Small and medium enterprises (SMEs) are the backbone of most economies, especially in developing economies. SMEs make up around 90% of businesses globally and are crucial for job creation and economic growth. SMEs contribute to over 50% of employment worldwide, and in emerging markets, they account for up to 40% of national income (GDP). These figures are even more impressive when you include informal SMEs.

The World Bank estimates that by 2030, the global economy will need to create 600 million jobs to keep up with the growing workforce, putting SME development high on the agenda for governments around the world. In emerging markets, SMEs are the powerhouse behind job creation, responsible for 7 out of 10 formal jobs. However, despite their importance, access to finance remains a significant hurdle for SME growth.

As mentioned in our previous article, SMEs are challenged with cash flow problems, and traditional finance can only partially answer their needs, even though it has developed several services for financing SMEs. At first glance, just like large-scale businesses, the banking sector was supposed to offer SMEs loans and other types of financing tools. Still, especially after 2008, the increase in collateral requirements in traditional banking for loans caused most SMEs to be deprived of necessary financing. Accordingly, we started to observe the development of different lending platforms, and SME-focused solutions began to become widespread. Let’s dig deeper.

Nonbank Financial Institutions (NBFIs) Solutions: Private Credit

Private credit, often referred to as direct lending, is a form of financing provided by nonbank financial institutions (NBFIs) like private equity firms, hedge funds, and specialized lending firms. Unlike traditional bank loans, which are typically subject to stringent regulatory requirements and standardized lending criteria, private credit offers more flexible and tailored solutions, especially for small and medium-sized enterprises (SMEs). These loans are structured to meet the specific needs of businesses that might not qualify for or find the terms of bank loans suitable. Private credit can offer more customized terms, such as longer repayment periods, higher loan amounts, or more lenient collateral requirements. This makes it a crucial financial tool for SMEs, which often face significant barriers when seeking financing from traditional banks.

The main challenges faced by the private credit sector in providing sufficient financing to SMEs include high risk and collateral requirements, high costs and fees, and the lower scale and insufficient information of SMEs. Private credit providers often require strict collateral due to the high-risk nature of the loans they offer, which means SMEs may struggle to provide the necessary collateral. Additionally, private credit typically involves high costs and processing fees, which restricts the accessibility of such financing for small and medium-sized enterprises. Lastly, SMEs are generally smaller in scale and have less comprehensive financial data and performance information compared to larger companies. This makes it difficult for private credit providers to assess risks accurately and further complicates SMEs’ access to financing.

One of the most popular private credit solutions is invoice-backed financing, but the inadequacies of the traditional private credit sector effect are being felt. Let’s take a look at it!

Invoice-Backed Financing

Invoice Financing

Invoice-backed financing, or receivables-backed financing, is a form of short-term borrowing in which trade receivables are used as collateral. It is tailored for small and medium-sized businesses to enhance their cash flow.

In the invoice-dependent sectors, regardless of a certain discount rate, businesses want to turn their invoices into immediate cash. In a nutshell, invoice financing keeps businesses’ working capital topped up and prevents the credit and cash flow problems that could occur when customers take a long time to pay. So it’s one way to finance slow-paying accounts receivable or to meet short-term business liquidity needs. But this is not the only way to accelerate the cash flow. Let’s look at the next one.

Invoice Factoring

Invoice factoring is a type of invoice finance in which businesses sell some or all of their invoices to a third party to improve cash flow and revenue stability. Different from invoice financing, the invoices are not the collateral. Invoice factoring can be considered as trading the time with a pre-decided discount rate. Most of the time, we as consumers do not face invoices in our routine; for instance, when we buy a coffee, immediate payment is processed, but this is not the case in most of the sectors. In the invoice-dependent sectors, usually, the payment occurs within at least 30 and at most one year, but there are common terms like 60, 90, and 180 days too. As mentioned, businesses that need better cash flow apply to invoice factoring companies and sell their invoices to escape the remaining time till the payment due date.

