Micro Connect "Experiment": Challenging the "Impossible Triangle" of Micro and Micro Finance

Li Hui

Editor's note/ From the "Macmillan gap" to the "impossible triangle", small and micro finance has always been regarded as the most difficult bone to gnaw on in the financial industry.

The Central Financial Work Conference at the end of November 2023 emphasized that it is necessary to accelerate the construction of a financial power, help build a strong country with high-quality financial development, and do a good job in five major articles: science and technology finance, green finance, inclusive finance, pension finance, and digital finance. As an important part of inclusive finance, small and micro finance calls for innovative paths that can solve the difficulty and high cost of financing. The chemical reaction between inclusive finance and digital finance is expected by the industry to solve the traditional business problems faced by this field.

At the beginning of 2021, after the resignation of Charles Li, the former Chief Executive Officer of the Hong Kong Stock Exchange (HKEX), and Zhang Gaobo, the founder of OP Financial, jointly established Micro Connect, an innovative financial platform dedicated to investing in China's small and micro enterprises, which has attracted wide attention from the market and capital. According to official information, as of November 2023, Micro Connect has signed contracts to invest in more than 12,000 stores, covering more than 100 consumer goods tracks.

Innovation often comes with controversy. At the end of October 2023, Song Xiangqian, the founder of Jiahua Capital, "fired" on Weibo, brought Micro Connect to the forefront. In the article, Song Xiangqian sharply questioned the nature of Micro Connect's non-equity and non-debt business, the cost of capital, and the cross-border business structure in many places, which aroused heated discussions in the industry.

"In fact, it has not been a long time since the field of financial innovation has attracted such attention, and Micro Connect is indeed a business case worth dissecting in recent years, and it is also a test path worth exploring in financial inclusion solutions. A senior bank practitioner interviewed said bluntly.

Achieving the three goals of risk (controllable), cost (controllable) and scale (development) at the same time has always been regarded as the "impossible triangle" for the development of small and micro financial business. Micro Connect uses a new form of "Daily Income Contract" to find a third path between equity and debt, and to a certain extent, realizes the shortest link from the end of small and micro financial assets to the capital side. In the initial stage, it has weathered the test of the new crown epidemic and quickly achieved scale expansion, which can be regarded as the initial operation of Micro Connect's business model.

However, in the process of its scale and continuous maturity, it still needs to face more questions around the sustainable development of the model and the development of compliance and security: whether it has helped the development of small and micro enterprises with a reasonable level of funds? how to evaluate their risk control capabilities and long-term business value? What market and regulatory challenges may Micro Connect (Macau) financial asset exchange MCEX (hereinafter referred to as "Micro Connect ASX") face when carefully building an innovative financing closed loop? Join you to get to know Micro Connect and discuss Micro Connect's business model and the controversy surrounding it.

1. Business model

Non-equity and non-debt, delicate closed loop

After accepting Micro Connect's three-week due diligence, Shan Huajiang, general manager of Youjia Hi Store VR, raised the first batch of 2 million yuan. Unlike the previous sporadic borrowing from banks and small loan companies, the amount of money is large, the payment is fast, and the financing does not dilute the equity.

The funds obtained by Shan Huajiang are not debt financing for repayment of principal and interest by traditional banks and financial institutions, nor are they different from equity financing with the nature of venture capital in the primary market such as VC and PE, but a new "middle ground" - according to the actual revenue of the store, the revenue is shared with Micro Connect on a daily basis, and there is no need to return the investment funds if the operation fails. Because this model can greatly reduce the threshold for entrepreneurs to enter, it is welcomed by a large number of brands and franchisees.

According to Micro Connect's white paper, the key point of this model is the "Daily Revenue Contract" (DRC), in which Micro Connect invests in physical stores, deducts a fixed percentage of store revenue from the store revenue every day, and receives daily interest payments through the digital "Store Sharing Automatic Payment Collection System (ARM)" to ensure liquidity. It should be noted that according to the legal obligation of daily revenue sharing, the invested stores have no obligation to repay principal and interest, and if the operation fails, Micro Connect will bear the investment loss.

