Primer on MSME Financing

Kanakprabha Jethani & Timothy Lopes

finserv@vinodkothari.com

Micro, Small and Medium Enterprises (MSMEs) have received a lot of attention from the government in recent times in terms of regulatory measures, reliefs and benefits. Consequently, the eligibility criteria and incentives offered to the MSME sector in terms of financing has been attracting the attention of businesses across the country. Additionally, with various schemes being introduced for revival and upliftment of MSMEs, banks and financial institutions have also started focusing on the MSME segment of borrowers.

This usually-overlooked segment of borrowers is now becoming the most targeted customer base, however, there are many uncertainties around the concept of MSME and the benefits associated with MSME financing.

Below we have listed some of the generally raised concerns in this regard and our response to the same.

We shall keep updating these FAQs regularly based on the notifications issued by the ministry, RBI and other bodies.

Meaning of MSMEs

1. What is the meaning of MSMEs?

Section 7 (1) of the Micro, Small and Medium Enterprises Development Act, 2006 (‘MSMED Act’), provides the definition of MSMEs. As per the definition, enterprises engaged in the manufacturing sector or services sector are classified as MSME based on their investment in plant and machinery or investment in equipment respectively.

The definition provided in the MSMED Act was further amended through a press release on June 1, 2020, which revised the criteria for classification.

Currently, following is the definition of MSMEs:

Classification Micro Small Medium
Investment Upto Rs.  1 crore Upto Rs.  10 crores Upto Rs.  50 crores
Turnover Upto Rs.  5 crores Upto Rs.  50 crores Upto Rs.  250 crores

Earlier definition is provided in the annexure below.

2. What is the meaning of ‘enterprise’?

The term “enterprise” has been defined as follows [Section 2(e) of the MSMED Act]:

“enterprise” means an industrial undertaking or a business concern or any other establishment, by whatever name called, engaged in the manufacture or production of goods, in any manner, pertaining to any industry specified in the First Schedule to the Industries (Development and Regulation) Act, 1951 (55 of 1951) or engaged in providing or rendering of any service or services;

3. What type of entities are considered as carrying on manufacturing activities? Is there a prescribed list of manufacturing activities?

Section 7 of the MSMED Act defines MSMEs under two main heads i.e. enterprises engaged in manufacturing and those engaged in provision of services. Under the said section it is specified that enterprises engaged in the manufacture or production of goods shall pertain to any industry specified in the First Schedule to the Industries (Development and Regulation) Act, 1951.

The Schedule provides an exclusive list of items, the manufacturing of which shall be considered as a manufacturing activity under the MSMED Act. Accordingly, enterprises engaged in manufacturing of such articles are considered as manufacturing enterprises.

 4. Are all service sector enterprises eligible for classification as MSME?

There has been a lot of confusion on what shall be considered as service enterprise for the purpose of classification as MSMEs. The ministry of MSMEs issued a notification in June, 2009 providing clarity on this issue.

As per the notification, following activities were to be considered as services:

  • Consultancy Services including Management Services;
  • Renting of Agricultural Machinery (Harvesting)
  • Composite Broker Services in Risk and Insurance Management;
  • Third Party Administration (TPA) Services for Medical Insurance Claims of Policy Holders;
  • Seed Grading Services;
  • Training-cum-Incubator Centre;
  • Educational Institutions;
  • Training Institutes;
  • Retail Trade;
  • Practice of Law, i.e. legal services;
  • Trading in medical instruments (brand new);
  • Placement and Management Consultancy Services; and
  • Advertising agency and Training centres

Further another notification issued by the ministry of MSMEs in 2014, included the following in list of activities considered as services for the purpose of the MSMED Act:

  • Retreading of tyre
  • Infrastructure and real estate activities
  • Power Distribution Service
  • Warehouse, godown and cold storage services

6. Are traders (retail or wholesale) eligible for classification as MSME?

Initially, there was a confusion as to what activities shall be considered as services for the purpose of classification of an enterprise as MSME. In this regard, the notification issued by the ministry of MSMEs (discussed above) containing the list of activities considered as services, specifically covered retail trade as an eligible activity.

