Alternative Financing Options for SMEs in 2023

Small and medium enterprises (SMEs) are perceived as the foundation of all economies. India, a nation of small businesses, is home to more than 64 million SMEs, collectively contributing about 30% of the country’s GDP. However, a lack of financial resources has been a pertinent hindrance to the constant and positive growth of these SMEs. The lack of traditional assets as collateral for loans from conventional financial institutions has been a major roadblock to securing funds. Hence, came the concept of alternative financing.

This article discusses different alternative finance options available for SMEs so that securing funds does not pose a hindrance to acquiring their working capital and sustainable development.

The following are the alternative finance options available to Indian SMEs in 2023:

Securitized Debt
Crowdfunding
Factoring
Supply Chain Financing
Warehouse Receipts
Participating Loans
Purchase Order Finance

Securitized Debt

Securitized debt refers to a financial arrangement where an entity, often a bank, also referred to as the originator, provides loans to a group of borrowers, usually small and medium-sized enterprises (SMEs). These loans are then combined into a package or portfolio, which is sold to investors in the capital market through the issuance of notes. This entire process is facilitated by a Special Purpose Vehicle (SPV), which is a separate legal entity established specifically for this purpose and is backed by the loan portfolio. These asset-backed notes are evaluated and rated by credit rating agencies and are made available for purchase by capital market investors. Additionally, it is also to be noted that the originator bank may choose to retain a portion of these notes.

Crowdfunding

Crowdfunding is a form of external funding from a large audience where everyone contributes a small amount of the funding requested. Instead of securing funds from a small group of specialized investors, this method allows small borrowers to raise funds who are unable to do so through conventional means due to credit scores and higher interest rates. It is a web-based method to seek substantially smaller funds through social platforms to fund new ventures. Crowdfunding relies heavily on social media penetration, and India, with its high number of Facebook users, is well-positioned for this financing method.

According to the World Bank report titled 'Crowdfunding's Potential for the Developing World,' Facebook usage could prove to be a useful tool because in crowdfunding the “single most predictive factor for the rate of emergence is social media penetration.”

Factoring

Factoring is a financial arrangement that provides short-term financing to businesses, especially SMEs, by allowing them to sell their accounts receivable (invoices) to a specialized institution called a "factor" at a discount. This provides the SMEs with working capital financing. The primary benefit of factoring is that it provides immediate money to the seller to finance the business. Factors buy the right to accept payments against the seller’s receivables and release 80-90% of the invoice value to the seller. A CRISIL study on 5,000 SMEs reveals that SMEs can increase their profit by at least 15% if they receive time payments from large corporations. It would facilitate SMEs to reduce interest costs, improve profitability, and have a positive impact on the long-term health and sustainability of India’s SME sector. Another major advantage it provides is that the factored receivables are removed from the bankruptcy estate of the seller and become the property of the factor.

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Supply Chain Financing

Supply chain financing is quite similar to factor. Here the supplier gets advanced payment on the outstanding invoices from a third-party funder for a small fee. But the difference is that here the financing solution is being initiated by the buyer where the buyer agrees to pay an invoice early for a discount. The benefit of the buyer here is the discount on the invoice price, whereas, the benefit of the supplier is early payment, typically at a discounted rate less than factoring. Supply chain finance can be made possible at any point of sale, purchase, production, and at the point of delivery as well.

Warehouse Receipts

In this setup, commodity producers deposit their commodities at a warehouse facility known for its secure and trusted storage practices. The warehouse issues a receipt that certifies its possession of a particular quantity of a commodity that adheres to specific standards. The deposit is then used as collateral to the depositor to secure loans from lending institutions. The lender places a lien on the stored commodity, preventing its sale until the loan is repaid. SMEs often face challenges in providing conventional collaterals, such as real estate or assets, to secure loans from banks and financial institutions. This mechanism reduces risks for the lenders and serves as a viable option for SMEs to secure credit for their working capital.

Participating Loans

Participating loans are a type of loan agreement where the interest or repayment to the lender is not fixed but is instead dependent on the financial performance of the debtor firm or the borrower. The remuneration or returns to the lender can be tied to various factors such as sales or turnover, profits, and share price. The lender's returns may increase or decrease based on the borrower's sales or revenue. If the company's sales go up and generate more profit, the lender may receive higher returns.

However, participating loans do not share in the losses incurred by the borrower. If the debtor firm faces financial losses or difficulties, the lender does not bear the burden of those losses. The lender's returns are contingent on positive financial performance but do not involve assuming any of the financial risks.

Also, if the debtor firm goes bankrupt or undergoes liquidation, the providers of participating loans are treated similarly to other loan creditors. They receive a share of the proceeds from the liquidation process, but this distribution is not influenced by the borrower's financial performance at that point. In essence, during bankruptcy, participating loan providers become regular creditors and do not have any special privileges based on the loan's contingent nature.

Purchase Order Finance

Purchase Order Finance (POF) allows a supplier to secure funds during the production or manufacturing stage. It is designed to address the working capital needs of SMEs when they have received a confirmed purchase order from one or more customers but lack the necessary funds to fulfill the order. The SMEs receive a verified purchase order from the buyer and subsequently estimate the cost required for the production and delivery of the product, which includes labor, raw materials, packaging, shipping, and insurance. The purchasing order is submitted to the financer, and following the approval of the loan, the approved costs are typically paid directly to the suppliers. The loan supports the SMEs in preparing final goods for shipment to the buyers as part of working capital finance.

FAQs

What are the alternative finance options available to Indian SMEs?

Following are the alternative finance options available to Indian SMEs:

• Securitized Debt
• Crowdfunding
• Factoring
• Supply Chain Financing
• Warehouse Receipts
• Participating Loans
• Purchase Order Finance

What is Securitized Debt?

Securitized debt refers to a financial arrangement where an entity, often a bank, also referred to as the originator, provides loans to a group of borrowers, usually small and medium-sized enterprises (SMEs).

What is Supply Chain Financing?

In Supply Chain Fiancing the supplier gets advanced payment on the outstanding invoices from a third-party funder for a small fee. Supply chain finance can be made possible at any point of sale, purchase, production, and at the point of delivery as well.