Raising Funds Through Debt: What Startups And SMEs Need To Know

Navigating different avenues to raise capital has always been daunting for businesses, particularly for startups and small and medium enterprises (SME) with limited expertise in banking and finance. Today, many of them are exploring debt funding as raising equity gets harder. It is the right time as the lending environment gets increasingly favourable to startups and SMEs. But for that, companies need to improve their internal processes and boost their risk profiles.

A stable interest rate regime is expected to boost debt financing. Economists are forecasting the current high-interest rate cycle to end soon. Major economies, including India, have witnessed high interest rates over the past few years. However, with inflation cooling off, central banks have taken a more dovish stance towards borrowing. As interest rates plateau, debt financing becomes an attractive proposition for companies.

Moreover, the central government announced a slew of measures in Budget 2024 to boost credit availability for micro, small and medium enterprises (MSME), such as a credit guarantee scheme for MSMEs in the manufacturing sector and credit support during financial stress. The proposal to allow public sector banks to adopt in-house methods for credit assessment, including incorporating data from a company’s digital financial footprint, is another positive move.

Choosing Debt Over Equity

Traditionally, equity and debt have been the two basic types of financing. According to the latest Indian Tech Startup Funding Report by Inc42, the share of debt funding in Indian startups is growing. The value of debt investments in the first half of 2024 reached $576 Mn, more than double the amount raised in 2023.

Interest in debt funding is growing for several reasons. Founders can retain their stake in the business and reduce the cost of raising capital. They can use interest payments as a tax-deductible expense. Moreover, a fixed repayment schedule makes it easier to forecast cash flows. 

But there are disadvantages too. Businesses find it difficult to find the right partner to bank with. Besides banks and non-banking finance companies, there are venture debt funds, a new class of debt funding. 

Secondly, although fixed repayments are good for financial forecasting and modelling, they can exacerbate financial difficulties when a company experiences irregular cash flows.

Pre-Requisites For Raising Debt

It takes much more than a sleek marketing campaign to convince lenders of a company’s ability to honour repayment terms. Founders need to demonstrate business viability and robust financials to lenders.

• Lenders require businesses to have a proven track record of profits or an uptrend in their bottomline. That indicates that a borrower can comfortably repay the principal and interest.
• Business owners must contribute to the company’s capital. Their conviction in the business is evident when they have contributed a substantial part of the capital.
• Companies need to provide assets with real value to back up their loans. Assets may be tangible or intangible, but the value should be such that it can be mortgaged or hypothecated to the lender. 
• The credit profile and risk rating of owners and companies give empirical credibility to the business. A good credit standing enables a business to get better terms on loans.
• A new business with no performance data to back up financial projections can rely on the credentials and credibility of the founders. A founder’s track record of setting up or running a successful business boosts lenders’ confidence.

Establishing Internal Practices 

Critical factors that ensure a positive outcome of a loan application are the company’s internal risk rating and its ability to map its requirements to the fast-evolving, complex lender ecosystem.

• Accounting Practices: Lenders evaluate a company’s financial health by looking at many parameters, including past income and expenditure statements, balance sheets, cash flow statements, customer acquisition cost, the cash burn rate, monthly recurring revenue and projected financial statements. Companies need to monitor these key performance indicators and establish accounting practices that can withstand scrutiny.
• Personal Credit Assessments: Business owners need to have a good personal credit score, while also building the commercial credit score of their business. A strong personal rating depends on factors such as the borrower’s repayment history, the amount of credit limit still available and the length of credit history. The advice of banking professionals is critical in understanding how to assess and boost financial credibility.

• Lender Relationship Building: Startups and SMEs struggle to keep pace with and understand new government schemes or a new class of debt instruments. Besides, they need to be aware of different lenders’ preferences and lending capacity. A lender may have an industry preference or a quota to fill. Founders who have access to professional banking advice stand to gain immensely.

The external environment for debt financing is encouraging for MSMEs. However, business owners need to display long-term commitment and prepare their organisation to move in that direction. Strong internal practices and professional help for a nuanced understanding of the market will go a long way in securing funding.