collage of money, key, globe, worker, harvard collage of money, key, globe, worker, harvard
collage of money, key, globe, worker, harvard
collage of money, key, globe, worker, harvard collage of money, key, globe, worker, harvard

Alternative Financial Contracts

Psychometric screening may be less accurate than other (more expensive) screening methods. But the evidence suggests that the upside from profitable SMEs in the missing middle will be more than enough to compensate for the failures1. If funders were able to capture more of this upside, this would allow them to expand finance to an even larger pool of potential entrepreneurs. We are therefore very interested in alternative financial contracts such as micro-equity and income-contingent debt.

Traditionally, the only contract used for financing small businesses on a large scale is debt. Equity has been used for investments in larger firms, as well as VC investment in small numbers of very high-potential (usually technology-focused) SMEs, but is not suitable for small businesses financing on a larger scale because there is no traditional exit, and monitoring & verification is extremely difficult.

The problem with straight debt contracts is that it limits the up-side potential of each client to the lender, reducing the amount of risk that a sustainable portfolio could support. If lenders could capture more of the up-side, they could expand their markets and take on clients that might otherwise be higher-risk.

While this could not be done for firms in the missing middle with a traditional equity contract, as there is not a traditional exit option, alternative financial contracts with flavors of both debt and equity could be possible. For example, income-contingent debt has been used by some SME lenders with very positive results. In these contracts, the base contract is a debt contract for the principal, with the additional pledging of royalties based on sales. The debt contract limits the downside risk as the entrepreneur is responsible for repayment of the principal no matter external circumstances, but the up-side potential is increased to the degree that royalties are paid. Another possibility is microequity at a group level.

There is an obvious verification problem: the lender has no easy way to monitor the borrower’s business performance, and they will under-report performance. Note that even if a fraction of the royalties that are truly owed can be captured, this could be a viable contract. Moreover, we have some preliminary ideas on how this could be minimized, such as:

  1. Ex ante selection of more honest entrepreneurs using the honesty module in our psychometric test. Preliminary results suggest the honesty module is a strong predictor of dishonest behavior among borrowers, which could make it possible to focus such contracts on high-honesty individuals who are less likely to cheat on royalty payments (but who still have high entrepreneurial ability).
  2. Randomized audits with penalties. Economic theory would suggest that a randomized audit would be an effective enforcement technique provided that the penalty is sufficiently high. We can test this, and determine what penalties garner sufficient compliance. 
  3. Group monitoring. The microfinance revolution was based on capitalizing on the information that members of a community had on the credit worthiness of one another through group liability. It could also be possible to harness this information for verification, as members of a community might be more able to observe the degree of a businesses’ success or failure, and this knowledge could be harnessed with the right group incentives.

These preliminary ideas are currently being evaluated, and added to, in cooperation with pilot partners, industry experts, and the academic community. It is our hope that more applied work will begin next year.

1.E.g. de Mel, McKenzie & Woodruff. (2007) Returns to capital in microenterprises: evidence from a field experiment.