MICRO VENTURE capital (MVC) financing is more effective than micro credit financing (MCF) in improving developing economies.
Micro venture capitalists finance small start-ups and companies for capital growth. Alternatively, micro creditors lend cash to low-income households for interest earnings. According to a recent research report by Goldman,Sachs & Co, MVC financing has a 10 per cent higher return and a five per cent lower default rate than MCF. MVCs have 10 per cent less overhead cost than micro credit banks. The cost structure for MVCs is flexible while the cost structure for micro credit banks is fixed.
Micro venture capitalists finance small start-ups and companies for capital growth. Alternatively, micro-creditors lend cash to low-income households for interest earnings. Micro venture capital firms differ from Venture Capital (VC) firms in their choice of exit points (the time when the venture capital fund ends its involvement in the business). VCs use IPOs, mergers, acquisitions, and buyouts as exit points. MVCs end their involvement in a business when they are able to collect their original investment, a return on it (which can range from 50-100%), and a fee for the expertise that the MVCs provide in the early stages of the startup. MVCs collect money only when the start-up is profitable. Micro credit banks offer small loans to low-income households and follow a weekly payment collection schedule. Micro loans tend to carry a higher interest rate than conventional bank loans. Micro lenders require borrowers to form groups. Each member of the group takes an individual loan, and must make an individual weekly payment on that loan. If one of the members of the group misses a payment, the entire group is denied further credit until the delinquent loan is brought current. This encourages the group to make sure every member keeps his or her loan current.
MVCs have higher returns because investors assume a higher risk; however, the investor is able to reduce the number of bankruptcies by educating the entrepreneurs and providing expertise. MVCs are interested in the profitability of the business rather than regular fixed payments. Micro lenders have lower returns because investors assume lower risk. The rate of default tends to be higher, however, because the micro-lender insists on a weekly payment, whether the business is profitable or not. The lender takes no interest in the success of the business, leaving the borrower with no advisory assistance. Borrowers have no collateral, so if they default, the lender has no means to recover any portion of the loan.
The cost structure for MVCs is flexible while the cost structure for micro credit banks is fixed. MVCs have less overhead cost because they have fewer employees and fewer branch offices. MVC employees are primarily consultants, providing advice and expertise to start-ups. They do not need to meet with entrepreneurs every week, and the number of MVC employees is not as important as the expertise they posses. Contrarily, micro credit requires a large force of collection officers to visit borrowers every week and collect the weekly payments. The approval process of the MVC is simpler and more definitive because it relies on evaluating business plans, while micro credit model relies solely on the borrower’s character. Fewer employees at MVCs mean fewer and smaller branch offices. MVCs also have a flexible cost structure. When a start-up fails and cannot repay an MVC’s investment, the MVC simply charges it as a sunk cost and moves on to other opportunities. MVCs only increase their workforce when they are profitable and when they need more consultants to assist a larger number of businesses. On the other hand, when a borrower defaults on a loan, the micro creditor must send employees to attempt redemption of the loan. Therefore, as the revenue of the micro lender is falling, its costs are increasing. In the case of a large number of defaults, the micro lender could be put out of business due to falling revenues and rising costs.
MVCs significantly improve peoples’ standards of living while micro credit financing only causes incremental and cosmetic changes. MVCs tend to invest in micro-enterprises, which are larger in scale than the businesses funded by micro creditors. Within one year, 80% of micro-enterprises have at least one employee, according to the report. In contrast, one fourth of micro credit is used for personal consumption rather than income generating activities. Seventy five per cent of the remaining credit is used to finance small agricultural projects with low returns. These activities raise the borrower from just below to just above the poverty line, and rarely generate employment for others. Profit margins of micro-enterprises are, on average, 10 times higher than the profit margins of micro credit-financed projects, according to the economists at Goldman. With increased business profits, disposable incomes rise and people become more likely to spend; this in turn stimulates the economy and positively affects business profits.
The MVC model of financing motivates entrepreneurs to educate themselves, their families, and their employees. Entrepreneurs who receive MVC financing also receive training in basic business skills. A survey of households with MVC- financed businesses, conducted by the Association of icro Venture Capitalists, indicated that 76 per cent of respondents feel that their participation in the programme has made them more likely to send their children to college. MVC- financed businesses also create a demand for skilled labour, which develops the need for a better education. Micro Venture Capital business financing causes higher profit margins and increased innovation in the economy compared to micro credit business financing. Profits coupled with innovation increase the GDP and its rate of growth. MVC financing model creates more jobs than the micro credit model of financing businesses, and increases the demand for skilled labour, which increases wages fairly. These changes reduce poverty. The MVC model predisposes the entrepreneurs in the country to educate themselves, their families, and their employees. This motivation increases the nation’s literacy rate.
The micro credit model of financing does not place a high value on knowledge, so micro loan recipients are not motivated to educate themselves. Therefore, as compared to the micro credit financing model, the micro venture capital model is a superior approach to helping a developing economy.