Whether driven by an idea or a necessity, how do most of the people set-up new enterprises? With their own funds or with that of their friends and relatives. So either it is you who have trust on your idea for starting a business or people who have trust on you -not necessarily on your idea, that is your circle of ‘trust’. This is how the seed capital is created for the new enterprises around the world.

Entrepreneurs’ seed capital is the primary source of finance for start-ups. It is much later that external sources of finance- including institutional ones, come into picture. ‘The Capital Structure Decisions of New Firms’ – a paper by Alicia M. Robb & David T. Robinson (2012) notes that the owner capital is a part of insider financing and is the largest sources of informal finance for the start-ups including owner’s equity, loans and credit card. Insider finance channels mostly include finance from the family members, friends and affiliates of the firm.

In India, where financial markets are still shallow- exclude large swathe of potential consumers and rigid- lacking competition and mostly controlled by the government through public sector banks, entrepreneurs have little to rely upon but their own circle of trust for funds.

The last census of Micro, Small and Medium Enterprises (MSMEs) finds that 92.77% of units are self-financed and merely 5.18% of them have access to funds from institutional sources like banks and Financial Institutions. Friends and family remain the only source for the most entrepreneurs to raise money to launch a business.

In this back-drop a time bomb has been set to tick through new deposit rules under the Companies Act which makes acceptance of unsecured loans/ deposits by a private company illegal. All existing private limited companies will have to return these deposits by 31st march 2015 failing which stringent penalties are prescribed.

According the new provisions (deposit rules 73-76, Companies Act 2013), “if a company fails to repay the deposit or part thereof.. the company shall, in addition to the payment of the amount of deposit or part thereof and the interest due, be punishable with fine which shall not be less than one crore rupees but which may extend to ten crore rupees and every officer of the company who is in default shall be punishable with imprisonment which may extend to seven years or with fine which shall not be less than twenty-five lakh rupees but which may extend to two crore rupees, or with both.”

In the new deposit rules the definition has been amended. While the earlier definition of deposits excluded amounts received by any company from its directors or from its members, and directors’ relatives, the new one includes them.

Loans and deposits form the critical source of funds for MSMEs. Because of limited bargaining capacities, most small enterprises suffer from shortage of working capital. The payment cycles of their bills are longer. The malady of payment delays runs so deep in India that it is one of the few countries in the world which has distinct legal provisions against defaulters. Still, it continues to be to major problem.

How do MSMEs tide over the shortage of cash when taxes, statutory dues and salaries are to be paid by specific date every month or they attract penalties and may even attract imprisonment, though payments due to them are routinely delayed? In large number of cases, they bridge the gap by taking loans from friends and relatives.

The new deposit rules have closed this critical route to all companies but it is the MSMEs that would have severest blow.

The 4th MSME census states that 97% of MSMEs are proprietorship or partnership firms and less than 3% of them are ‘Companies’. It would act as perverse incentive for MSMEs to remain un-incorporated. The irony is that the provisions are to affect progressive units more which adopted the corporate structure of a Company.

On the one hand we rue that MSMEs do not adopt corporate structure by becoming Companies, on the other hand we create conditions that make Company structure highly unattractive.

The case for allowing MSMEs to accept deposits and loans from friends and relatives is clearly strong enough. More than anything, it is plain common sense. The Finance Minister happens to be Minister of Corporate affairs too. Let’s hope the better sense prevails.