startup loan for new business

In this article, Shamika Vaidya discusses the best option to choose between Bank Loan and Private Equity if a startup is thinking of raising capital.

Introduction

For a set of people with extraordinary business ideas, raising capital is the most important thing on the list. In spite of excellent business model, lack of capital can get the project to standstill. On the other hand, individuals with extra money look to invest in right businesses to gain good returns. Individuals either save it in the bank who further invest the money in various projects assuring a fixed return or directly in the capital market or private equity where the returns are more but not assured. When a promoter assures such investor to invest in his business for good returns he can successfully raise capital for business.

Start-up and need for funding

A start-up is different from traditional business. It mostly focuses on an area which is innovative, possibly technology based and altogether a new concept which is not out in the market. It varies from the traditional business right from the areas of funding, exit options, marketing and technology.

A start-up is defined as an entity that has its headquarters in India, the annual turnover being not more than twenty-five crores, in existence not before seven years and not formed by splitting up or reconstruction of business already in existence, typically,

Download Now
  • 1) Innovation
  • 2) Development
  • 3) Deployment
  • 4) The commercialisation of new product process and services as stated by the DIPP (Department of Industrial Policy and Promotion) under Ministry of Commerce and Industry.[1]

Funds Requirement

Funds are required in a start-up for –

  • Research and Development
  • Working Capital
  • Workspace and basic setup
  • Salaries
  • Equipment and machinery
  • Intellectual Property & Software Purchase or registration.
  • Scaling up.

Scope of Start-up Funding

The definition of a start-up is large and accommodating.

  • A setup which has a recent inception which in the process to build up a business plan, find a permanent workplace, register itself, research and develop it
  • A business successful with pilot project, ready with a business model to work on and looking forward to enter the market
  • A business with few years of operation having a good base of customers looking forward to scale up its business.
  • A business which was bootstrapped and turned out to be successful looking forward to aggressively expand and increase the market size

Although all the above-mentioned examples are start-ups but they will be funded in different ways.


https://lawsikho.com/course/diploma-m-a-institutional-finance-investment-laws

Click here

How startups can raise capital

  • Bootstrapping

Precisely, not using credit as a primary resource of investment. Bootstrapping is when the capital for the company comes from the personal savings or funds. It can also include borrowings from family and friends. Limited capital can make the companies grow slowly but organically. The promoters have the complete power which is otherwise diluted due to the investors. Mirraw, a start-up on online platform which was bootstrapped by the promoters with 1lakh in 2011 grew near to 100 crores in 2015.[2]

  • Accelerators and Incubators

Accelerators provide with capital for a start-up and expect equity in the company somewhere between (3%-8%). Accelerators are for short period of time and their goal is to get the start-ups ready to rounds of initial capital funding. Incubators are affiliated to universities, colleges or institutes. Primarily, they do not fund the start-up. They provide guidance, mentoring, infrastructure & technology support

  • Angel Investors

Angel investors only invest in an early stage start-ups and invest individually. They also mentor the entrepreneurs and help them to network. They use the high risk high return matrix in the form of High stake of Equity, in case of OYO Rooms the angel investor exited with return of 280x.[3] SEBI (Alternative Investment Funds) Regulations,2012 regulate the angel investor funding.

  • Venture Capitalist

Venture Capitalist invest in the primary stage of a start-up. In turn, the returns that they expect are high compared to any other investors the level of risk being high. Few of India’s top VC firms are Sequoia Capital, Matrix Partners, Nexus Venture Partner, Accel Partners, Kalaari Capital, Lightspeed Venture Partners, IDG Ventures, —have together raised $3.8 billion since the start of 2015, according to `Mint research.

  • Foreign Direct Investment

Investors incorporated outside India can invest in Venture Capital Funds and Domestic Capital Undertaking by following the norms set by Foreign Exchange Management and SEBI. They are defined both under FEM (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 and SEBI (Foreign Venture Capital Investor) Regulations 2000. Bertelsmann India an Investment arm of Germany Bertelsmann SE & Co KGAA, is funding Treebo, Saavn, Pepperfry, Lendingkart.[4]

  • Strategic Investors

Strategic Investors come into play after a start-up is established. Not only do these investors invest in the business but also have control over management and strategies to expand or grow the business to the next level.

  • Bank Loans

Both the Public Sector and Private Banks provide loans for start-ups. In India currently, the Non-Performing Assets are very high. Thus, the Banks have a strict criterion while progressing loans to start-ups. Few of the Schemes provided by banks need the start-up to register with the inter-ministerial board from (IMB) Inter ministerial Board and Minimum Qualification of the Entrepreneur. The government has come up with more than 50 schemes to strengthen the start-up ecosystem in India. The famous MUDRA scheme under which the government has given 12 crore loans totally amounting to 5.75lakh crore. [5]

CGTMSE Loans (Credit Guarantee Trust for Micro and Small Enterprises MSE)

TO encourage entrepreneurship, The Ministry of Micro, Small & Medium Enterprises (MSME), Government of India has launched Credit Guarantee Trust for Micro and Small Enterprises MSE) Loans up to 1 crore can be availed without collateral or surety.  Any banking institutions which have signed an agreement with Credit Guarantee Trust, all scheduled commercial banks and specified Regional Rural Banks, NSIC, NEDFI, and SIDBI can be approached by the Micro and Small Enterprise.[6]

Types of Loans a Startup Can Avail From Banking Institutions

  • Loan for Working Capital
  • Loan for a particular Transaction
  • Letter of Credit (LOI)
  • Bridge Loans
  • Syndicate loans
  • Overdraft facilities for current account holders
  • External Commercial Borrowings

Loans can be taken from foreign institutions and are governed by Foreign Exchange Management (Borrowing or lending in Foreign Exchange) Regulation 2000 and RBI Master Regulations. Violation of any of the provisions can attract fine by the virtue of Section 15 of FEMA. There are two routes a) Automatic Route (sectors without permissions of RBI, loan can be availed) b) Approval Route (needs prior approval from RBI)

Companies prefer taking loan from foreign institutions as the rate of interest is low than those in India. However, not all type of organizations can avail them. Incorporated companies can receive ECB, One person company, LLP, partnership firms and NGO are not eligible for it.

