Why Small Firms Stay Small?

By Aryasilpa Adhikari, IFMR Capital 

In India across various industrial and trading clusters, small scale manufacturers and traders use manufacturing methods aided by simple tools and technology, basic machines (usually old-reused machines which have outlived their useful life) and low skilled labour to produce and trade goods that get either locally consumed or form a part of the larger OEM[1] value-chain as part manufacturers. These businesses are generally very small, employ less than 6-7 people (low-skilled) and usually offer reasonable income to its owners. While proliferation of a number of smaller businesses opens up employment opportunities, avenues for cheaper “Cost of goods sold”[2], and indicates a thriving and growing economy, empirical research[3] across the world has suggested that the spurring up of tiny units of manufacturing is less likely to promote a stable and resilient economy as compared to a developmental model driven by medium scale manufacturing enterprises.

For a growing and rapidly industrialising economy, the proportion of small to medium scale enterprises is always in flux. A mix more inclined towards medium scale enterprises will ensure absorption of unskilled workers, better capital productivity and technological efficiency[4]. Theory and experience from other developing and industrialised countries have suggested that firms should be encouraged to grow beyond the micro-enterprise level to enable the manufacturing sector to generate employment, to produce efficiently and to trigger technological development. In spite of a strong case for promoting medium scale enterprises and Government of India’s consistent push for the SME sector (in the form of fiscal packages and policy reforms), small and micro enterprises still form a whopping 96% of total registered MSMEs in India[5]. Most businesses start and remain very small.

This post highlights the reasons for the firms staying small based on anecdotal evidence, commonality and trends observed among smaller firms. The methodology used is direct observation, conversations and in-depth interactions with small and micro-business owners (90 firm owners) across 8 states of India in their major industrial and manufacturing clusters. The subsequent sections will highlight major trends exhibited by small enterprises and factors that determine such behaviour and trends.

For the purpose of clarity, this post defines an enterprise as small on the basis of (a) number of workers employed – usually six or less, and (b) annual turnover less than INR 40 Lakh (INR 4 million).

Commonalities observed among small business owners:

Irrespective of nature of product, profitability, business vintage, industry and even geographies the small businesses operate in; they exhibit strikingly common characteristics in terms of their choice of labour-mix, place of production, machine, product offering, supplier selection, bargaining ability, pricing decisions, market discovery ability and risk appetite. While the labour-mix, place of production and low capital intensity offers small firms the power of flexibility to survive uncertain business environments, poor bargaining capability, low risk-appetite, weak market outreach and a non-existent control over pricing decisions, act as constraints for small firms to grow.

Small firms usually have low-paid or unpaid labour and mostly follow a family organisational pattern. The women folk of the households usually double-up as unpaid labourers, offering the flexibility of reduced wage costs to the firm. This pattern is overwhelmingly prominent in firms that use rudimentary production technology and techniques that are transferred across generations. For instance, hand block print textile firms and lac-bangle-making units in Jaipur, rugs and carpet manufacturing units in Panipet rely heavily on low-paid and unpaid labour, usually the women folk of the household.

A majority of small firms usually operate from free or in-expensive workplaces as these are places of business activity and production. Many firms find it convenient to incur and absorb additional cost for transportation of finished goods to buyer locations instead of producing in a costly near-to-buyer location – A case in point being the number of very small firms spread across the outskirts of the Pitampura industrial hub in Indore or in the outskirts of Hosur industrial zone producing exactly the same products as that of the units located within the zone, but with the added cost-advantage. These units dodge the high rental expense and offer the cost-advantage proposition to buyers.

Most of the small firms have exhibited low level of capital investment. They tend to operate with simple tools and equipment for production, which means lower fixed costs and lower maintenance costs. Investments in bigger machines would require significant capital, skill upgradation and a strong visibility of order pipeline to attain the turnover that would economically justify capital-infusion. Firm owners usually track their capital investment vis-à-vis turnover. The decision to invest additional capital is triggered on the basis of visibility of order pipeline to achieve the turnover target. In the absence of any one of the above parameters, firm owners find it risky to invest in technology upgradation and tend to continue remaining small. Many small firm owners have confided that low physical capital helps them change their product mix to meet changing demand or input availability without worrying about the unutilized expensive equipment.

