Securing adequate funding is essential for startups to drive growth and achieve sustainability. Traditionally, equity financing has been the go-to option for many startups. However, with equity financing declining significantly, they are now turning to debt financing as a viable alternative to drive growth. This shift signals a growing understanding of diverse financial strategies that can help startups grow without diluting their ownership.
Before we dive deeper, it's important to understand the difference between equity and debt financing. With equity financing, you raise capital by selling shares in your company, which dilutes your ownership but doesn't require repayment. With debt financing, on the other hand, you borrow funds that you must repay with interest without giving up any ownership, but which adds financial debt to your company.
“Ownership management puts a strain on cash flow”
Abhishek Gupta, MD and CEO, Caspian Debt, said debt funds offer many benefits, including giving founders control over decision-making and future financial returns. In addition to this, fixed interest rates, flexible repayment schedules and quicker access to debt funds also translate into lower overall costs, he said. Live Mint.
Founders can also reduce their tax outlay as interest payments are a business expense, said Gagan Agarwal, chief financial officer at Clix Capital. He said ease of budgeting through monthly payments and paying off loans on time strengthens credit bureau scores, making it easier to borrow additional money at better rates for growth.
However, industry players point out that debt funds also carry several risks and challenges. “Excessive leverage can increase financial risks and strain cash flows. Defaulting on debt payments can damage the company's creditworthiness and hamper future fundraising options,” Gupta said.
“Debt carries interest and must be repaid regularly, even if the business is not profitable. During an economic downturn, this can increase financial stress. If payments are not made on time, it can affect your credit score, increasing your future borrowing costs or even limiting your borrowing capacity,” Agarwal said.
“Debt-to-Equity Financing Ratio”
Therefore, experts suggested that startups need to have a clear understanding of their risk tolerance, cash flow and growth trajectory to determine the balance of debt and equity financing that suits their business model. It is important for entrepreneurs to be aware of cash flow projections and other obligations to repay debt in a timely manner, they said.
“A capable finance head is essential for a startup. If hiring isn't possible, outsourcing to a quality CA or CFO firm is an option. If you are considering external borrowing, this role will be as important as a technology or marketing leader as it will help you forecast future cash flows and evaluate borrowing options appropriate for your growth stage,” recommends Gupta.
Meanwhile, Clicks Capital's CFO argued that minimizing borrowing costs is important, as growth often requires large amounts of borrowing: “Reducing costs can increase profitability and the overall health of the company. By comparing with peers, companies can find the right balance of debt and equity for optimal growth and stability.”
“Bank loans, secured loans”
Further, they advocated various types of debt financing for startups such as bank loans, term loans, working capital loans, secured loans from NBFCs, vendor finance or invoice finance, debentures, debentures and trade credit.
“Banks offer the lowest cost loans, but may not be a good fit for startups without mortgage collateral. Startups often struggle to obtain bank loans. Instead, focus on lenders that are known for funding startups and meeting their criteria. You should not target every lender,” Gupta said.
“Ideally, loans should be made to companies with revenue track record, ability to repay, and collateral. Startup lenders use proxies for these parameters, so data transparency is key. While mature startups may consider term loans or hybrid financing for growth, early-stage startups often opt for venture debt, convertible notes, lines of credit, or asset-backed loans for flexibility and favorable repayment terms,” he added.
Agarwal said early-stage SMEs may find it difficult to obtain bank financing and should therefore consider term loans, working capital loans and secured loans from non-banking finance companies, adding that vendor finance and invoice finance are also options if supplying to larger companies. “Mature SMEs have more options including bank loans, non-banking finance company loans, debentures, bonds and trade credit,” he said.
“Debt is a reliable source of information during fundraising winters.”
Venture debt funds surpassed the $1 billion mark in 2023, but equity fundraising, which includes private equity and venture capital investments, fell about 35% from $62 billion in 2022 to about $39 billion in 2023, according to a joint report released last month by Bain & Company and IVCA.
Experts believe that debt financing can be a reliable option for entrepreneurs who want to scale their businesses during fundraising winters. “In the case of fundraising winters, when equity investment options are limited, startups can resort to debt capital to scale their businesses,” Gupta said.
“Startups can use debt to seize strategic opportunities and preserve equity value by deferring raising capital until it is more accessible, but they must ensure they can repay the loan. In other words, startups should not turn to debt simply because capital is not available, but with a clear repayment plan in mind,” he added.
Clix Capital's CFO said the uncertain environment and rising risk aversion among investors meant equities posed the risk of reduced investment, which could slow start-ups' growth plans and lead to business losses.
“Debt financing is a faster and more reliable source of funding for businesses and helps them grow their business without losing ownership of the company. Debt financing allows companies to leverage smaller amounts of capital into larger amounts, enabling further growth that would have been difficult otherwise. Hence, during the fundraising winter, businesses should positively consider debt financing,” Agarwal added.
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