Thereafter, another notification issued by the ministry in 2017 (discussed in Q 10 below), required all MSMEs to get registered. However, another notification by the ministry (discussed in Q 11 below) specifically excludes trading activities from purview of eligibility for registration.    

Additionally, various schemes for MSMEs such as Credit Guarantee Scheme (CGS) specifically provides for provisions relating to MSEs engaged in retail trade.

Drawing inference from the above discussions, it may be stated that retail trade is not classified as MSME under the MSMED Act but, may be specifically included for the purpose of the respective schemes.

7. Are small road transport operators eligible for classification as MSME?

The RBI Master Circular- Lending to Micro, Small & Medium Enterprises (MSME) Sector provides definition of MSMEs. It states that MSMEs shall include  small road & water transport operators, small business, retail trade, professional & self-employed persons and other service enterprises.

Thus, small road transport operators are eligible to be classified as MSMEs.

 8. Is classification as MSME linked with registration or is it discretionary?

Classification as an MSME is independent of registration. An enterprise fulfilling the requirements mentioned in section 7 of the MSMED Act is classified as an MSME, irrespective of its registration status.

 9. Can entities without registration still be eligible for benefits extended to MSMEs?

The benefits to MSMEs may be based on registration or their classification. Whether an unregistered MSME will get benefit under a certain scheme shall be based on the eligibility criteria provided in the scheme.

The eligibility criteria of a few schemes for MSMEs has been discussed in Q.17 below.

Registration

10. Are all MSMEs required to be registered?

As per section 8(1) of the Act,-

Any person who intends to establish,—

  1. a) a micro or small enterprise, may, at his discretion; or
  2. b) a medium enterprise engaged in providing or rendering of services may, at his discretion; or
  3. c) a medium enterprise engaged in the manufacture or production of goods pertaining to any industry specified in the First Schedule to the Industries (Development and Regulation) Act, 1951 (65 of 1951),

shall file the memorandum of micro, small or, as the case may be, of medium enterprise with such authority as may be specified by the State Government under sub-section (4) or the Central Government under sub-section (3).

…”

Accordingly, micro and small enterprises (manufacturing or service) and medium enterprises engaged in services have a discretion to get registered while medium enterprises engaged in manufacturing are compulsorily required to get themselves registered.

However, a notification issued by the Ministry of MSME dated January 10, 2017 provides that every micro, small and medium enterprise engaged in the manufacturing of goods or rendering of services with total investment in plant and machinery below the limit specified in section 7 of the said Act, shall file the memorandum.

11. Can all service sector enterprises be registered as MSME?

As discussed above, the notification by the ministry mandates for all MSMEs to get registered. However, pursuant to the notification dated June 27, 2017 issued by the Ministry of MSME, the following list of activities, are not covered/excluded under the Act for registration of Udyog Aadhaar Memorandum (UAM)-

  1. Forestry and logging
  2. Fishing and aquaculture
  3. Wholesale and retail trade and repair of motor vehicle and motorcycles
  4. Wholesale trade except of motor vehicles and motorcycles
  5. Retail Trade Except of Motor Vehicles and motorcycles
  6. Activities of households as employees for domestic personnel
  7. Undifferentiated goods and services producing activities of private households for own use.
  8. Activities of extraterritorial organisations and bodies

Further, the activities relating to crop, animal production, hunting and related activities are also not included as per section 7 of the Act, except for certain activities specified therein the notification which are as follows:

  • Production of eggs
  • Operation of poultry hatcheries
  • Bee-keeping and production of honey and beeswax
  • Raising of silkworms and production of silkworm cocoons
  • Operation of agricultural irrigation equipment
  • Support activities for animal production
  • Preparation of crops of primary markets
  • Cotton ginning, cleaning and bailing
  • Preparation of tobacco leaves
  • Other post-harvest crop activities
  • Seed processing for propagation

PSL Categorisation

12. What is the minimum funding that should go to MSMEs under the Priority Sector Lending (‘PSL’) criteria?

As per Master Direction – Priority Sector Lending – Targets and Classification, domestic Scheduled Commercial Banks (SCBs) as well as foreign banks are required to extend 40% of their Adjusted Net Bank Credit (ANBC) as loans to priority sectors. These priority sectors include the following:

