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Exercise Equity Market: A Financing Model to Vitalize SMEs

The funding environment of small- and medium-sized enterprises (SMEs) is becoming critical, as the supply-demand gap in SME finance continues to widen in Asia and the rest of the world. Global economic uncertainty and financial regulatory tightening, denoted by Basel III, are accelerating this trend.

Lessons learned from the global financial crisis suggest that the limitations of traditional bank lending to SMEs have prompted many countries to consider diversified financing modalities that allow them to raise stable and safe funds for small businesses.

ADB surveys indicate that SMEs are seeking to access formal and diversified funding instruments with long-term tenure to reduce informal finance and self-funding dependency. Equity finance is one of the options SMEs are considering to escape the poor funding environment and grow further with their increased social credibility. However, most SMEs cannot tap the regular exchange market due to the relatively strict listing requirements, and more importantly, SMEs lack of basic knowledge of capital market financing.

One approach to meeting SMEs’ funding needs is to elaborate an exercise equity. It is not a simple funding venue, but rather a learning opportunity for SMEs about the benefits and obligations of capital market financing through which we can expect to stimulate a growth and graduation cycle, create a base for business growth, and help promote resilience and diversification of national economies.

The exercise market concept is based on public-private sector collaboration in SME financing by making the best use of all possible resources in the financial sector with technology. It aims to create a market mechanism that incubates smaller but growing firms that will eventually tap the exchange market. There are two steps involved: set up the public Apex Fund and establish the exercise equity market comprising the two financing channels of crowdfunding and over-the-counter (OTC) market.

Among the key challenges to develop the exercise equity market are demand creation and market sustainability.

The public Apex Fund provides credit lines to partner banks and venture capital companies servicing SMEs to deliver growth capital for viable SME segments—such as agribusiness, women-led SMEs, and social enterprises—and provides capacity building programs through regional incubation centers or business development services. Through these practices, the Apex Fund creates data stock for a pool of promising SMEs.

The exercise market also creates a crowdfunding platform managed by a private sector company and an OTC market operated by a self-regulatory organization, like the securities dealers association as the SME incubation segment. The Apex Fund selects SMEs with effective business models from the SME pool and connects them to either the crowdfunding segment or the organized OTC market.

The crowdfunding segment supports investment and working capital finance in SMEs, connecting them to individual investors and/or their business supporters. The organized OTC market provides a chance for SMEs to learn more market rules and obligations (such as disclosure) before tapping the exchange market, and helps SMEs improve their corporate culture through learning the importance of increased corporate value for growth.

The exercise equity market will be especially beneficial for economies that highly rely on natural resources, and as such have faced unstable economic growth with high price volatility, and often lack a base for domestic growth. The exercise market can promote SME internationalization and global value chain development by aligning itself with the national export and branding strategies, which will in turn boost national productivity.

Not all SMEs are eligible to be economic growth drivers. SMEs include sole proprietors and slow- or zero-growth enterprises; these are not a group for tapping capital markets. High-end SMEs that seek long-term growth capital for businesses with innovative mind-sets are more appropriate for capital markets.

Among the key challenges to develop the exercise equity market are demand creation and market sustainability. A comprehensive mechanism for supporting SMEs in equity finance is thus required and should include fostering the venture capital industry as an initial risk capital provider for SMEs; developing the base of professionals that support SMEs’ internal control system, such as certified public accountants; and designing government policy support measures—like tax incentives—for SME issuers and investors.

There are also several issues to address for developing an SME equity market in the form of a non-exchange market. For instance, the existing capital market law may restrict the size of the exercise equity market and its investor base due to the statutory shareholders limit. In this regard, a small-scale market is not a problem because it is a venue for learning market rules and obligations through the experience of issuing and trading stocks within the established system.

Finally, SMEs are concerned about high costs and complex procedures to access equity markets, so the exercise market concept should focus on simple procedures and low-cost structure for SMEs in both the crowdfunding and OTC segments.

This piece first appeared on the ADB Blog.

Shigehiro Shinozaki

Financial Sector Specialist (SME Finance), Sustainable Development and Climate Change Department for the Asian Development Bank

Shigehiro Shinozaki is a Financial Sector Specialist (SME Finance), Sustainable Development and Climate Change Department at the Asian Development Bank. Shigehiro supports ADB developing member countries in improving SME access to finance through various technical assistance projects.

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