Equity financing for MSMEs: Top 3 reasons why it's a good alternative to raising debt

Micro, small, and medium enterprises (MSMEs) form the backbone of a nation. They play an irrefutable role in supporting economic viability and employment. Every large conglomerate was once a small business. With time and the right resources, these businesses became household names; for instance, multinational giant Reliance Industries, in 1966, was just a small textile company. 

Spread across all sectors, MSMEs contribute to over 30% of India’s Gross Domestic Product (GDP) and account for more than 45% of the nation's exports. Currently, they offer employment to nearly 120 million individuals. 

While the numbers look promising, for MSMEs, business is no bed of roses. Despite government support, MSMEs encounter several roadblocks, with availing financing topping the list. 

In a typical setup, raising debt is the most sought-after option by MSMEs to fund their business. According to a report, the number of MSMEs availing of formal credit facilities is as low as 16%. The rest opt for informal credit, leading to a higher debt expenditure, leaving little or no air to fan the revenue growth. 

Is there a way out of this seemingly vicious circle?

If you look hard, there is an alternate option that most miss—add equity as a financing option to debt. Instead of signing up for a loan, opting for an equity investor brings many potential benefits for MSMEs. To start with, it reduces the strain on the bottom line and thickens the opportunity to expand. 

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Here are the top three benefits that equity financing offers over debt to MSMEs: 

Long-term finance to enhance leverage

Debt financing involves getting a bank loan or choosing informal institutions/creditors for funding. It puts the MSMEs at the mercy of their creditors. It includes financial covenants and a legal requirement of pledging collaterals. Also, debt financing is typically short-term, requiring a business to borrow in the future. 

Equity financing is a different fish. It is about MSMEs sharing a mutually decided equity part of their business with investors. It dilutes the primary ownership but does away with the collateral requirement. It gives the MSMEs the freedom to focus on growth opportunities. There are no covenants on opting for more resources to fund more projects, and in many cases, the initial equity player is likely to fund further expansion.  

Space for research and marketing

Research and marketing are a must for startups, which requires a tidy sum of money. Who does not remember the CRED ads?! 

Equity financing is the secret behind the freedom of incurring such expenses. 

We live in an era of  “Jo Dikhta Hai Woh Bikta Hai.” Those that fail to get on this bandwagon are in for a rough ride. A debt-financed business will be hard-pressed to find finances to fund a fraction of the expenses of this scale. Debt-ridden businesses' primary focus is on earning enough to pay it back in line with the deadline to avoid consequences and interest penalties. 

Today, consumers demand innovation and value additions for their products and services. For that, research is the base zero. Marketing is crucial to spreading the word about innovation and uniqueness.

Onboarding equity investors help MSMEs to have the freedom to spend money on necessary business operations without the fear of short-term paybacks, leading to a sustainable partnership and overall business growth.  

Investor expertise and sustainable business model

Compared to startups, MSMEs have fewer funds in their pockets. Thus, by onboarding investors via equity financing, they can explore expansion. Moreover, they get access to expertise that can help them evaluate their current business model and its scalability. 

Equity investors bring expertise to help businesses scale up in exchange for a percentage of ownership; MSMEs get investor skills and finances. 

Building a viable business model is the first step to onboarding equity investors. It includes steps such as analysing the company (ratio calculations, trend analysis, etc), valuing the present and future value of a business, performing a competition analysis, a tentative exit strategy for investors, and breaking down the goal into achievable milestones. 

MSMEs don't have to create a business model for debt financing. They have to show the profit and loss parameters, but it is limited. They get to know what will work and what will not work for their business. Equity financing can open the doors of opportunity that a business doesn't even know exists. 

The bottom line

The government targets to increase the share of MSMEs in national income to 40% or nearly $2 trillion by 2025. It aligns with the vision to make India a $5 trillion economy. To hold this true, I believe MSMEs need more than government schemes for financing. Equity investors bring expertise, and value speaks more than the price in the business. MSMEs should expand their horizon, step out of their comfort zone and explore equity financing to complement debt to sustain a growth prospect for an extended period.