In an exclusive interview with reporters at the end of 2022, Li Xiaojia explained the logic of this sharing model: Micro Connect is a "stock-like" model, and the shareholding is phased, not a permanent oppressed equity, nor is it a creditor's right with immediate repayment pressure. "Every contract from Micro Connect comes from the revenue sharing arrangement for the store in the next three to four years – when the store has no revenue in the early stage, it does not have to pay money, and when it has income, it will be given until the return is completed, and Micro Connect can exit after receiving the return, and the store will not have to pay back if it goes out of business. ”

This model is indeed more attractive to small and medium-sized franchise industries. Shan Huajiang told reporters that taking the VR experience hall of Youjiahi Store as an example, it is generally three years to sign an agreement with the shopping mall, and the investment cycle of Micro Connect is generally three to four years, which is more compatible in terms of capital cycle and payment speed.

In Li's view, Micro Connect's "daily revenue share contract" can be seen as either "discounted financing of the short-term cash flow of a store business" or "declining equity". Only such investment can completely solve the problems of financing difficulties and high financing costs in the small and micro economy.

Since 2000, more than 10 start-ups have emerged internationally based on this type of "revenue-based financing" (RBF), which includes a combination of loans, debts, commercial contracts and other forms to provide capital to the financier in exchange for 5%-20% of its future sales.

Micro Connect is the first large-scale professional RBF operation institution in China, and its investment targets are mainly concentrated in the field of commercial chain franchising. From the perspective of financial business logic, Micro Connect's investment approach is completely opposite to the traditional public or private fund model. While public and private equity companies concentrate their funds on one or a few projects, Micro Connect does the opposite – investors and funds are relatively concentrated, but the target projects are numerous and small.

According to Liu Xiaochun, president of the Shanghai New Finance Research Institute, Micro Connect tries to use large amounts of money in small-scale areas, and this kind of reverse thinking has an innovation in "risk pricing". "In the past, we talked about risk pricing as 'future discounted pricing', but Micro Connect is to divide all the 'future money' now, which makes logical sense. He said.

The discounted financing of the future cash flow of small and micro stores in China can be regarded as the underlying asset of Micro Connect. On the capital side, unlike similar foreign institutions, Micro Connect has found an almost impossible path in China - directly securitizing the underlying assets through exchanges, which has also prompted it to quickly become the leading institution in this investment model.

In March 2022, Micro Connect ASX under the leadership of Charles Li and Gaobo Zhang officially commenced trial operations in Macau, becoming the world's first DRO (Daily Revenue Obligations) exchange for revenue sharing products.

When explaining the original intention of the establishment of Micro Connect ASX, Micro Connect said in an interview with reporters: On the domestic asset side, it is difficult for traditional financial equity and debt products to be applied to small and micro enterprises. Therefore, we must use commercial contract products suitable for Chinese small and micro enterprises as financing vehicles. On the overseas capital side, since international investors are only familiar with traditional stocks, bonds or fund products, we must convert domestic commercial contract products into large-scale, similar stocks, bonds or fund products for investors to hold and trade.

In a blog post published in August 2022, Li Xiaojia vividly made an analogy: DRC is a domestic commercial contract, like "direct current"; DRP (Daily Income Portfolio) is an offshore financial product, which is like "alternating current"; DRO is an exchange conversion product, which is like a "transformer".

However, it should be noted that the degree of standardization and risk of discounted future cash flow of small and micro enterprises as the underlying asset is not the same as that of highly standardized securities transactions such as "Shanghai-Hong Kong Stock Connect".

Micro Connect told reporters that international investors need time to familiarize, understand and participate in the new asset class of "daily revenue share". There is still time to polish and optimize in many aspects such as price discovery, market operation and risk control supervision.

2. Core risk control

Digital technology + follow the vine

The above-mentioned exchange model of one-hand funds and one-handed assets has also promoted the rapid development of Micro Connect in the past two years.

As of the end of November 2023, Micro Connect has signed contracts to invest in more than 12,000 stores, covering more than 100 consumer goods tracks. However, the establishment of the above model also has a rigid premise - the digital level of the industry, the construction of complex account distribution network, and the selection and risk control of investment groups. In addition, Li Xiaojia's own endorsement has also become a non-negligible factor in the establishment of Micro Connect's business model.

First of all, compared with foreign RBF institutions, Micro Connect selects investment groups concentrated in chain micro, small and medium-sized enterprises, which are dynamic but have a higher risk factor. Public data shows that from the perspective of survival cycle, the average life expectancy of small and micro enterprises in China is about 3-5 years, and most of the non-small and micro enterprises are more than 10 years.