  • Agriculture
  • Micro, Small and Medium Enterprises
  • Export Credit
  • Education
  • Housing
  • Social Infrastructure
  • Renewable Energy
  • Others

Further, domestic SCBs and foreign banks with 20 branches and above are specifically required to lend to Micro enterprises, a minimum of 7.5% of their ANBC or Credit Equivalent Amount of Off-Balance Sheet Exposure, whichever is higher as part of the PSL targets. This limit of 7.5% shall be inclusive of loans to Khadi and Village Industries Sector.

Furthermore, following transactions shall also be considered eligible for meeting PSL targets:

  • Factoring transactions by SCBs on ‘with recourse’ basis, where the assignor is an MSME, shall also qualify for the PSL targets.
  • Loans given by banks to registered NBFCs (other than MFIs) for on-lending to MSEs up to Rs. 20 lakh per borrower are also eligible under PSL targets.
  • Securitisation/Direct Assignment (DA) transactions by banks, where the underlying asset is composed of PSL loan pools.

13. Are loans provided to unregistered MSMEs considered eligible under the PSL targets?

The Master Direction provides for the definition of manufacturing and service enterprises as follows:

Limits for investment in plant and machinery/ equipment: The limits for investment in plant and machinery/equipment for manufacturing / service enterprise, as notified by Ministry of Micro, Small and Medium Enterprises, vide S.O.1642(E) dated September 9, 2006 are as under:-

Manufacturing Sector
Enterprises Investment in plant and machinery
Micro Enterprises Does not exceed twenty-five lakh rupees
Small Enterprises More than twenty five lakh rupees but does not exceed five crore rupees
Medium Enterprises More than five crore rupees but does not exceed ten crore rupees
Service Sector
Enterprises Investment in equipment
Micro Enterprises Does not exceed ten lakh rupees
Small Enterprises More than ten lakh rupees but does not exceed two crore rupees
Medium Enterprises More than two crore rupees but does not exceed five crore rupees

 Bank loans to Micro, Small and Medium Enterprises, for both manufacturing and service sectors are eligible to be classified under the priority sector as per the following norms:

Manufacturing Enterprises

The Micro, Small and Medium Enterprises engaged in the manufacture or production of goods to any industry specified in the first schedule to the Industries (Development and Regulation) Act, 1951 and as notified by the Government from time to time. The Manufacturing Enterprises are defined in terms of investment in plant and machinery.

Service Enterprises

All bank loans to MSMEs, engaged in providing or rendering of services as defined in terms of investment in equipment under MSMED Act, 2006, shall qualify under priority sector without any credit cap.”

Accordingly, the enterprises falling under the above limits shall be considered as MSMEs for the purpose of PSL classification. There is no requirement to get registered for the same.

14. How does a lender ensure that the applicant is an MSME and the loan to such applicant can be classified as a loan to the priority sector?

Udyog Aadhaar Number (UAN) of an MSME is sufficient evidence of the enterprise being an MSME. MSMEs are required to file UAM and on the basis of examination of their investment in plant and machinery or equipment, as the case maybe, UAN is granted.

Further in case of unregistered MSMEs, refer Q 15.

 15. Since registration of MSME is not a compulsory requirement for their eligibility under the PSL criteria, how would a lender identify whether an entity is an MSME?

Unlike registered MSMEs, unregistered MSMEs do not have a UAN. Thus, the only way to determine whether they qualify as an MSME, is to assess the size of their investment in plant and machinery.

The Master Direction – Lending to Micro, Small & Medium Enterprises (MSME) Sector incorporates the updated guidelines / instructions / circulars / directives issued by RBI in the matters relating to lending to MSMEs by commercial banks. It refers to the notification issued by the Ministry of MSME, Office Memorandum(OM) F. No. 12(4)/2017-SME dated March 8, 2017, wherein it is clarified that for ascertaining the investment in plant and machinery for classification of an enterprise as Micro, Small and Medium, the following documents could be relied upon:

  1. A copy of the invoice of the purchase of plant and machinery; or
  2. Gross block for investment in plant and machinery as shown in the audited accounts; or
  3. A certificate issued by a Chartered Accountant regarding purchase price of plant and machinery.