Smaller businesses or firms within an industry segment tend to produce identical or nearly identical products – both in terms of quality and design, without offering significant product differentiation. This has implications over the pricing power of the manufacturers (and subsequently on margins) as well. The buyers always command an upper hand in pricing in the absence of clear product differentiation. The shoe manufacturing cluster in Karampura prominently highlights this commonality of small firms. Taking a close look at the tiny-shoe manufacturing units in Karampura cluster, it will be extremely difficult to identify what differentiates one manufacturer from the other. Surprisingly all of the manufacturers supply to 3-4 buyers (middle-men) in the region. The firm’s ability to choose its own buyer is limited by the quality and quantity of output produced by the manufacturer (bigger buyer will buy from a relatively bigger manufacturer).

Small firms find it difficult to identify or discover markets beyond localised markets. This can be attributed to lack of information, both on part of consumers and manufacturers, to discover each other. It is difficult for consumers to learn about the existence and quality of different firms’ outputs. As a result, consumers often buy exclusively from a local producer, and producers sell mostly to local customers. The limited size of their potential customer base limits firms’ ability to grow[6]. A comparison of firm size and profitability of manufacturers in the Kolhapur and Karampura shoe clusters will prominently highlight the fact that market discovery beyond local markets has contributed significantly to the overall profitability and prosperity of Kolhapur shoe unit manufacturers.

Understanding the factors driving the commonalities:

Specifically addressing the question of “why small firms stay small” and the reasons for demonstrating the common behaviour- a significant number of factors like lack of capital, lack of skill – technical and managerial, limited market availability, weak policy and infrastructure frameworks and low risk-appetites contribute to constricted growth. However, it was observed that it is primarily the risk management strategies of small firm owners (given all other factors kept unchanged or nearly stable) that prevents or augments the growth of small firm owners into medium scale enterprises.

On the basis of discussions with small firm owners who have been profitable for more than 2 years and have still remained small, it was found that they have invariably adopted risk-averse strategies of opting for a product line which promises lower certain returns as compared to a variable one with higher expected value from a new product line. Many firm owners clearly mentioned that their choice of business line or product mix is determined by the ability of the product to offer a minimum income to them. While a few expressed an intention to take their business to the next level, they were constricted by a lack of capital and skill. For instance, a first generation entrepreneur, whose business was in making automotive spark plugs, illustrated this point aptly. He wanted to purchase a new machine that would enable him to introduce a new product line for his 8 year old business. He had collected about INR 10 Lakhs from personal savings to purchase the machine. He required additional INR 8 Lakhs to set up the machine. However, he could not raise the additional capital and was forced to stay small.

Many small-firm owners have managed risk through flexibility – flexibility which is achieved through employing low-paid or unpaid labourers (in lean seasons, firm owners and labourers take up alternate income generating activities), working in inexpensive workplaces (reduces the overhead expenses during lean periods), flexibility in level of capital deployed. On the basis of discussions with collection executives for various financing companies who deal with recovery from stressed firms, it was found that small firms invariably fall into financial stress when they compromise on capital-flexibility – if a significant chunk of capital is blocked at the firm level and it is unable to generate the expected return, firm profitability plunges. However, businesses with higher vintage are better placed to invest capital in business, mainly because of strong networks built over a period which would ensure better order visibility.

The risk appetite of small firm owners has also engendered an inertia against moving to new product lines and venturing into new markets or unknown geographies. Many businesses clearly stated that growing to a medium scale enterprise will force them to be compliant with various regulatory requirements and hence, they find little incentive to expand beyond the “small-firm”. Instead they find it more lucrative to open/invest in a second small business or purchase an asset which would offer economic security in the event of failure of the first business. For instance, a classic example of this behaviour was observed in Mr. Durgalal (name changed), a stone carving firm owner in Jaipur, who insisted that he would prefer to remain an owner of a 4-member labour team and buy agricultural land instead of investing capital in buying new machines for stone cutting or securing labour advance. Small firm owners resort to livelihood diversification instead of investing in the same business.

