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The rise of equity crowdfunding: A game-changer for MSMEs

ByopinionJune 24, 20233 Mins read200

Equity crowdfundinding could be key to MSME recovery post-pandemic. Photo by Nafinia Putra on Unsplash

By: Dr Mohamed Hisham Hanifa

The recognition of the importance of micro, small and medium-sized enterprises (MSMEs) as the backbone of the Malaysian economy is not surprising as they account for 97.4 percent of total business births in 2021.

According to the Malaysia Statistical Business Register (MSBR) published by the Department of Statistics, Malaysia (DOSM), MSMEs contribute 37.4 percent of the country’s GDP and employ 47.8 percent of Malaysia’s working-age population.

However, the presence of a COVID-19 pandemic poses a serious threat to human health. The multiple lockdowns from March 2020 are seen as the first line of defense to contain the spread of COVID-19, but at the expense of livelihoods.

Obviously, the COVID-19 pandemic has caused significant disruption in various sectors, but the impact on micro and medium-sized enterprises (MSMEs) has been nothing short of catastrophic.

According to SAMENTA (Small and Medium Enterprises Association of Malaysia), it is estimated that at least 10 percent of mainstream MSMEs have been forced to close their doors during this difficult period.

The government recognizes the importance of MSMEs and has put in place several support and incentive programs to help them recover.

In the revised 2023 budget, RM40 billion worth of financing facilities have been allocated to MSMEs, while RM1 billion is earmarked for support of digitization and automation as well as tax cuts that could result in cost savings for MSME taxpayers.

These initiatives are expected to accelerate the recovery of MSMEs, particularly those forced to shut down operations during the pandemic.

However, entrepreneurs need to realize that the path ahead will not be without its challenges. One of the biggest headwinds is the rising overnight policy rate (OPR), which increases funding costs.

According to the Malaysia Department of Insolvency, as of April 2023, 264,127 bankruptcies were being administered, 17 percent of which resulted from corporate financing, leaving these companies without access to formal financing or inducements.

While it is understandable that such rules are in place to ensure accountability and responsible use of taxpayers’ money, they create obstacles for troubled MSMEs.

To address this problem, alternative avenues for bank-agnostic solutions through public funds, known as equity crowdfunding (ECF), are gaining traction.

This is because ECF investors become shareholders of MSMES by purchasing shares, either through preference stock or common shares. This allows investors to potentially earn returns based on the company’s projected performance or otherwise lose the entire investment.

The popularity of ECF as an alternative financing method is evident from statistics in the Securities Commission’s 2022 annual report. Despite a 36% drop in total raised capital between 2021 and 2022, the trend shows continuous increases, with a 100% increase between 2020 and 2021 and a staggering 457% growth between 2019 and 2020, benefiting more than 7,200 MSMEs.

The operational mechanism of the ECF involves three parties connected via a digital platform: the fund seeker (entrepreneur/issuer), the investors and the platform operator. The platform operator plays a crucial role by carefully scrutinizing the projects based on the documentation provided by the issuers and creating campaigns to attract potential investors.

Each investment opportunity includes project background details, required investment amount (minimum and maximum), target dividend payout, number of shares offered, and campaign duration.

The ECF area harbours both opportunities and risks for investors. Therefore, it is crucial for investors to conduct a thorough risk assessment and be prepared for potential losses.

The Securities Commission puts a lot of emphasis on regulating ECF platform operators as they play a gatekeeper role. Ultimately, their goal is to ensure investor protected and enable issuers to have a healthy fundraising market through various laws and guidelines.

SC currently oversees 10 registered ECF platform operators and offers a range of investment opportunities including both Islamic and conventional investment opportunities.

However, there are concerns of a growing bubble in the ECF market, which could erode investor confidence. One of them is the urgent need for fair valuation practices.

Valuation is very important at ECF, not only during the capital raising phase (pre-money valuation) but also when investors exit their investments (post-money valuation).

The dynamic interplay between an issuer’s business model, visibility into risk and return, and operational performance can create opportunities for overestimating company valuations.

A worrying aspect is that, unlike publicly traded stocks, since there is no secondary market for ECF stocks, issuers allow them significant freedom in choosing valuation tools to value their companies.

This unrestricted flexibility can lead to inflated valuations, which has a negative impact on investors.

In addition, ECF platform operators generate revenue based on funds raised through campaigns. Capital size is closely linked to the valuation set by the issuer.

Consequently, the lack of risk transparency places a higher burden on ECF investors, forcing them to take on a larger proportion of the overall business risk relative to their expected returns.

The regulatory framework established by the SC serves as a solid foundation to ensure the sustainability of the ECF.

To achieve the desired ECF outcome, the right policies should be in place to balance the SC’s role in protecting ECF investors and facilitating access to finance, while reducing MSMEs’ financial constraints.

While the former can be implemented in stricter rules and regulations, leading to higher costs for issuers, the latter requires more flexibility and lower transaction costs due to the inherent high risk of start-ups.

Nonetheless, ECF can and should be a viable alternative financing option to boost MSME recovery.

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^{The author is a Senior Lecturer at the Department of Finance, Faculty of Business and Economics,
Universiti Malaya, and may be contacted at mhisham@um.edu.my}