Broadening approach to SME financing: Adding tools to the artillery

SMEs should conduct thorough research and SWOT analysis before drafting their fundraising strategy. There is no good or bad option, but there is a right option, the win is to arrive at it.

Broadening approach to SME financing: Adding tools to the artillery

Tuesday December 27, 2022,

5 min Read

Small and Medium Enterprises (SMEs) need stable access to funding in order to grow, diversify, and stabilize their business. As these firms are vulnerable to financial shocks, reliance on the banks for financing may not do well to help evade these risks. 

While SMEs focus on business growth and diversification, they must also create a diverse funding portfolio outside of traditional banking and debt options. Unlike large companies, SMEs do not have access to raising capital via multiple vanilla and structured options.

SMEs' financing struggles are full of clauses, and sourcing funds is expensive. Does this mean it is a lost battle? Perhaps not. All that is required is better strategy of which there are two viable options that are less explored by SMEs—Initial Public Offering (IPO) and Private Equity (PE).  

This is how they work in detail. 

IPOs for SMEs: 

An IPO refers to companies raising funds by selling shares to the public by listing themselves on national stock exchanges like the Bombay Stock Exchange (BSE) or National Stock Exchanges (NSE) 

For an SME to be eligible for an IPO, it needs to have a post-issue capital in the range of Rs 1 crore to Rs 25 crore. Businesses with less than ₹ 1 crore of post-issue capital cannot explore this option. 

On the other hand, any company with a post-paid-up capital between Rs. 1 cr. to Rs. 25 cr. is eligible for an SME IPO. 

As awareness about this method of fundraise grows, this instrument is gaining traction among SMEs. A quick look at the numbers reveals this. While 28 SMEs were listed in 2019, this number increased to 60 in 2021, and this year it almost quadrupled to 98.  

That begs the question, what makes the IPO route a good option for raising funds?

For starters, it enables quick access to funds. To use this method effectively, one needs to hire a merchant banker to help align with the required compliances. Then comes increased brand Equity: High brand visibility and improved brand equity in the eyes of the customer. 

The flip side is that as a listed company, every detail - financial or non-financial, comes under the scrutiny of investors–both retail and institutional. But on the brighter side, the SME retains the control to make decisions and is not answerable to individual investors. 

A listed SME also has an additional focus on keeping its share prices from crashing, requiring it to discuss valuation, share price stability, underwriting, and compliances in detail with the merchant banker. Moreover, to keep the offering relevant SMEs will be required to advertise. But with an IPO, the timeline for a fundraise is certain. 

PE for SMEs 

PE refers to an asset class in which investors take ownership stakes in a company in exchange for their capital. PE investors typically hold these securities for three to seven years with the expectation to generate attractive financial returns upon exiting the investment. 

As investors hold a stake in the company, they come on board with skills and experience to assist SMEs drive their growth. 

When opting for the PE fundraise route, the SME does not have to disclose details like business information and financials to the public. All disclosures are limited to the investors. More importantly, the additional challenge of managing share price performance is not present while raising funds through PE. 

The downside is perhaps that SMEs may have to loosen control as the management broadens to include the PE investors. The investors will also be required to give regular updates on the company’s progress, even while there are no compliance requirements. 

On the other hand, mo additional recurring expenses help these SMEs become cost-efficient and divert funds for expansion. 

What is the right choice: IPO or Private Equity? 

There perhaps is no right answer to this question. It boils down to the needs of the SME, the stage of growth, the sector of operations, and its strengths. 

If the SME has a unique product offering or deep tech offering that it preferably kept quiet private equity is the right choice. It will ensure the USP is known to a few individuals having the same purpose. However, if the SME is internally compliant and wishes to build brand recognition and equity in the market, then IPO is the right choice.   

Valuation is a crucial decider when choosing between SME IPO and PE. An IPO valuation focuses more on past performance, whereas PE focuses on forecasted performance. 

Thus, if the SME is new and its performance in the past hasn't been remarkable, opting for private equity is better. However, if the performance has been exponential and the fundraising is to expand to the next level, SME IPO makes more sense. 

Either way, the SME IPO and PE are great fundraising tools. Having them in your artillery is a must. The choice of a tool at a given time will be determined by why the funds are required. SMEs should conduct thorough research and SWOT analysis before drafting their fundraising strategy. There is no good or bad option, but there is a right option, the win is to arrive at it.

Edited by Akanksha Sarma