The notification further clarifies that for the purpose of classification of an enterprise as MSME, the investment in plant and machinery is to be reckoned at purchase value of the plant and machinery and not the book value i.e. purchase value minus depreciation.

Further, since the audited accounts of an enterprise would be available for the previous year, a certificate from the auditor of the borrower or a chartered accountant may also be obtained with respect to change in the amount of investment during the year.

It is also possible that a large segment of the borrowers might not be maintaining proper books of accounts. It will be difficult for the lenders to verify the details provided by the borrower. In such cases, the lender may rely on one or more of the following means:

  1. Self-declaration by the borrower with respect to the extent of investments in plant and machinery;
  2. Copies of invoices of purchase of plant and machinery;
  3. By engaging field agents to verify the declaration made by the borrower.

Sources of funding for MSMEs

16. What are the various sources of funding for MSMEs?

The following broad sources of funding are available to MSMEs –

  1. Owned fund;

This is the equity capital maintained by the MSME representing the amount of own investment in the business.

  1. Term loans from Banks/ NBFCs;

There are several credit guarantee schemes available for MSMEs (refer above) that avail term loans from banks and NBFCs that enable them to easily access required credit.

  1. Working capital facilities from Banks/ NBFCs;

Similar credit guarantee schemes are also in place for availing working capital facilities by MSMEs.

  1. Subordinated debt;

This is a recent facility introduced as part of the economic stimulus package of the Government. Details are covered above.

  1. Collateral free credit;

This forms part of the economic stimulus package recently introduced. The details are covered above.

  1. PSL loans from Banks;

Banks need to achieve certain priority sector lending targets prescribed by RBI. Since MSMEs have the required priority sector status, they are likely to easily avail of loans from banks who must meet the targeted requirements.

  1. Mudra Loans;

Micro Units Development and Refinance Agency Ltd. [MUDRA] is an NBFC supporting development of the micro enterprise sector in the country. MUDRA provides refinance support to Banks / MFIs / NBFCs for lending to micro units having loan requirements upto 10 lakh. MUDRA provides refinance support to micro business under the Scheme of Pradhan Mantri MUDRA Yojana.

  1. Direct loans from SIDBI;

There are several facilities available by MSMEs from SIDBI directly under their various direct loan products.

  1. Equity infusion from venture capital and private equity firms.

Various schemes for MSMEs

17. What are various schemes announced by the government for aiding MSME financing? 

Schemes for MSMEs Eligibility Benefits provided For registered/ unregistered
Interest Subvention Scheme All MSMEs having a Valid Udyog Aadhar and Valid GSTN Number 2% interest subvention on fresh or incremental loans. Registered/ unregistered
Emergency Credit Line Guarantee Scheme An MSME borrower shall be eligible to avail the benefits under the Scheme if all of the following conditions are satisfied:

– The loan account is classified as standard, SMA-0 or SMA-1;

– They have an outstanding credit of up to Rs. 25 crores as on February 29, 2020; and

– The annual turnover is up to Rs. 100 crores.

100% guarantee coverage to be provided by National Credit Guarantee Trustee Company Limited (NCGTC)  for additional funding of up to Rs. three lakh crore to eligible MSMEs and interested MUDRA. borrowers, in the form of a Guaranteed Emergency Credit Line (GECL) facility. Registered/ unregistered
Credit Guarantee Fund Scheme for Micro and Small Enterprises (CGS-1) New or existing Micro and Small Enterprises to which credit facility has been provided by the lending institution without any collateral security and/or third party guarantees. The Trust set up under the scheme provides guarantees to credit facilities extended by Member Lending Institutions to eligible borrowers by way of term loan or working capital (not exceeding Rs. 50 lakh or Rs. 200 lakh) without any collateral security and/or third party guarantees . Registered/ unregistered
Credit Guarantee Fund Scheme for NBFCs (CGS-II) New or existing Micro and Small Enterprises (MSEs) to which credit facility has been provided by the lending institution. The Trust set up extends guarantee on credit facilities extended to an eligible borrower by an NBFC not exceeding Rs. 200 lakhs with/without any collateral security. Registered/ unregistered
Fund of Fund (FoF) Details regarding eligibility have not yet been released. A FoF with a corpus of INR 10,000 crores is proposed to be set up. The FoF shall leverage the corpus in order to provide equity infusion of Rs. 50,000 crores to MSMEs.