While intuitively the risk management strategies adopted by small-firm owners, safeguards them from uncertainties of the business environment, at a broader macro-economic level, the larger goals of employment generation and efficient production remain unachieved. The true benefits of a growing economy will be realised when the proportion of medium scale enterprises increases and this shift would require targeted and specific strategies that would address the risk-concerns and risk-response of small firm owners.

[1] Original Equipment manufacturers

[2] Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold.

[3] The Growth and Decline of Small firms in Developing Countries by Alex Coad, Jagannadha Pawan Tamvada; An Analysis of Small Business and Jobs by Brian Headd, Success in Small and medium scale enterprise: the evidence from Columbia by Cortes, Mariluz; Berry, Albert; Ishaq, Ashfaq, Risk and growth in Nairobi’s small scale manufacturing by McCormick, Dorothy

[4] Risk and growth in Nairobi’s small scale manufacturing by McCormick, Dorothy

[5] Annual Report by Ministry of MSME 2015-16, 2017

[6] Information, demand and the growth of firms: Evidence from a natural experiment in India by Robert Jensen, Nolan Miller


Privacy on the Line: What do Indians think about privacy & data protection?

This post is authored by the Future of Finance Team at Dvara Research.

We met Sulekha[1] in a village in Uttarakhand. She was talking about the information she considered most important to her: her ration card, Aadhaar card, NREGA job card and her phone number. When asked how much she would sell this information for, she visibly withdrew saying she did not want any money for it. What would she need to share this information? She replied simply: a guarantee that it would not be misused.

Sulekha was one of the 50 people we spoke to as part of a small, deeply qualitative study on which the Future of Finance Initiative (FFI) at Dvara Research partnered with Dalberg Design and CGAP. We set out to understand: ‘how do ordinary citizens of India think and act on their privacy and data protection?’ Across four regions of the country (Maharashtra, Uttarakhand, Tamil Nadu and Delhi) we used the Human Centred Design (HCD) method to have discussions to understand not just what people say, but how they think, act and feel. The final report on the study is available here.

Our conversations in the field revealed that contrary to common perception, people in India care deeply about their personal data and privacy. Respondents were surprised that service providers could share their personal information with third parties and wanted to be informed of such sharing. People were also sensitive about sharing their personal data such as photos, messages and browsing histories—even with their family—and were unwilling to sell certain types of personal data like their telephone numbers.

Even the data that they were willing to share in order to receive services came with conditions. People wanted to know how their data was handled. They also, much like Sulekha, wanted an assurance from providers that no harm would come to them through the use of their data. Many of the interviewees recognised their inability to understand standard notice clauses and wanted more visual forms of consent that they could easily understand without relying on others.

Alarmingly, most interviewees had experienced fraud (especially via phone impersonators), and did not know how to protect themselves or seek redressal. Women, in particular, were highly vulnerable to reputational harms, and self-censored themselves (for example by not sharing phone numbers or photos) to protect themselves.

Although the government and its institutions inspired universal trust, people working in government institutions were not trusted with personal data – unless the employees came from the same community group or geographic area. Agents of banks and mobile network providers were also recognised as common perpetrators of illicit disclosures of personal data.

In cases where harm was caused to them as a result of a data breach, the respondents wanted easy access to seek redressal, and wanted to be compensated fully.

We heard individuals asserting their right to have their personal information treated responsibly. They indicated clear and strong preferences for a system that provides them agency and control over their data. Citizens at the grassroots want a data protection regime where providers are held accountable and are obligated to treat personal data responsibly.

You can read the full report here and watch the below video on the study.

[1] Name changed. Note: The details of the respondents in the main report were included with their permission and after informing them that a report would be released on this topic.


Conversations with the newly banked in Indian cities

By Bindu Ananth

Initially, Kanhaiya[i] was wary of speaking to us. He was clutching his wallet tightly and declared upfront that he would not be showing us his ATM card. As we spoke more about his journey as an agriculturist in a small village in Madhya Pradesh to a plaster of Paris contractor in Ghaziabad, he started opening up. He told us about the many times he didn’t get paid for his work but this one time, he was so angry that he destroyed his own creation. More recently, his ATM card had broken and when he went to the branch to withdraw cash to pay his workers, he was refused because his signature didn’t match. While he is waiting to be re-KYCed, he has taken a loan to make payments to his workers. He resignedly concluded to us “dhokha bahut hota hai”. Before he left us, he made us write down on a chit of paper “Recurring Deposit”. He wanted to take it to his bank to ask them how he could open one of those things for his 2 year old daughter.

