By Sunil K. Goyal, Managing Director, YourNest Capital Advisors
Many questions and doubts exist around PE/VC investment in MSMEs. Rather than worry entrepreneurs, the investment brings with it a reassurance and additional benefits that help MSMEs scale up to the next level.
Micro, small and medium enterprises (MSMEs) are considered the backbone of the Indian economy due to their significant contribution to the GDP. Employing more than 11 crore workers, MSMEs steadily contribute about 30% to the GDP and constitute nearly half of the country’s exports. These numbers are even higher globally as MSMEs are one of the most significant contributors to the US$ 90 tn global economy. However, a lack of funding has prevented many SMEs from fully unravelling their potential.
At the CII Indian MSME Growth Summit, 27-28 June 2022, I had the privilege of moderating a panel of four esteemed guests who brought vast experience working in private investments across various sectors. On the panel were:
- Mohit Dhawan: Senior VP & Head, Strategy, Mergers & Acquisitions at Hero Enterprises
- Manu Chandra: Founder at Sauce.VC
- Prashant Narang: Founder at Agility Ventures, and
- Vinay Singh: Founding Partner at Fireside Ventures
The following discussion addressed some pressing issues that have widened the gap between MSMEs and private investment. While watching the discussion would be the best way to grasp the takeaways (video link), I have tried to summarise our thoughts basis inputs from all the panellists.
Are MSMEs ready for Private Equity & Venture Capital?
MSMEs are characterised by a lower capital-output ratio, i.e. even a low level of investment is enough to produce a good growth rate. However Private Equity (PE) and Venture Capital (VC) players in India have shied away from MSMEs. The small size and non-corporate structure of these industries make it hard for investors because of higher transition costs and exit challenges associated with them. On the other hand, business owners have their own apprehension regarding private equity as it differs vastly from banking finance which dominates MSMEs.
On the bright side, private equity investors bring a lot more to the table than just their capital. They have a vested interest in the business and can actively participate in building the MSME by formalising structures, streamlining operations and expanding the scope of the company.
“Private equity investors bring a lot more to the table than just their capital”
Bridging the gap between MSMEs & Investors
MSMEs are often starved for funds and lack direction in technological expansion. By finding common ground, business owners and private equity investors can scale several industries in the MSME sector to global significance. In the following section, we will distill the highlights of the discussion with the investor panel.
Dispelling common myths and clearing the air around concerns by MSMEs and VCs:
1. Will founders lose control over their business to VC?
Founders often dread losing control of their businesses to investors. The reality is that most VCs do not want to run the companies they invest in; they want to act as advisors and mentors who bring experience and connections to the table to help founders solve business and growth problems. More importantly, VCs and PEs have such small teams – usually just 4-5 partners supported by a few associates – that it is operationally impossible for them to run the business. The VCs and PEs are mostly cheerleaders to the businesses, and bring their network and connections to develop the business. And while they would want to safeguard their investments, they cannot become controlling entities or operationally overbearing.
2. What is a drag-along right of investors? How does an MSME deal with that?
The drag-along rights allow a majority investor to sell a business to a third party while dragging along the minority investor to join the sale. It is important to understand that VCs and PEs are investing somebody else’s money into businesses and they too need to provide assurance and a safety net to their investors. This clause is only used if the business has failed completely with no path to revival. From a VC’s lens they need to drive maximum growth and, hence, returns from their investments; often, even when a business is not performing well, VCs continue to fund them, even if at a lower valuation (down round), to help the business stay afloat. So contrary to the point, VCs are as invested as much in the business as the owner. At the same time, it is important to understand when taking VC/PE money that one needs to provide them an exit – preferably when the business is doing well. As long as they are given a good exit strategy, the drag-along situation can be avoided and, more often than not, the VC/PE will continue to support the owner in troubled times if the business is solid.
3. Why would an MSME want to choose VC money over debt/capital/financing?
VC capital, unlike debt capital, is not just money but also the experience, advisory, connects and partnership of the incoming VC/PE. This is capital which comes in with a long term vested interest in the business. The wisdom and experience they can bring to scaling the business are invaluable for a founder/entrepreneur. VC investment is excellent for both capital allocation and strategic support. It frees you from the burden of returning the debt and, instead, focuses on scaling for a higher value in the future.
On the other hand, debt money is returnable capital and comes with several strings attached. It works well for your business when you have a robust cash flow that can meet the debt requirements and covenants.