The discount rate is the percentage of the invoice that the factoring company retains for itself. According to Universal Funding Corporation, the discount rates are assessed on the creditworthiness of the customers and the financial stability of the business. In the same source, it is mentioned that the discount rate ranges from %1 to %5 of the total invoice for 30 days, but under specific circumstances, the rates could vary.

Since this is a sale of the invoice, another issue arises, who will collect the payment? The business or the factoring company? The answer is it depends, let’s go deeper.

Recourse Invoice Factoring

Recourse invoice factoring is a financial solution that allows businesses to sell their accounts receivable to a factoring company while retaining responsibility for the risk of non-payment. In this arrangement, a company can quickly access cash by selling its outstanding invoices to a factoring firm. However, if the customer fails to pay or defaults on the invoice, the business remains liable for the amount due. Essentially, the factoring company has the right to seek reimbursement from the business if the invoice goes unpaid.

This type of factoring generally comes with lower discount rates compared to non-recourse factoring because the factoring company assumes less risk. Businesses using recourse invoice factoring can benefit from improved cash flow and immediate funds while being aware that they must cover any unpaid invoices. It’s a valuable tool for companies looking to enhance liquidity but requires careful management of credit risk and customer payment reliability.

Non-Recourse Invoice Factoring

Non-recourse invoice factoring is a financial arrangement where a business sells its invoices to a factoring company and transfers the risk of non-payment. Unlike recourse factoring, if a customer fails to pay an invoice, the factoring company absorbs the loss, not the business. This type of factoring generally involves higher discount rates due to the increased risk taken on by the factoring company.

Reverse Factoring (Supply Chain Financing)

Reverse factoring, also known as supply chain financing, is a financial arrangement where a company’s suppliers can receive early payment on their invoices through a factoring company. In this process, the buyer initiates the arrangement by working with a factoring firm to improve the payment terms for their suppliers. Once the supplier submits an invoice, the factoring company pays them promptly, while the buyer later repays the factoring company on the agreed due date. This method helps suppliers get faster access to cash flow while buyers can extend their payment terms, improving their own working capital and supplier relationships.

Yes, these methods sound useful, and many businesses benefit from these services, but does the system work flawlessly? It does not seem so according to our previous article findings, especially SMEs have still crucial cash flow inadequacies.

Problems of Traditional Invoice Financing

Traditional invoice financing can sound like a great way for small and medium-sized businesses (SMEs) to improve their cash flow, but it’s not without its issues. For many SMEs, the process can be more of a hurdle than a help.

First off, the costs can be pretty steep. Between application fees and ongoing administrative expenses, it’s easy to find that these costs end up eating into any financial benefits you might get from the financing. For small businesses already pinching pennies, these extra expenses can be a real burden.

Access is another big challenge. Traditional financial intermediaries often focus on larger companies, leaving smaller businesses struggling to get their attention. The process can be complicated and intimidating, especially for businesses that don’t have a lot of resources or experience.

Collateral requirements also pose a significant problem. Financial institutions typically ask for a lot of collateral, which can be tough for SMEs that are already dealing with cash flow problems. It doesn’t make much sense to expect businesses in financial distress to have extra assets lying around. Perhaps the biggest issue is over-collateralization. Traditional invoice financing often requires businesses to put up more collateral than the value of the invoice itself. This extra demand only adds to the stress of managing cash flow and can defeat the purpose of seeking financing in the first place.

In short, while traditional invoice financing can help with cash flow, its high costs, accessibility issues, and hefty collateral demands can make it tough for many SMEs. Looking into alternative financing options might be a better way to navigate these challenges and get the support you need.

