Here is how invoice discounting works. When startups and SMEs (small and medium enterprises) turn vendors to supply goods to large corporations, they often have to wait long periods, ranging from one to four months, to receive payments for the goods delivered. Such delays create a working capital crunch for these vendors and stifles their potential for expansion. Typically, in such a situation, the vendor often raises cash advance from banks and non-banking financial companies (NBFCs) against the invoice for the goods delivered. Such working capital loans are charged an interest rate of 18-30% per annum. The vendors repay the lenders as and when they receive their payment from the companies concerned.
Soon, online discounting platforms sniffed an opportunity here and started lending to these vendors at competitive rates, ranging from 14-18% per annum. The platforms, in turn, allowed retail investor participation, offering a sweet 10-13% internal rate of return (IRR) pre-tax.
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Platforms like TredS, which is regulated by the Reserve Bank of India (RBI), and KredX were early movers in the invoice discounting space. Other players like Jiraaf, Leaf, and Grip made their presence felt during the covid pandemic.
Everybody is a winner
Here is how invoice discounting is beneficial for all parties involved. Let’s take the hypothetical example of vendor A, a goods supplier, which raises an invoice of ₹100 on C, a corporate buyer, and approaches an invoice discounting platform, say B, for financing since it needs immediate liquidity.
B evaluates the invoice and lists it on the platform to pool money from investors. It raises ₹96 from retail investors and transfers it to A. After three months, when the corporate buyer C settles the payment by fulfilling the invoice of ₹100, the discount platform retains ₹1 as its fee and pays ₹99 ( ₹3 as interest and ₹96 principal) to the investors. In this process, all parties benefit: The vendor enjoys enhanced financial flexibility, investors earn returns , and the discounting platform gets it cut for facilitating the transaction.
Most invoice discounting platforms secure their transaction by using an escrow account for transfer of funds. GripInvest, however, follows a slightly different method with its product InvoiceX. It has a tie-up with an NBFC that provides loans on invoices as collateral and issues pass-through certificates (PTCs). The investment tenure for investors is longer at 9 months and the minimum investment amount is ₹10 lakh.
“InvoiceX is a RBI regulated instrument and also rated by a credit-rating agency to provide more transparency to investors. Grip’s subsequent InvoiceX offerings will also be listed on the stock exchange in compliance with Sebi regulations. Our first InvoiceX product is a A1+ rated instrument consisting of receivables from 200+ invoices against 22 companies”, said Nikhil Aggarwal, founder and CEO, Grip.
Barring Grip, the minimum ticket size of invoice discounting investment for retail investors ranges from ₹50,000 to ₹3 lakh. Returns from such investment are taxed at slab rates, with a standard 10% tax deducted at source (TDS) by the platform. Additionally, all investments are paid at maturity, providing investors with a predictable timeline for returns. It is worth noting that these investments remain unrated, indicating that they are not subject to external credit assessment.
Investors looking for different risk-return profiles can explore these platforms, which offer attractive pre-tax IRRs between 10% and 15%. The commonalities in these investment structures provide investors with a range of options to suit their financial goals and risk appetites.
Defaults galore
Invoice discounting platforms have their own credit rating system for vendors, but it is unreliable. The 2019 episode of Zefo, a startup dealing with refurbished furniture prior to its acquisition by Quikr, is a case in point. KredX had given it a high rating (80-81). But Zefo was stuck in a vicious cycle of circulating debt, using incoming funds to pay off earlier invoices. Moreover, Zefo was paying a higher rate of interest, at 24%, for the sums it borrowed from KredX, which indicates that it was a high-risk borrower for KredX. While no investor was impacted, the episode brought to light how platforms manipulate ratings to earn bigger commissions.
There have been instances when vendors also defaulted on their loans because they did not receive payments from the company they supplied goods to. One such case at KredX resulted in a delay in payments to investors for more than a year. KredX did not respond to queries sent by Mint.
“Retail investors believe that invoice discounting is a lucrative investment option. However, they do not completely understand the risks involved. An invoice receivable is an operational debt. The corporates very frequently delay payments in such invoices, and such delays do not impact their credit rating. Sometimes corporates may raise disputes and not pay the invoice at all. Such instances have come to light where even large corporates did not make the payment leaving investors to bear the losses,” says Anshul Gupta, co-founder and chief investment officer, Wint Wealth.
In case of defaults, investors are usually the last in the line of creditors to get relief. Earlier, invoice discounting platforms claimed to be financial creditors, implying that they had a higher priority in recovering funds in case of a default by the borrower. However, a recent court judgement quashed their status as financial creditors and said they are to be treated on a par with operational creditors, akin to the sellers.
There is a solution for this though. GripInvest has addressed this issue through PTCs. Since the underlying NBFC provides loans, the investors in GripInvest’s platform are considered true financial creditors. In this way, the investors‘ claims are secured and have a higher priority in case of any default by the borrowers.
Despite platforms claiming to prioritize security and protection for investors through tri-party agreements, penalty clauses, and by securing post-dated cheques (PDCs) from vendors, delays and defaults have been increasing in frequency.
Concentration risk is another concern. For example, almost 45% of all deals on Jiraaf come from just three manufacturing companies. This sector concentration increases the vulnerability to headwinds in the industry, potentially impacting payment flows for invoices. GripInvest addresses this risk through a diversified pool of 200 invoices, but it’s worth noting that 64.7% of these invoices are still in the manufacturing sector .
In terms of performance metrics, the IRR used in invoice discounting is flawed because it assumes reinvestment at the same rate. For instance, a deal on Jiraaf may have a 12.25% IRR, but the term sheet’s yield is only 11.39% per annum. This discrepancy can inflate numbers and mislead investors into thinking they are earning higher returns.
So, retail investors need to be cautious. “These are clearly not retail products. Most of these products are not regulated, which puts retail investor at a disadvantage. Also, there are chances of a complete capital loss in some of these products, no retail investor is comfortable with that. And even if gains are made, the gains are in the form of interest and it gets taxed at slab rate. This reduces a 12% pre-tax return to a 8-9% post tax return, which is not attractive for the risk one takes. These products are also not perpetual in nature. You will have to invest time and expertise during each transaction which is nearly impossible to do over a long period of time,” said Amol Joshi, founder of Plan Rupee Investment Services.
If the RBI opens up Trade Receivables Discounting System (TReDS) for retail investors, it could open new opportunities and potential growth horizons for this asset class. Retail investors‘ participation in TReDS can enhance liquidity, encourage investment diversification, and support the growth of MSMEs by providing them with timely access to working capital.
“Unlike TReDS, unregulated platforms have limited recourse to such defaults leading to little recovery. The RBI can deepen the market by permitting retail investors to participate in the Trade Receivables Discounting System (TReDS). TReDs provides due reporting and recourse measures against defaulting buyers. Moreover, investors can also take credit insurance on the platform to reduce risk,” says Gupta.