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The Era of Alternative Lending

– A brief introduction to Revenue Based Financing (RBF) Introduction It is no secret that Indian MSMEs face a massive credit gap. Some studies estimate this deficit to be to the

7 months ago

Latest Post Addressing the Great Indian Credit Gap by Akshay Nagpal public

– A brief introduction to Revenue Based Financing (RBF)

Introduction

It is no secret that Indian MSMEs face a massive credit gap. Some studies estimate this deficit to be to the tune of ₹ 45 Lakh Crores, or $ 600 Billion. The magnitude of this credit gap is so large, that almost 9 out of 10 MSMEs in the country have to resort to informal sources of credit, due to the severely limited access to formal credit facilities.

When it comes to the problem of lack of access to formal credit, the primary culprit is the lack of collaterals, improper financials and an absent credit history. Due to this, MSMEs have to resort to alternative solutions for financing, such as personal loans and borrowings, personal savings and the informal sector. When these enterprises resort to financing from the informal sector, they end up paying almost twice as much in interests as they would have otherwise. This makes financing from the informal sector a very exorbitant affair.

Enter Revenue Based Financing

As the Indian economy looks for new sources to finance its 63 Million MSMEs, one innovative new class of capital that has proved to be very promising in its current form is Revenue Based Financing (RBF).

But what exactly is Revenue Based Financing?

Revenue Based Financing, or simply RBF, is a recently introduced and increasingly popular model that allows enterprises to raise funds by pledging a certain share of their future revenues to the financiers.

For a majority of Indian MSMEs, their financial health is a factor that may determine their very existence, with the ecosystem going through multiple macroeconomic disruptions at regular intervals of time, especially in the last 5-6 years. Many a times, these enterprises are left with no avenues for the inflow of working capital. And this is especially true since the last few years, with increasingly stringent financial regulations coming into play, making access to bank lending a lot more difficult for these MSMEs, as banks grow a lot more hesitant in servicing the aforementioned, due to no tangible collaterals, improper financial records and incomplete overall documentation.

This is perhaps why entrepreneurs are seriously considering Revenue Based Financing, which provides a respite from this problem. Leveraging their estimated future earnings, MSMEs, or the borrowers in this case, essentially pledge ‘revenue share’- a certain proportion of their revenue, to the financier, after which they pay back the principal amount along with the revenue share. This makes it non-dilutive funding, allowing the enterprise to retain ownership of its organisation, its assets and other collaterals it would have needed to leverage in order to raise funds from the banks.

And for early-to-mid stage startups, this makes a lot of financial sense, as financial growth become crucial for survival in the intensely competitive Indian MSME ecosystem, as entrepreneurs seek to avoid problems like the debt trap. Another factor that works in RBF’s favour is the flexibility it offers these enterprises, allowing them to grow at a pace they are comfortable with.

Why RBF?

Over the years, there have been monumental infrastructural changes within India’s economy, which has pushed the adoption of revenue based financing in the country.

Some of these include:

  1. The onset of GST, which has promoted greater availability of transparent data on business transactions, thus aiding visibility on the real revenues of businesses.
  2. Adoption of ERPs and subsequent ERP driven business management practices, that has allowed businesses to invest in data maintenance, which can readily be used by financiers another stakeholders.
  3. E-Invoicing: With its push to go digital, the Government has made E-Invoicing mandatory for companies with a turnover greater than ₹ 20 Crores. This enables the digital availability of invoices.
  4. E-Way Bill: The introduction of E-Way Bills as digital proof of transportation of goods is another method in which the country’s digital infrastructure is solving the information asymmetry problem.

It is reported that an estimated 30% of the cash in the Indian banking system is corporate surplus, which yields low returns for them.

Revenue Based Financing vs. Traditional Financing: A Sneak Peek

Here’s how Revenue Based Financing is different from Traditional Financing.


Assessment

Security

Loan Value

Repayments

Traditional Financing

Asset available as security

Asset Mortgage

Factor of the value of mortgage

Pre-defined payment schedule

Revenue Based Financing

Sales of the company & sustainability

Future cash flows as security

Factor of the revenue

Linked to payouts from the customer

The Way Forward

Perhaps another reason why Revenue Based Financing is so important is because of the promising role it can potentially play in the future of Indian Supply Chain Finance, as RBF, still in its infancy, is yet to grow to its full potential.

It is reported that an estimated 30% of the cash stashed in the Indian Banking System is actually corporate surplus. Add to this statistic the fact that the systematic reduction in interest rates is forcing corporates to look for alternative avenues for investing in order to maximise their treasury incomes, especially on investments made in risk-averse assets. And when we talk about Credit Line Utilisation, only about half these companies have utilisation exceeding 50%, with only 20.2% companies reporting utilisation of 80% and above, and a measly 28.3% reporting utilisation in the range of 50-80%.

Invoice Discounting: the oldest form of Revenue Based Financing?

One such avenue is Invoice Discounting, which is perhaps the oldest Revenue Based Financing Instrument, and has the potential to revolutionise the Indian SCF ecosystem. This is because enterprises have access to funds which can enable credit to vendors via invoice discounting.

The shift to revenue based financing can thus solve both these problems: the problem of lack of working capital avenues for vendors and the problem of low-yielding corporate surplus.

In Summary

Currently, Revenue Based Financing is still relatively limited in terms of the coverage of the ecosystem, and the number of organisations offering such solutions (which currently is just limited to FinTechs such as Clear, offering technology-enabled platforms enabling Invoice Discounting). However, as we progress towards a more digitised, transparent economy, RBF is all set to grow to its full potential.

Akshay Nagpal

Published 7 months ago