Therefore, in terms of the continuity of the model and the grasp of risk control, it is necessary to make a more accurate portrait of the invested small stores. According to a PPT of Micro Connect's revenue sharing model, the target stores invested by Micro Connect need to meet the following conditions: at least 2 years of operation, at least 10 or more chain stores, the more the better, and a history of financing is preferred. The ideal range of investment for a single store is 200,000-2 million yuan, which is determined according to the calculation, and the proportion of Micro Connect's investment is ≤50%, and the payback period is less than half of the lease period of the store.

In addition, Micro Connect also has a clear bottom line of "four no-investments": do not invest in data fraud, do not invest in those who lack constraints on franchised stores, do not invest in those with unclear disputes/legal risks, and do not invest in those that do not meet the calculation model.

In an exclusive interview with reporters, Li Xiaojia explained why he chose to invest in chain brand stores. In his opinion, it is definitely safer for "melons" to have rattans, and it is difficult for independent shops on the street to withstand the risks. For a chain store to be successful, it must meet several conditions: the brand, supply chain and operation management system are relatively mature. This kind of subject also has a certain collective bargaining power, can choose a good location, and has enough experience to choose the right store manager.

"The traditional VC/PE is a hunter's idea, and it is to find a star enterprise at the level of 'Zhuge Liang'. The idea behind Micro Connect was to find the 'Stooge'. Traditional VC/PE hopes to make a judgment on the status of node enterprises in 10 years, but Micro Connect's investment target is stores, which collects money every day, and two years of investment recovery and two more years of money is a good return, in addition, most small and micro enterprises only have a life cycle of three to five years, so there is no need to make a careful judgment on too long a cycle. Li Xiaojia said.

In terms of investment logic, Micro Connect follows the law of large numbers (generally referred to as the law of large numbers, which is a law that describes the probabilistic nature of the appearance when the number of experiments is large) and focuses more on the effectiveness of the allocation portfolio rather than just the success of the investment individual. Li Xiaojia once said: We are not investing in one store, waiting for it to grow up, but to invest in many stores, and the number of cooperative stores with node enterprises starts at least three or five. In terms of negotiation strategy, knowing the payback period and estimated turnover, we can roughly get a baseline for the share ratio.

In the expansion process, Micro Connect has divided more than 300 urban regions across the country through its self-built intelligent business district system, and selected industries and brands based on understanding the local people's flow, characteristics, and population portraits. By cross-comparing the revenue of different stores in the same business district, and then using the platform store revenue figures to correct, we can finally accurately estimate the turnover of a single store in a specific business district, which is also considered by Micro Connect to be an important moat for business.

In addition to specific investment regions and groups, the development of digital technology has become another prerequisite for the establishment of the Micro Connect model. Through digital payment, the data of the invested chain industry is guaranteed to be true and at the same frequency, and the cash flow of franchisees is controlled.

According to the above PPT file, the operating system of the invested chain store must be able to control 100% of the revenue data, and there must be clear rules, systems and data for confirming revenue, which can be directly exported by the system.

In terms of funding channels, some traditional financial institutions have completed cooperation with Micro Connect.

However, compared with other enterprises, the life cycle of small and micro stores is short, and the complexity of the market and the probability of anti-contract are much higher than those of the capital market. Therefore, in addition to strictly controlling the income data of the invested small stores, there must also be a corresponding rate of return design for risk interception.

The reporter learned from the interview that the contract between Micro Connect and each franchised store basically stipulates four points: the amount of investment, the agreed payback period, the determined share ratio, and the "stepped" payback cycle - the proportion of revenue share will be reduced proportionally after the return on the cost.

Shan Huajiang told reporters: According to the revenue estimate of 150,000 yuan per store at that time, Micro Connect agreed on an 18-month recovery cycle, and the first phase of its share ratio was about 18%, and after the return on investment, in the remaining cycle, the share ratio of Micro Connect dropped to 8%-9%.

However, not every investment target has the same collection practices and terms, which are mainly based on the actual operation of different stores. But on the whole, the faster the return on investment, the greater the decline. According to Li Xiaojia's statement at the online exchange meeting at the end of October 2023, the above-mentioned sharing ratio between Micro Connect and small stores varies from store to store, and will be calculated based on data, and it is necessary to ensure that the free cash flow left by small and micro business owners must be higher than that under the Micro Connect model.