We met Salim in a cramped room in Tughlakabad, Delhi where he was executing an elaborate design on a bridal lehenga. He lives and works in this room with eight others. His family lives in Nawabganj village of Bareilly. He used to work in a company previously but left because he felt disrespected. When we ask him about how he plans his finances, he laughs and says “only rich people can plan their money”. He talks about losing savings balances to minimum balance fees and not being disciplined enough to sign up for chit funds that many of the other workers are a part of.

Dinesh Gowda moved to Bangalore from Mysore three months ago armed with a Bachelors in Mechanical Engineering degree and found a job at a metallurgical unit, earning Rs. 15,000/month. He spoke to us passionately about starting an auto-parts business back in Mysore after a few years of acquiring skills & experience. His brother-in-law is his money manager. He withdraws his entire salary from his bank account every month, hands it over to his brother-in-law every month and receives a fixed allowance for expenses. We met him around Diwali and he was waiting to get his allowance to buy gifts for his parents and sister back in Mysore. When we asked him how he felt about this arrangement, he shrugged and said, “family knows best”.

Our[ii] conversations with Kanhaiya, Salim and Dinesh were part of a series of 100 + interviews across Mumbai, Shimoga, Bangalore, Chikmanglur, Kochi, Thiruvalla, Delhi, Gurgaon and Ghaziabad where we tried to understand the journeys of the “newly banked”. We defined this as a category of people, who by virtue of migration from the village to the city or starting out at a new job, have recently gained access to a bank account and a smart phone. Our hypothesis is that this combination becomes an important on-ramp for the broader suite of financial services (credit including mortgages, investments, insurance) that are relevant to people. What we found on the ground for now is a dogged duality – almost everyone we spoke to had a bank account (this would not have been the case even 3 years ago) that they opened either as a salary account or to facilitate remittances in the case of rural-urban migrants, but relied heavily on the informal sector (friends, family, chits) to manage their broader financial needs.

Should’ve, could’ve, didn’t (invest)

The apparent reasons for this duality are not surprising. We consistently heard that it is difficult to scale the relationship with the bank beyond the savings account. While there is a strong desire to save/invest for long-term goals, there are no good solutions to solve for challenges around income volatility (a few people spoke to us about lapsed LIC policies due to inability to make regular payments) and behavioural aspects (illiquidity preference, mental accounting). Talking about investments evoked considerable feelings of “FOMO” amongst everyone – everyone had a sense that they may be leaving money on the table but were not comfortable approaching banks with their questions. Interestingly, there doesn’t seem to be a clear “action point” or “go-to brand” when it comes to figuring out investments, people talk about the market as a whole or in abstract concepts. A notable exception was a lady tailor in Delhi who asked us how she could get in on the Bitcoin bandwagon! By and large, LIC endowment policies are the way people invest for long-term goals. This is also true of educated, new-to-the-workforce millennials who follow parents’ advice on investments. The LIC ecosystem doesn’t seem very inter-operable for migrants. People routinely spoke about going back to their villages to make payments[iii].

We asked people specifically who they turn to for advice if they received an unexpected bonus or extra income. This always led us in the direction of some member in the extended family who was relatively speaking better-off and seemed in control of his (in all cases, a man) finances. There was blind faith in these trusted advisors. One young respondent who worked in an IT firm in Bangalore had signed up for unit-linked plans with ten year lock-ins on the advice of his uncle in Patna.

Almost everyone we met had a smartphone and was an active user of whatsapp, FB and Youtube. While the educated, urban respondents used the apps of their banks typically for checking balances and Paytm for sending friends money and bill payments; there was no dominant financial app being used in an integrated manner.

