India’s highest valued start-up, Byju’s, has seen its fortunes plummet over the past year, as it careened from one crisis to another. The latest episode involving ‘predatory lenders’ in the US, besides raising questions on the growth model adopted by the company, also highlights the manner in which many Indian start-ups may be biting more than they can chew by resorting to debt financing.

The edtech, founded in 2011 by Byju Raveendran and Divya Gokulnath, had its heart in the right place, intending to make learning fun for kids, teaching math and science concepts through interesting video-based tutorials. The Covid-led lockdown gave a fillip to the company as parents found the Byju’s app a good way to engage children stuck at home.

The company went on an acquisition spree buying up 17 companies including WhiteHat Jr, Toppr, Aakash Educational Services and Osmo to expand its product bouquet. Private equity, venture capitalists and angel investors became enamoured by this story, helping the company raise around $6 billion in 27 rounds, between March 2013 and May 2023 from investors including Tiger Global, Blackstone, T Rowe Price and Mark Zucherberg-backed Chan-Zuckerberg Initiative.

The story began going sour when reports of unsavoury marketing practices adopted to increase subscriptions and undue pressure on staff to bring new business began doing the rounds. With the pandemic ending and children going back to schools and offline tuition classes, sustaining growth and showing profitability became more challenging resulting in the company resorting to large-scale layoffs. To dent credibility further, the Enforcement Directorate raided the company and its promoters for alleged FEMA violations.

What would have rattled the investors more was the company auditor calling for re-statement of the annual accounts, resulting in loss of ₹4,588 crore in FY21. While the company claimed that it clocked ₹10,000 crore revenue in FY22, its actions in laying off employees and desperate search for funds show that the company is in a weak financial state.

Debt financing

The recent troubles for the edtech company stem from the $1.2 billion of Term Loan B raised from institutional lenders in the US. The lenders had accused Byju’s of siphoning money away from its US subsidiary, and had tried to change the management of the company. They have also been asking Byju’s to accelerate the repayment of the loan amount.

Byju’s has gone on the warpath and has sued Redwood, a US based hedge fund that also deals in distressed debt for resorting to predatory tactics by increasing its holding of Byju’s TLB with the intention of making ‘windfall gains’.

It is however hard to sympathise with Byju’s in the ongoing drama with US lenders. The company took Term Loan B, from US borrowers because it was in dire straits and could not raise funds from other sources. It should have been aware of the consequences of resorting to this kind of financing.

What is Term Loan B?

Term Loan B is senior ranking debt offered to speculative-grade companies. It allows companies to make very small repayments of the principal amount annually, with the bulk of the repayment to be done on termination of the loan. The rate of interest on these loans are therefore much higher than other loans. The lenders reduce their risks by selling these loans in secondary markets where they can be purchased by hedge funds such as Redwood, which focus on distressed debt.

Byju’s should have been aware of what it was getting in to while taking on this large TLB loan and it can not really fault the AIFs such as Redwood in taking precautions to ensure that they get the principal back.

Of note is the fact that many other Indian start-ups are also now turning to such debt financing to get through the current phase. Indian hotel chain Oyo and API Holding, the parent company of PharmEasy have also raised loans overseas to fund their growth.

Venture debt in India

Venture debt is taking off in India as well. According to Bain & Company, venture debt increased to 0.03 times equity financing in 2022 and is becoming “increasingly attractive to founders as non-dilutive funding or bridge financing option in a volatile macro environment.” Total venture debt in India increased from approximately $550 million in 2021 to $600 million in 2022.

Start-ups have a difficulty in accessing finance since these are high-risk investments. With PE, VC and angel investors, who provide equity financing, beginning to tighten their purse strings and demanding better performance, these companies are now increasingly turning to debt.

The domestic corporate bond market is rather shallow and unsecured bank financing is also not easy to come by. Therefore the start-ups are beginning to look at overseas debt financing, where the lenders are willing to take the risk, but for a high price.

The Trade-offs

While this could look like a good short-term fix, such venture debt financing is fraught with risk because the investments entail fixed interest payments over the term of the loan, besides repayment of the principal. Default on any instalment will lead to confiscation of assets pledged and can lead to the company being dragged into insolvency proceedings, threatening its existence.

Such risks are not prevalent with equity funding where the investors can realise their profits only when they exit through stock market listing or by selling to other investors. In cases where valuation of a company plummets, the way Byju’s has, the equity investors have to bear the loss.

While PE/VC equity investors do begin playing an active role in the businesses of start-ups they have invested in, in order to drive growth and improve valuation, the steps taken by debt investors are swifter as it will be tied to periodic payments of principal and interest. And it can be harsher too.

There is no easy way out from the logjam that start-ups currently face. They need to change their entire business model — to stop chasing growth in order to drive valuations. The aim should be a slow but sustainable growth accompanied by reduction of unwanted expenditure and mindless acquisition of companies, simply to bolster revenue numbers. If the companies begin providing customers optimum service and delivering value to all stakeholders, growth will follow.

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