 

The said fund will be based on a mother level and daughter level structure.

 

An expert committee on MSME had recommended setting up a Government sponsored Fund of Funds (FoF) of Rs. 10,000 crore in order to support funding from venture capital and private equity firms in the MSME segment.

One will need to see the details.
Subordinated Debt MSMEs that are NPA or stressed will be eligible for this facility. The Government of India will facilitate provision of Rs. 20,000 crores as subordinated debt, as part of the economic stimulus package introduced recently. Not specified.
Credit-Linked Capital Subsidy Scheme for technology upgradation (CLCSS) MSMEs having a valid UAM number are eligible for this scheme and are required to apply online through Primary Lending Institutions (PLIs), from where the MSMEs avail term loan, in order to apply for the CLCSS scheme. This scheme is set up to facilitate technology up-gradation in MSEs by providing an upfront capital subsidy of 15 per cent (on institutional finance of upto Rs 1 crore availed by them) for induction of well-established and improved technology in the specified 51 sub-sectors/ products approved. Registered MSMEs.
Scheme of Micro Finance Programme MFIs/ NGOs Under this scheme, the government contributes to 75% of the security deposit required by SIDBI in order to avail a loan. This allows MFIs/ NGOs to procure loans from SIDBI while contributing only 25% of the security deposit amount (approximately amounting to 2.5% of the total loan amount). Not specified.
Promotion of MSMEs in North East Region and Sikkim Since multiple schemes were introduced the eligibility under each scheme would be different. Finance facilities were provided for the following –

A. Setting up new and modernizing existing Mini Technology Centres.

B. Development of new and existing Industrial Estates.

C. Capacity Building of Officers.

One will need to see the details of the said scheme.
Marketing Assistance schemes Manufacturing / Service sector MSEs registered at Udyog Aadhaar Memorandum (UAM) Portal Several schemes are introduced to assist MSMEs in exploring new markets and provide marketing support through subsidies on rent space, travel expenditure, publicity and freight assistance, etc. Registered MSMEs.
MUDRA loans under Pradhan Mantri Mudra Yojana (PMMY) scheme Micro units having loan requirements up to Rs. 10 lakh MUDRA provides refinance support to Banks / MFIs / NBFCs for lending to micro units. Registered/ Unregistered

Annexure: Provisions of law

Earlier Definition of MSMEs

“Notwithstanding anything contained in section 11B of the Industries (Development and Regulation) Act, 1951 (65 of 1951), the Central Government may, for the purposes of this Act, by notification and having regard to the provisions of subsections (4) and (5), classify any class or classes of enterprises, whether proprietorship, Hindu undivided family, association of persons, co-operative society, partnership firm, company or undertaking, by whatever name called,—

  1. a) in the case of the enterprises engaged in the manufacture or production of goods pertaining to any industry specified in the First Schedule to the Industries (Development and Regulation) Act, 1951 (65 of 1951), as—

(i)  a micro enterprise, where the investment in plant and machinery does not exceed twenty-five lakh rupees;

(ii) a small enterprise, where the investment in plant and machinery is more than twenty-five lakh rupees but does not exceed five crore rupees; or

(iii) a medium enterprise, where the investment in plant and machinery is more than five crore rupees but does not exceed ten crore rupees;

  1. b) in the case of the enterprises engaged in providing or rendering of services, as—

(i)   a micro enterprise, where the investment in equipment does not exceed ten lakh rupees;

(ii)  a small enterprise, where the investment in equipment is more than ten lakh rupees but does not exceed two crore rupees; or

(iii) a medium enterprise, where the investment in equipment is more than two crore rupees but does not exceed five crore rupees.”

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