As an Alternative: DeFi

The summer of 2020 can be seen as a turning point for historical economic norms. The so-called DeFi Summer is when the popularity of DeFi exploded, with millions of users flooding into the decentralized finance ecosystem in search of accessible providers without the need for middlemen. From the summer of 2020, DeFi did not stop but expanded the areas it could affect. According to SkyQuest, the global Decentralized Finance (DeFi) market was valued at $22 billion in 2022, $23.99 billion in 2023, and is projected to grow to $48.02 billion by 2031, growing at a CAGR of 9.06% in the forecast period (2024–2031). On the other hand, according to the Statista Market Forecast, traditional retail banking growth is expected to grow at a compound annual growth rate (CAGR) of 4.59% from 2024 to 2029, leading to a market volume of US$4.68 trillion by 2029. Even though there is a huge volume difference between them, the growth rate difference between DeFi and TradFi tells us a meaningful inference: DeFi came out of the gate like a racehorse.

But What Does DeFi Offer That TradFi Does Not?

Decentralized Structure

As is widely known, DeFi operates on decentralized networks, primarily built on blockchain technology, which removes the need for intermediaries like banks or brokers. Opposite to centralized finance, there is no room for bottlenecks and points of failure. This decentralized structure of DeFi allows investors and borrowers to meet at the most optimal points of finance, removing most of the barriers that TradFi forces upon them.

Smart Contracts

Smart contracts enable trustless transactions and provide network structures without relying on a central authority. They reduce the need for trust between parties without paying tremendous amounts for operational costs. In addition to operational efficiencies, smart contracts give complete transparency. Transparency offers investors access to all the information they need during their transactions, which TradFi can not. This trustless infrastructure behind DeFi creates a more secure and trustworthy ecosystem.

Accessibility and Inclusivity

DeFi platforms are accessible to anyone with an internet connection and a digital wallet, making financial services available to individuals globally, including those in underserved regions. According to Global Finance Magazine, hundreds of millions globally have no checking or savings bank account. Financial exclusion undermines their quality of life and holds their nations’ economies back. In Türkiye, 31% of the population are unbanked and in many emerging economies like the Philippines 66%, Egypt 67%, Mexico 63%, Indonesia and Argentina 51% of the population is unbanked. DeFi removes the geographical and regulatory barriers.

In addition to geographical and regulatory barriers, DeFi also removes the high entry barriers to most of the TradFi financing instruments. It is now almost in seconds to borrow or lend in any DeFi platform with very little capital and collateral. The idea of decentralization exceeds the inclusive TradFi ecosystem by creating a collective effort of global finance.

Transparency and Auditability

DeFi systems are more transparent and auditable than traditional finance (TradFi) because they are built on blockchain technology, as we said before. Every transaction and smart contract is recorded on a public ledger, which anyone can access and verify. In contrast, TradFi often relies on opaque systems and intermediaries, making it difficult for users to verify and track financial activities. This transparency in DeFi reduces the risk of fraud and enhances accountability. Most of the audits done in TradFi are done by private firms that are obliged to regulations that have often failed the finance ecosystem. However, the transparency behind blockchain does not allow this, as the audit process in DeFi involves the evaluation of security, transparency, and compliance with the decentralized industry standards.

Ownership

DeFi offers enhanced ownership and custody compared to traditional finance. In DeFi, users maintain direct control over their assets via personal wallets. As of mid-2024, Ethereum-based DeFi platforms alone hold approximately $36 billion in total value locked (TVL), according to DeFiLlama. In contrast, traditional finance requires assets to be managed by banks or brokers, which introduces additional risks and potential delays in accessing funds. This direct control in DeFi minimizes counterparty risk and enhances security.

Cost Efficiency

DeFi is a game-changer in finance cost efficiency, and here’s why. By leveraging blockchain technology, DeFi eliminates the need for traditional middlemen, who often inflate costs. This translates to significantly lower transaction fees and reduced administrative expenses. For example, DeFi platforms typically charge minimal fees compared to the higher costs associated with account management and financial services in traditional finance. As the saying goes, “A penny saved is a penny earned,” and DeFi embodies this by providing more affordable and efficient financial solutions.

“The only constant in life is change.”

Written by: Karan Kayaturan, Yağız Efe Özmeriç