Ownership and Corporate Governance in Indian SMEs
Micro, small and medium enterprises (MSMEs) are often hailed as the core or backbone of socio-economic activities in India and predominantly figure in the growth and development indicators of the country.
Despite the growing academic interest in these enterprises, aspects of corporate governance of these firms – especially in the context of emerging markets such as India – remain underexplored.
Since, in the Indian context, limitations of funding and investor support in SMEs have led to their increased listing with stock exchanges to raise their capital, these firms now offer their corporate governance standards to disclosure and scrutiny.
It is therefore a fortuitous time for researchers to look into the specific corporate governance practices of SMEs in India, following the fact that SMEs are no longer single proprietor-owned firms without any public accountability and are answerable to their investors.
MSMEs in India
According to the 2017-18 annual report of the Indian ministry of micro, medium and small enterprises, SMEs hold 28.77% of the overall GDP of the country, 45% of its manufacturing output and 40% of the total exports.
Additionally, they offer employment opportunities to a large part of the population (around 80-100 million) and (with an estimated 20% or more operating outside of urbanised areas) provide regional balance by ensuring industrialisation in rural and underdeveloped areas of the country.
Further, MSMEs fulfil a complementary role to large industries as ancillary units, and a large percentage of them are entrepreneurial in behaviour and outlook.
The Growth of Indian MSMEs
The ever-increasing importance of MSMEs in India was acknowledged by the Indian government when, in 2006, the Micro, Small and Medium Enterprises Development (MSMED) Act was introduced.
While seeking to facilitate the development and improved competitiveness of these enterprises was a major motive behind its implementation, the more pertinent role of this act was to provide the first-ever legal framework for recognition and definition of an enterprise, notably within the manufacturing and service sectors.
“Indian MSMEs hold nearly 30% of the country’s overall GDP and offer employment opportunities to more than 80 million people.”
In the manufacturing sector, a ‘small enterprise’ is defined as one with investments in plant and machinery between INR 25 lakhs and up to INR 5 crores (note that at time of writing this article, 1 Indian rupee (INR) = £0.011 in British pounds).
On the other hand, in the service sector, investment in equipment is the benchmark for this classification, with a ‘small enterprise’ having an investment between INR 10 lakhs and INR 2 crores and a ‘medium enterprise’ between INR 2 and 5 crores.
Corporate governance in Indian SMEs
A 2015 report on the financial architecture of the MSME sector in India revealed that the lack of a timely supply of finance and inadequate working capital are among the major challenges that these firms face.
Since 2015, Indian SMEs have been listed more frequently on stock exchanges. That the Bombay Stock Exchange (BSE) offers a separate listing platform for SMEs is indicative of the increased opportunity of SMEs to raise capital from the public, as well as harbouring an investor-friendly environment for SMEs by ensuring some regulation and organisation in an otherwise unorganised sector.
Starting its operation in 2012, over the last six years BSE-SME has listed 280 companies, some of which have since moved out of the SME listing to the main board.
"MSMEs fulfil a complementary role to large industries as ancillary units, and a large percentage of them are entrepreneurial in behaviour and outlook."
Though arguments exist that all corporate governance norms that apply to any other firm should also apply to SMEs, my research attempts to understand if corporate governance characteristics play out differently in these firms.
Ownership structure and board characteristics are the most commonly studied aspects of corporate governance across the world. I attempt to understand the association between these characteristics and performance in listed Indian SMEs.
Interestingly, the results demonstrate a non-linear relation between ownership, board characteristics and performance in these firms, rather than a linear relation which is often assumed in many studies.
Promoters (founders) play a prominent role in SMEs since most SMEs generally have their origin from a solo proprietor who continues to be a part of the organisation in later stages as well. In evaluating the relationship between promoter shareholding in the firm and the performance of the firm, I find that at an ownership of over 45% shares within the firm, promoter ownership impacts SME performance positively – while at lower levels, the impact is negative.
This signifies that a promoter who is locked-in (or committed) more to a firm contributes positively to firm performance.
Another notable outcome of the analysis is the insignificance of board independence on firm performance. In this aspect, SMEs appear to be no different from larger firms, where insiders often have more intimate knowledge about the firm, and the role of independent directors is limited to one of compliance to the listing norms.
Board size, however, is an important determinant of firm performance, and in support of an optimum board size (rather than a large one), I find that there is a non-linear relation between board size and firm performance.
Indeed, a board size of around six seems to be optimum for an SME. A board smaller than this may not be effective in contributing knowledge and resources to the firm, and too large a board could result in group thinking and restrict individual participation.
This research is ongoing with several unexplored or under-explored aspects that need further analysis to offer new insights with respect to both theory and methods, as well as enriching the existing knowledge on Indian SMEs.
For instance, understanding the determinants and consequences of corporate governance standards in SMEs can be of interest to theory and practice. Also, BSE shows that listed SMEs often move to the main board, indicating positive growth trends.
Understanding this transition in terms of changes/improvements in corporate governance structure can provide SMEs inputs in terms of this shift.
In addition, the role of proprietor, their involvement in firm management and the emotional value they attach to the firm and its strategic decisions can throw light onto this relatively unexplored segment from a governance perspective.