Opportunity for a new, customer-centric architecture

One upshot of all the technological innovation in finance in recent times is a significant reduction in fixed costs & entry barriers. In India, we have identity-as-a-service (Aadhaar), KYC as a service (e-KYC) and payments as a service (UPI) that is already catalyzing a remarkable number of start-ups who are specialized and are innovating at the application layer. Experts[iv] in this space have already predicted the “unbundling and re-bundling” that is likely to occur in retail financial services and the emergence of new players and value propositions. Banks are unlikely to be able to serve this newly banked customer base effectively given the continuing challenges with cost-to-serve. This was clear to me when I was at a panel recently with Mr. P.N Vasudevan of Equitas Small Finance Bank. He noted that their liability customers are completely distinct from their credit customers because of the need for minimum balances in the former and this is a bank whose ethos is deeply about frugality and has a ready base of millions of micro-customers.

The early wave of business models among fin-techs, however, continues to be product-driven (digital credit, digital investment platforms) while leveraging the digital infrastructure for efficiencies. However, for the generation of customers who are new to the formal system, the product lens is not intuitive and often, drives them back to familiar arrangements of friends and informal channels.

In our view, what would be transformative is a proliferation of segment-specific (students, free-lancers, migrant) interfaces and solutions that enable the on-ramp from the bank account to the broader universe of financial services. Automated savings apps such as Digit are a good example of this. A deep understanding of the needs of the customer, converting that into a meaningful and trusted solution and getting interface design right will matter a great deal. Building trust is also obviously a big factor when going beyond credit and small-value payments. Despite poor service and experiences, people repeatedly go back to Public Sector Banks and LIC because of the sense that their money will be fundamentally in safe hands[v].

Watch this space for further updates on our own work on this front.

[i] All respondent names have been changed

[ii] This is joint work by Dvara Research and Pensaar Design. A lot of my thinking on this topic was triggered during a recent stint as an entrepreneur-in-residence with the Omidyar Network

[iii] One merchant we met told us that LIC APIs are not available for integration with third-party platforms such as remittance service providers.

[iv] https://www.omidyar.com/blog/now-fintech-has-unbundled-our-financial-lives-can-it-re-bundle-them

[v] Separately, the virtue of Public Sector Banks being focused on providing access to savings and term deposits and limiting the asset side of their balance sheet to rated debt securities and government securities (https://www.bloombergquint.com/opinion/2017/10/09/do-indias-weak-banks-need-a-stronger-dose-of-corrective-action) needs to be seriously explored.


Pudhuaaru KGFS Turns 9 – The Journey of the First Branch


From Looking to Seeing

By Kshama Fernandes, CEO, IFMR Capital

I met today with the promoter and CEO of one of our newer Small Business Loan Originators and visited some of their end borrowers in Bombay. I heard an interesting story of their very first client not too long ago. This was a sandwich vendor who runs a makeshift stall outside the Bombay Stock Exchange (BSE) and has been supplying sandwiches to the entire BSE crowd for years. Imagine a business with a captive clientele in one of the oldest and the largest exchange in India. One would think the vendor must be an attractive credit opportunity for any sensible lender. Well, it so happened that the gentleman had no access to formal credit for decades despite being located on Dalal Street – traditionally considered the nerve center of India’s capital. Till the day a credit officer from our Originator discovered him. As expected he had little to prove his credit worthiness. So the credit officer spent two days standing next to his little stall and counting the number of sandwiches he delivered to the BSE building from morning to evening. This was followed by a personal assessment through a Q&A session, a visit to his home and a few conversations with neighbours. Using the sandwich-movement-activity based cashflow and other observations, the credit officer built the sandwich vendor’s P&L and B/S. The vendor was given a one-year loan of INR 9 lakh. He repaid the loan in 6 months and reapplied for a larger loan, tapping into a formal source of finance for the second time in his life.

The CEO told me that when he left behind a promising career in a mainstream commercial bank and decided to get into a more interesting and possibly a higher margin business, he thought he would have to go to far flung areas of the country in search of those who had no access to credit. He was wrong. He found many such down the street from his office. I visited some of them today.

India is indeed a promising land. We simply need to look a little closer and go a little deeper into the lives of people around us – people whom we always ignored because we never thought they had potential. We need to stop looking and start seeing!