Finance for small-firm growth: Towards flexibility and innovation

While microfinance contract innovations like repayment grace periods help small-firm owners, they can increase default rates for microfinance institutions. Based on field experiments in Pakistan and Kenya, this article finds that performance-linked repayments can stimulate more profitable investments and are particularly beneficial for entrepreneurs with high risk aversion. It makes a case for leveraging India’s rapidly expanding digital ecosystem to better tailor financial contracts for small firms.

Microfinance institutions (MFI) have rapidly expanded worldwide, including reaching millions in India. Policymakers and NGOs (non-governmental organisations) have long regarded these institutions as important for spurring growth of small firms and alleviating poverty. While they have undeniably succeeded in extending credit to millions who would otherwise be excluded from formal financial systems, strikingly, multiple experimental studies have found that classic microcredit products yield only modest average impacts on key outcomes such as household income and consumption (Banerjee et al. 2015, Cai et al. 2025). These disappointing results pose a puzzle to the finance and development literature, given a large body of influential research that provides: (i) macro-level evidence of a positive relationship between financial access and growth (Beck et al. 2007); and (ii) remarkably consistent micro-level evidence that small firms have very high returns to capital (De Mel et al. 2008, Liu and Roth 2022).

Contractual innovations in the age of digitisation

One explanation for these disappointing results is that many borrowers simply use loans for consumption rather than business investment. Yet for the subset of borrowers who are more entrepreneurial and could earn high returns on additional capital, a key question remains: can microfinance deliver better outcomes for them? The classic microfinance model often imposes rigid repayment schedules, which is theoretically appealing because it can mitigate problems that lenders face in terms of screening new clients, monitoring them and getting repaid. However, such a rigid contract structure may not suit businesses with high potential returns but riskier investment opportunities that may take longer to generate profits. This rigidity can push entrepreneurs toward safer, short-term projects rather than the more productive investments that can generate broader private-sector development and employment growth. Encouragingly, evidence – including important studies in India – shows that contractual innovations such as repayment grace periods that allow borrowers extra time to make repayments can improve outcomes for businesses by aligning repayment requirements more closely with a firm’s cash flows, thus enabling entrepreneurs to better manage temporary income shocks or lean periods (Fischer 2013, Barboni and Agarwal 2021, Battaglia et al. 2021). However, flexible-repayment microcredit contracts have sometimes led to increased MFI default rates (Brune et al. 2022, Field et al. 2013).

Rapidly expanding digital ecosystems – exemplified by Digital Public Infrastructure (DPI), where India has emerged as a global leader – are opening up new possibilities for enhanced borrower screening and better-tailored financial contracts for small firms. By leveraging richer digital footprints – from the Unified Payments Interface (UPI) to emerging Account Aggregator frameworks for secure data sharing¹ – financial institutions can not only identify high-potential borrowers more effectively, but also utilise high-frequency data after disbursing loans. This environment enables lenders to offer more flexible, customised repayment terms that support small businesses in pursuing growth-oriented investments.

Exploring equity-like innovations for small firms

In my research (Meki 2024), I investigate how ‘equity-like’ financing can improve outcomes for some small firms. These contracts use performance-linked repayments, tying what borrowers owe to how well their businesses perform. Linking repayments to small firm performance is increasingly enabled in many low- and middle-income countries by the growth of digital footprints. Such contracts are similar to equity in linking payments to a measure of performance, but not ‘conventional equity’ in the sense of taking a formal ownership stake, which has been shown to be very challenging in many low- and middle-income settings, for example, due to legal enforcement constraints and limited exit strategies (De Mel et al. 2019) – which can be especially problematic in countries where court processes often face significant delays.

I tested this idea in Kenya and Pakistan with 765 small-firm owners who sought to purchase new capital assets to expand their businesses. Working closely with local institutions, I conducted “artefactual field experiments,” in which each entrepreneur made incentivised investment decisions under two contracts: a standard fixed-repayment debt arrangement and an equity-like arrangement with performance-linked repayments. My first objective was to measure how equity-like contracts influence investment choices compared to debt, while my second objective was to see how these impacts differ based on each entrepreneur’s risk preferences, which I measured through about 30,000 incentivised risk-elicitation questions. In those activities, I found that, on average, business owners exhibited a moderate level of risk aversion (suggesting they value insurance-like or risk-sharing mechanisms to mitigate income volatility), many were loss averse (placing greater weight on potential losses than on equivalent gains), and a substantial fraction overweighted small-probability events – a phenomenon also documented in high-income contexts, with important implications for household finances and financial market asset pricing (Barberis and Huang 2008, Dimmock et al. 2021).