However, under the design of this income recovery cycle, the actual cost of capital borne by small and micro enterprises is indeed higher than that of traditional bank lending (4%-7%). This is also one of Song Xiangqian's previous doubts.

"Investment income ≠ interest rate. Since the Micro Connect model is an investment, not a loan, the interest rate does not apply, and the issue of interest rate is fundamentally different from that of a loan. Micro Connect told reporters.

Shan Huajiang told reporters: After calculating, the cost of funds provided by Micro Connect is about 20%. "Because it is paid on a daily basis, the comprehensive annualized interest rate may indeed be higher. But he also bluntly said: "Micro Connect's account sharing comes from a part of the daily flow, so there will be no sudden repayment pressure of a large amount of money, which is more friendly to cash flow." For example, when our income fell during the pandemic, it also had a small share. ”

Ji Shaofeng, an expert in small and micro credit, also tends to think that it is not appropriate to use usury to describe "Micro Connect". "It's not a loan in nature, it's an investment that's in line with the principle that high risk must be backed by high returns. Of course, we should also think about how this kind of high-risk, high-reward cooperation can avoid mutual harm and how it can be sustainable in the long run. He added.

At the same time, it is not easy to find equity investment for a small chain similar to the scale of Hi store, Shan Huajiang told reporters: "In recent years, VC has no money in hand, and it is also necessary to gamble on shares, and it is difficult for banks to lend us millions of yuan at once, and the cycle cannot be given for three years. ”

However, due to the complexity of the legal relationship of such non-equity and non-debt contracts, one of the obvious side effects is the weakening of the right of recourse. Ji Shaofeng believes that Micro Connect's business model is convenient for expanding customers, but in terms of the nature of the risk, it is the dual superposition of the personal risk of the franchisee and the risk of the brand, coupled with the decline of the legal binding force brought about by non-equity and non-debt, in the event of a default, Micro Connect may face difficulties in protecting itself through legal means.

3. Risks and challenges

Model paradoxes and regulatory compliance

One reality that must be acknowledged is that there are huge structural differences and fractures between international and domestic markets, and between traditional finance and small and micro finance. Micro Connect also said in an interview with reporters that there are very big challenges for the two sides to "connect", and to complete this challenge, it is necessary to understand this difference and creatively and systematically find a compatible interconnection mechanism.

In terms of model, Micro Connect is a typical revenue share financing (RBF) product, which is characterized by the fact that investors invest a fixed amount of money in the investee company in order to obtain a portion of the investee company's operating income as a return on the investment.

The rise of the above model in China also has its special market background. Some people in the domestic chain industry bluntly said to reporters: the market share of Chinese chain brands is changing too fast, it is difficult to appear KFC, Starbucks and other large-scale brands, in recent years, it is difficult to exit the equity of venture capital, so some institutions began to pay attention to the RBF model, after all, its payback cycle is fast, and the exit is more convenient.

However, RBF's investment model is not suitable for all businesses. According to the analysis of Beijing Qinglu Law Firm, the types of businesses that the RBF model is suitable for include: enterprises with mature products and services, are on a stable growth path, and may not be able to provide the exit opportunities expected by equity investment institutions in a relatively short period of time;

Song Xiangqian said in an article "with his years of professional experience in investing in the consumer goods chain industry": "There is no chain business in China that can bear such a high cost of capital. The net profit level of the vast majority of chain formats is distributed within 2%-10%, and there is a natural mortality rate of 30%, which is very profitable and easy to lose. ”

The risk uncertainty of Micro Connect's portfolio industries is also one of the concerns of those in the financial industry. In Ji Shaofeng's view, the risk of misappropriation of the franchisee's liquidity after being controlled by the brand owner, under the premise that the brand owner and the franchisee will also work together to "deceive" Micro Connect, which is a great challenge.

In addition, there may be some paradox between scale and risk. Liu Xiaochun believes that the "franchise chain" model is a process of continuous exploration, and its applicability depends on the type of enterprise and operational strategy, and it is necessary to make a trade-off between space expansion and customer scope.

Regulation in the mode may bring certain uncertainty to the conduct of business by such institutions. At present, in China, the track of similar models has not yet formed a scale, and has not received regulatory attention. In fact, there are almost no public RBF precedents in Chinese mainland justice, let alone specific legislation in this area.

