Emerging Entrepreneurs

Why loan funding may be better than equity

Meera Siva  | Updated on January 22, 2018

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In the early stage, debt fund can help start-ups get more clarity on business financials

Start-ups most often approach angel investors or venture capital firms when they need to raise funds. But rather than equity funding why not take a loan? For one, loan processing is faster than raising equity capital and importantly there is no ownership dilution. In early stages of a start-up, it may be better for an entrepreneur to raise debt and look for equity after the business has stabilised. This can help them negotiate better terms.

Also, a loan at over 18 per cent rate of interest may still be cheaper than equity sources where investors expect an internal rate of return of over 25 per cent. The expected rate of equity returns are typically higher due to higher risks taken. So, while equity may seem like an inexpensive way to raise funds compared with loans where you have to pay interest, in the long run, debt may turn out to be a cheaper alternative in many cases.

Loan issues

One reason why start-ups typically do not consider loans is because there are not many loan providers in the early stages. When there are no established cash flows, borrowings are solely based on the strength of the promoter’s credit history, says K Mahalingam, Managing Director, Rupeezone, a financial consulting firm. This involves getting a loan against your personal assets. While this is possibly the only choice available to many entrepreneurs, there may be concerns such as placing one’s personal assets at risk.

 That said, there are not many venture debt options for start-ups as the segment is risky, says Venky Natarajan, Partner, Lok Capital, an impact investment venture capital firm. Why so? “The upside is limited to the interest received while the downside is complete loss of capital,” he explains.  This is unlike equity investments where the money lost in many investments can be recouped from a few winners. Still, there are a few institutions such as Innoven Capital India, Intelligrow and Caspian that provide debt financing; a few of these have limitations on which sectors they lend to. 

Still, even in the early years, it helps evaluate loan options. For one, the questions they ask can help you get more clarity on your business financials, similar to seeking funds with equity investors. Also, the exposure to lending institutions may come in handy later, says Sachit Singhi, Co-founder, Stayzilla, an online stay reservation portal. The documentation they ask for can help you set systems in place and be well prepared to tap business loans.  

Loan choices

A not-so-obvious choice for loans is government sources such as the newly-created Mudra Bank (Micro Unit Development and Refinance Agency). The agency facilitates loans of up to ₹10 lakh to small businesses. It works with multiple banks, NBFCs and micro-finance institutions for these loans.  Mudra is also in the process of offering specific schemes for qualifying entrepreneurs in select sectors and locations.  Loans cover asset purchases, working capital and bridge loans.  Likewise specialised banks such as Small Industries Development Bank of India (SIDBI) offers early-stage debt funding of up to ₹1 crore, especially for emerging technology under its Srijan Scheme.

Public and private sector banks are also keen to provide business loans in many cases, but there is a caveat. In most cases, only businesses with a track record of at least three years are eligible. You can approach the bank directly or go through intermediaries that facilitate the process. Establishing this relation early on can help you as banks may feel comfortable to upgrade your loan amount, extend better terms and process your request faster.

Don’t worry if you don’t meet this eligibility from banks — NBFCs such as Capital First and Shriram Capital may consider younger businesses as well. For instance, Capital Float lends up to ₹1 crore to companies that have been in existence for one year and have an annual turnover of at least ₹25 lakh.  

Another option is availing of short-term loans, against your outstanding receivable. Loans of up to 80 per cent of the invoice value can be obtained for 30-180 days.   

Doing your part

Getting a loan, however, requires a lot of preparation on your part. Similar to approaching an angel or VC, you have to explainthe business model, financials such as sales, profits, growth, margin, as well as background on the experience of the promoters.

Keeping records — VAT return, purchase bills, sales invoices and Udyog Aadhaar — are important to lenders as these documents help ensure compliance and ascertain business income. 

R Venkatakrishnan, Chartered Accountant, advises that entrepreneurs should get an SME number for their start-up.

Published on September 21, 2015

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