SMEs & The complexity of financing model
Many entrepreneurs accept a complex financing model without dwelling deep into it and ended up in a messy situation to deal with if slips to distress.
A few years back I witnessed one distressed SME in my known circle. He had been a very successful entrepreneur having a record of 20 years of successfully running his business. He was into manufacturing of packaging materials and major FMCGs were his clients. As the existing unit peaked its performance and, he started contemplating setting up the second unit with most modern technology sourced from abroad. It was necessitated because the industry was becoming very competitive due to clients demand for better quality and superior visual presentation of packaging materials.
During that time many consultants were visiting him to present newer technology platforms in the industry. At the same time, banks became very benevolent for lending to the SME sector. The financial consultant offered to structure a model to reduce the cost of borrowing by usance LC. Since it was high end advanced set up, they were sure of export opportunities to Europe. Hence they chose EPCG cover to reduce the cost of machinery. It was sounding like everything is falling in place favourably.
However, as the project progresses, it encountered many problems leading to delay and cost escalation. Not only that, even after starting commercial operation it had to confront with many challenges in realising expected quality and volume of the business. Even though they could improve the quality and capacity utilisation, the marketplace was unwilling to accept their product because it was too costly compared to many others who sell the same quality materials. The export market remained a far cry and rupee depreciation further added to the woes. Though Bank has extended enough working capital, it was consumed in addressing teething problems and debt servicing.
The initial plan did not work for. On the other hand, the bank started putting pressure as the debt servicing became a challenge. Facing challenges on too many fronts for which he was unprepared for, he caved into the pressure. The venture was shut down.
Unfortunately, the well run existing unit which should have been a support to sustaining the family to maintain the lifestyle also came down due to the diversion of funds to the new unit.
As time passes, having no long-term solution in sight, the promoter sought a settlement with the bank by resorting to slump sale of the unit. When it was going smoothly, the presence of EPCG cover become a challenge to deal with as they started seeking a penalty for non-compliance on expert front and raised objection for sale of machinery for which they have extended concessions.
The business which was built assiduously over the years collapsed.
On the hindsight we observed the following deficiencies:
- On the whole, the expansion plan was not properly drawn. Whatever the DPR prepared, it was meant to satisfy the bank to secure the loan than a document to guide the promoter to approach the expansion plan. There were loose ends/gaping holes left unattended to, rather not thought over at all.
- The capital cost was extremely high compared to the same machinery if imported from China and resulted in lesser competitiveness. There was not proper analysis nor market study to understand and strategise the buying of machinery. The decision was blinkered by the image associated with German-made machinery.
- Funding for business was very complex and did not have enough understanding of the risks. The financing involved LC with usance, taking EPCG cover, availing mortgage loan to meet the promoter contribution, term loan from the bank as well as taking surplus from existing unit. The model looks simple in the normal circumstances where everything goes smooth. However, it does not have any space to deal with a scenario of if not…..
- Overemphasising role of consultants: There are few consultants for various elements of the project like one for technology, another one for the bank loan, the third one for EPCG matter, etc. All these gentlemen have their eye on completing the task assigned.
However, the perception they could create in an entrepreneur’s mind is that they care for him and they do everything in a way that it satisfies his goal and risks are minimised. The entrepreneur told me that he felt secure in their assurances and believed them in full. The reality was that they have their interest to the extent of their agenda of selling the machine, raising the bank loan etc. None of them had given any thought on how the entrepreneur is placed in relation to his expansion plan. It was a stark contrast to his perception of them.
Growth is a complementary transition for a start-up but riskier.
Any enterprise passes through various transition stages- Startup, growth, maturity and exit including succession. Our understanding is that growth post success of a startup is riskier in SME space. It is because in the start-up stage entrepreneurs are alert and meticulous planning to secure a firm space in the business ecosystem. Secondly, many of the factors that contribute to success are under control and or impact of risks is not significant due to the smallness of the enterprise.
In the growth stage, many of these factors which were not considered the significant need to be reviewed and analysed from the perspective of financial implications. If the business expansion is debt funded, there is little room for missteps.
How to mitigate:
Hire an Independent Financial Advisor: Many entrepreneurs are not conversant with risks associated many of the financial products and facilities. Also many a time they tend to ignore analysing the financial consequence of strategic decisions. It is highly recommended to have a professional financial advisor which assist the management to figure out the risks and designing financial model without bias. Conflict of Interest is a major area of concern and seek an explicit undertaking from them.
Please read: Why SMEs need professional Financial Advisors
Have a DPR for yourself before embarking on the growth: Many a time we may not appreciate the significance of risks for want of proper analysis and lack of information. Financial Planning is just limited to convince the bankers. Having a well-prepared DPR(Detailed Project Report) will mitigate the source of risk emanating from information asymmetry and enable one to visualise “if not “scenarios. That will lead to well-informed decision making,
A sound financial model is important for any new strategic decision of growing the company’s business. An entrepreneur needs to tread cautiously or may end in dealing with distress compounded.
Author: Anil Kumar Shetty, Founder SME Advisors. We advise SMEs for designing growth strategy.