When it comes to Micro Connect ASX, the situation is even more special. Micro Connect is currently regulated in four jurisdictions, including Chinese mainland, Hong Kong, Macau and other overseas countries. In Chinese mainland, Micro Connect's revenue sharing contracts are governed by the Joint Operation Law under the Contract Law of the Civil Code of the People's Republic of China.

Liu Kaixiang, vice president of the Commercial Law Research Association of the China Law Society and professor at Peking University Law School, believes that the contract association model adopted by Micro Connect has a legal basis. There is no legal or policy substantive risk in the new business operation model formed by the two parties by signing a cooperation contract that does not require small and micro stores to provide security deposits or pledge guarantees, does not require repayment of principal and interest, and does not form a new organizational body.

However, there are also different views in the market on the nature of Micro Connect. Ji Shaofeng believes that from the "Micro Connect" asset organization to the exchange certificate financing, the entire financial attribute is very clear. However, he also raised questions: in the whole process, it seems that there is a lack of a financial institution that endorses, identifies, prices, and transaction risks for asset standardization, security, legality, etc., and it is possible to rely on an entity that has no capital constraints and does not accept financial supervision to play a leading role in it.

In response to the different views of the market, Micro Connect told reporters that Micro Connect currently has no benchmarking institutions in the market, and it is an exchange model. With the formation and enrichment of the market, more participants will be integrated into the market. Whether it is overseas or domestic, participants must comply with local management policies and relevant regulations.

At present, there is no clear signal of the regulatory attitude of Chinese mainland regulators towards this type of model. Chen Xin, professor of accounting and doctoral supervisor of Shanghai Advanced Institute of Finance, Shanghai Jiaotong University, suggested that in the future, China can also refer to foreign regulatory ideas for similar businesses of RBF and Islamic banks, and introduce regulatory policies based on the characteristics of the mainland system: consider characterizing enterprises with similar models as alternative financial institutions, clarify domestic regulatory authorities, and require such enterprises to make mandatory information disclosure on the details and terms of revenue sharing contracts. In addition, it is recommended that the regulatory authorities characterize it, and the Supreme People's Court should add a judicial interpretation of "joint operation contracts".

observe

Li Xiaojia's "game-breaking" battle

In 1931, the British politician Macmillan systematically put forward the theory of the financing difficulties of small and micro enterprises for the first time - the "Macmillan gap", that is, financial institutions are unwilling to provide funds to small and medium-sized enterprises according to their financing conditions, resulting in the widespread financing constraints and financing gaps of small and medium-sized enterprises. To date, this issue has not been fully addressed globally.

In China, micro, small and medium-sized enterprises (including individual industrial and commercial households) account for more than 90% of all market entities, contribute more than 80% of the country's employment, more than 70% of invention patents, more than 60% of GDP and more than 50% of tax revenue, which is crucial to promoting the development of the national economy, but the financial support they receive is still very scarce compared with large enterprises.

The difficulty of financing micro, small and medium-sized enterprises and the difficulty of financial model innovation in recent years have become the background of the emergence of Micro Connect.

Li Xiaojia once said: "The basic logic of the traditional financial model has almost nothing to do with the bottom, but how the money at the top sees each other." In fact, it is a group of well-educated people who are doing 'aunt's business' and follow each other. A new DNA is needed to break this financial deadlock. ”

Through the chain from the "Daily Income Contract" model to the exchange, Micro Connect realizes the shortest link from the end of small and micro financial assets to the capital end, reducing the path cost and transaction cost of financing for small and micro enterprises. As a result, although it is still facing a lot of controversy, the market is mostly sure that it is a type of innovation that is worth encouraging.

At present, Micro Connect is facing a series of challenges such as macroeconomy, risk control, market education, information disclosure, and mechanism establishment. On the asset side, it needs to choose the industry and track in the complex domestic economic environment, and constantly consolidate the risk control means of high-risk business, and pay attention to possible changes in regulatory expectations; The interconnection between the two very incompatible operating systems, international traditional finance and China's small and micro economy, has innovatively solved the problem of small and micro enterprises' difficulty in financing entrepreneurship", which can be regarded as Micro Connect's corporate ambition. This journey has just begun, and it is worth the industry to continue to track and observe.

The articles in this edition were written by reporter Li Huicai