOT provide loans even if they would be profitable due to consequences for having bad debt on their books.
India venture debt pioneer: IntelleGrow
We were very pleased to hear that one of the venture debt pioneers, IntelleGrow, raised additional capital this week to expand their venture debt lending business to fast-growing startups serving BoP Startups. IntelleGrow has created a lending methodology that they call a “viability-based lending approach” which provides capital along with support. They specialize in sectors which serve rural and BoP populations. Some of their current borrowers include Vortex Engineering (rural ATMs), Shree Kamdhenu Electronics (automated dairy solutions) and Husk Power Systems (rural, renewable energy micro power plants).
One pioneer like IntelleGrow though is just touching the surface. Is this not a market opportunity?