Key findings

Equity leads to more profitable investment choices on average: In the investment games, small-firm owners who financed their investments with equity chose more profitable options. This pattern, observed in both Kenya and Pakistan, aligns with previous research showing that rigid repayment schedules can discourage entrepreneurs from pursuing riskier yet more lucrative opportunities.

I next explore how these impacts differ based on each entrepreneur's risk preferences, using data from the incentivised activities that measure each small firm owner’s risk aversion, loss aversion, and overweighting of small probabilities. Figure 1 presents the results for loss aversion and probability weighting.

Figure 1. Investment choice: Heterogeneity by risk preferences

Notes: i) Each panel presents heterogeneous effects of the treatment (intervention), based on 3,060 observations from 765 unique business owners. ii) The dependent (outcome) variable is the expected profit of the investment option chosen by the business owner, with a ‘dummy’ for individuals with an above-median value for two distinct dimensions of risk preferences measured using incentivised activities at baseline: (1) loss aversion; (2) probability weighting. iii) In panel (1), ‘Equity*Loss-averse’ represents the expected profit of the investment option chosen by the most loss-averse business owners when financed with equity relative to the expected profit of the investment option chosen by the most loss-tolerant business owners under equity, and ‘Debt*Loss-averse’ represents the expected profit of the investment option chosen by the most loss-averse business owners when financed with debt relative to that chosen by the most loss-tolerant under debt. iv) The hypothesis tests whether individuals with higher risk preference are differentially affected by the equity and debt treatments. v) ‘p-values’ from a test of the null hypothesis that ‘Equity*Loss-averse = Debt*Loss-averse’ and ‘Equity*Overweighting = Debt*Overweighting’ are displayed in each panel.

Equity is most impactful for risk-averse and loss-averse business owners: Equity was more impactful for the most risk-averse small-firm owners, leading them to choose more profitable investment options than they would have under debt. This aligns with the idea that such individuals benefit from the insurance-like features of equity, which provide greater risk sharing than more rigid, fixed-repayment debt contracts.

Equity was also more impactful for loss-averse small-firm owners, leading to more profitable investment options than they otherwise would choose under debt. Because these individuals particularly value the downside protection of equity contracts – where lower required payments after a negative shock reduce the risk of falling below their ‘reference point’ (which might be, for example, the assets they currently own) – equity financing can be more appealing for such individuals than a fixed-repayment debt contract that puts their existing assets at risk. In return for that downside protection, they are willing to share in the upside, making equity contracts especially well-suited for business owners who are more sensitive to losses than gains.

Equity is least impactful for those who overweight small probabilities: Small-firm owners who overweight small probabilities performed better under debt rather than equity. In skewed-return environments (where there is a small chance of very high profits), they dislike equity because they would have to share a portion of those hypothetical very high profits. Even though the objective probability of such a high profit is small, it feels disproportionately large to the significant fraction of these small-firm owners. Consequently, they tended to do better under fixed-repayment debt, which helps them avoid sharing those high profits.

Providing better-tailored financial products for small firms in India

Building on these results, I then explore a contractual innovation that can address this demand-side constraint to the uptake of equity-like contracts. I examine a ‘hybrid’ contract that combines features of both equity-like and fixed-repayment debt structures. Like equity, the hybrid contract adjusts repayments downward when business revenues are low, offering crucial downside protection for risk-averse borrowers. At the same time, it caps repayments so that if a business experiences a rare, high-profit month, repayments stop once a preset maximum is reached (for example, twice the original loan principal). This design is particularly appealing to those who overweight small probabilities, as it avoids the need to share a disproportionately large portion of infrequent high profits. Field data from my Kenyan study suggest that these hybrid features can boost the uptake of equity-like financing among borrowers who otherwise prefer conventional debt.

India’s sophisticated and rapidly developing digital public infrastructure is transforming how financial products are designed and delivered. These tools enable lenders to accurately assess business performance and tailor repayment schedules to match real cash flows. By leveraging these innovations, policymakers and financial institutions can explore more flexible and innovative financing options that not only safeguard borrowers during lean periods but also encourage more productive investment and contribute to small firm growth.

Note:

Digital footprints refer to the verifiable records of financial transactions left by users in digital ecosystems. For example, UPI generates real-time, detailed transaction histories that lenders can use to assess creditworthiness, while emerging Account Aggregator frameworks enable secure, consent-based sharing of financial data across institutions (see Alok et al. 2024, Sahamati Annual Report, 2024).