“Debt money is returnable capital and comes with several strings attached”
4. How founders getting too attached to their brand backfires
Founders who have worked towards building their brand often get too attached to the business and refrain from transferring copyrights and trademarks to the company. Some old-school lawyers advise founders to keep the brand separate from the business in the hope of earning royalty in the future – this is not an acceptable practice anymore. The long-term value for businesses comes from the brand being recognised by loyal customers who make repeat purchases. VCs would prefer that all the key value-generating assets remain within the company and not outside, where there is little or no control because, especially in the case of B2C businesses, the business is driven by the resonance customers feel with the brand and is critical to its success.
5. How to develop the skills to pitch and raise capital
It might come as a surprise to many, but there is no science to pitching! It is often the case that good ideas and good people get funded. VCs look for entrepreneurs whose businesses have a differentiated defensible proposition or moat, to avoid scenarios where anyone who comes into the market with a similar offering begins competing with the business. PEs/VCs look for passionate founders who have built a solid second line of leadership. With strong growth projections there should be emphasis on profitability after a certain scale is attained. And there are other seemingly smaller things that also speak a lot about the business such having a good quality board, filing statutory dues in a timely manner. As long as you can pitch your ideas clearly and demonstrate good management, corporate governance and ethical practices, you will find VCs willing to invest.
6. How to instill trust that “private capital is good” to ensure the growth of its ecosystem
Founders may sometimes question if the VC/PE knows more about their business than they do, and to put that in perspective, typically partners at these VC come with years of operational experience; further, they spend tremendous time looking a over 5-6 such businesses every week which gives them insights into what works and what doesn’t. The knowledge of looking at businesses across industries and sectors and having invested in and grown many of them, is invaluable. The last thing that anyone would want to do is to not take advantage of it.
Trust – as in any other relationship – works both ways. It is essential to keep it transparent so that the founders and investors are on the same page regarding business details. It is also critical to put in place strong ethics, good corporate governance processes and timely communication to ensure the whole ecosystem of businesses and investors feels confident about long-term relationships. This brings me to the point that withholding information is the worst thing that can be done by any business raising VC/PE money and can leave no room for trust, especially during the initial evaluation stage.
“It is essential to build trust and transparency”
7. What are the risks and challenges for MSMEs seeking funding from private capital?
There are no risks to seeking funds from private capital. First, is the love for equity or desire for complete ownership, which is a significant hurdle for scaling the business. This attachment is not prudent in the long term, as its better to own 50% of a Rs 100 cr business than to own 100% of a Rs 10 cr business. Second, PE/VCs are looking to invest in futuristic businesses and hence it becomes critical that SMEs who are traditional businesses infuse innovation to their business model in order to attract VC/PE money. As a thumb rule, if a business is projected to be redundant or irrelevant in the the next 10 years, it must either by transformed or shut. Lastly, lack of corporate governance and shady business practices are a big deal breaker for investors across the board, and should be avoided by all means.
8. How existing brands and consumer businesses can pitch to investors
When it comes to brands, investors are always looking for clarity from the business about key questions: who is your consumer segment? why are they currently underserved? how is the business’s product addressing the needs? is it priced correctly? and is all of this translating into metrics of customer stickiness and business growth? It is essential to show a customer base and demonstrate how the audience receives the products. Any functional benefit that places the product above the competition is a plus, along with the marketing strategy and sales numbers. The second variable of the equation is the team behind the brand and its positioning to take advantage of the existing gap in the market.
Some interesting questions from the audience that day:
- How is roll-up as a strategy to mitigate risks and help grow the SME? (asked by an industrial manufacturing SME)
A roll-up is when a larger business acquires a smaller company and integrates the two. This is typically done when there is some form of synergy between the two businesses, e.g. if a company buys another company to vertically integrate or horizontally expand its customer reach, or increases the offerings to a similar set of customers. So what needs to be evaluated here is that does there exist an opportunity to create synergies from the combined business or will this merely become a tuck-in acquisition to increase size, in case of the latter a roll up will not make sense for the smaller business.
- Would an industrial manufacturing business be attractive to a VC/PE ?
There needs to be some form of differentiated proposition in the business versus a traditional industrial manufacturing business where the costs are lower and has a possibility of disrupting the market or improving the profitability disproportionately, and hence bringing an opportunity for a VC/PE to create value.
The discussion above highlights the benefits of private investment to MSMEs. However, a common issue that frequently dissuades investors from MSMEs is the lack of transparency, dubious book-keeping and lapses in regulation compliance. To entice investors, businesses must maintain meticulous records with complete transparency. While investors tolerate lapses in remedial oversight, a track record of negligence, intentional misconduct, or fraud is a deal breaker. Above all, it must be remembered that PEs/VCs infuse not just capital but much more into a business and accelerate its growth.