Venture Debt

Venture Debt is available for start-ups who do not have positive cash flows and collateral security. Banks have an arm where they accept deposits from start-ups and lend them capital as a part of their service. It is provided to start-ups which are backed up by the Venture Capital Funds, therefore resulting in availability of funds without diluting equity. Some of the banks that provide Venture Debts are Silicon Valley Bank, National City Bank [7]

Other Forms of Investments-

  • Crowdfunding for Start-ups
  • P2P Lending Platforms
  • Loans from NBFC

Bank Vs. Private Equity                   

  • Security for advancements

PE

For a PE it doesn’t matter whether the promoters have any tangible assets neither do they ask for any collateral security. The focus is more on the talent

Bank

Two types of loans are offered by the banks, secured loans and unsecured loans. Secured Loans need collateral security from the debtor. Unsecured loans though do not demand for collaterals, however, the personal guarantee has to be provided by the debtor. This makes it clear that a person having tangible assets is in a position to opt for a bank loan.

By the means of The Credit Guarantee Fund Trust Scheme, start-ups can avail unsecured loans. However, only entrepreneurs with strong business acumen are eligible for it. Small Industries Development Bank of India also offers Revolving Fund for Technology Innovation know as (SRIJAN Scheme) extending up to 1 crore and the rate of interest, not more than 5%p.a. Schemes introduced by the government are helping to opt for unsecured loans[8]

  • Approach

PE

Approaching a VC is a difficult task. For an entrepreneur, it is as important to know the background of an investor like it is important for the later to know about the former. The success rates of getting funded by a VC is just 8.3%

Bank

Banks are established entities and have networking all over the country making them easily approachable and have their various schemes.

  • Presentation

PE

For PE, who is also an equity holder in the company has a prime focus on the development and expansion scope of the business. One has to prepare a ‘Pitch Presentation’ which typically includes 1) Market Opportunity 2) Competitive Edge 3) Management 4) Innovation in Idea 5) Communal benefit 6) Sustainability 7) Statistics and Pilot Project achievement 8) Capacity of Promoters and associates (Ambition, Skills) 9) Strategies[9].PE stress a lot on abilities of the promoters, even if the product does not prove to be quite a success. An example is Hubspot which was mediocre in the initial years. Due, to market size being used and the potential of founders being extraordinary the company went public.

Banks

Banks need a Detailed Project Report which contains following information-

  • 1) Business Model
  • 2) Revenue Model
  • 3) Estimated Profits
  • 4) Promoters Background
  • 5) Estimated growth Ratio

They are not keen to know whether the business turns out to be revolutionary or the company will go for an IPO in the future. Their concern is limited to the extent of getting back what they have advanced with the interest.

  • Debt -Equity

PE

As the name suggest, in the private equity the return on investment is in form of equity. The investor is a part of the company. There is a dilution in stake.  Also, the decision-making power does not remain only in the hands of the promoter.  Typically, PE investors acquire equity about 20%-30% in the early period.

Banks

Loans that are advanced from the Banks are a debt on the company. The Company is liable to pay a rate of interest to the Banks on a periodic basis. Unlike the former there is no dilution of ownership. However, loans advanced by the banks are asset backed loans. Loss and profit to the company doesn’t change the pre-decided rate of interest and EMI.

  • Returns

Banks

For the loans advanced, banks typically agree on a return of 8%-10% for secured loans, 12% -15% for unsecured loan. If the company is doing extraordinarily well the banks cannot increase the rate of interest.

PE

They expect high returns out of the equity, depending on the sector and investment. Most of the VC expect to pull out of 5x -10x. SAIF PARTNERS pulled out 16x returns amounting to 400 million $ from Make my Trip whereas Tiger Global pulled out 20x returns from Just Dial. [10]Typical expectation of a VC is pulling out 5x-10x.

Management Control

PE

The investors have a representative on the Board of Directors as a nominee director. If there are multiple investors investing then a fund manager is appointed to represent them. Generally, they do not have voting power but just observe the meetings and report to the investors. They may also want few human resources on their end to take important decisions.

Banks

Banks do not interfere either with the decision making or control on management. However, they can appoint individual on their behalf to understand the position of the progress and the presence of unscrupulous activities.

  • Exit options

The whole returns of the PE are dependent on successful Exit

PE

1) IPO

Initial Public Offering is when a private company is listed on the stock exchanges and can trade its shares. Although IPO are seemed to be a hope of good exit, it is always not possible for a company to go public. Here the money goes from the public who would buy shares.

2) Buyback

When the company decides to buyback its shares from the investors it is an exit option. However, unless the company is not offering a high return unlike 2x or 3x the PE may take interest to sell. Here the money goes from the promoters.

3) Trade sales

By selling shares to other investors. The money goes to the investor to whom the shares are sold.

4) Liquidation

When the company is bankrupt or opts for liquidation.

5) Takeover or Merger

When a company will be takeover by other entity the VC exit themselves with good amount in hands that come from the acquiring company.

When a company goes for a voluntary liquidation it is an exit option for the investor.

Bank

A bank only exits when the principal amount is repaid along with the interest.

Secured Loans

After few defaults the account is declared to be NPA after 90 days and the bank can sell off the collateral security at the market price to the recover the money. In case shares or other movable properties are pledged the bank can sell them off.

Unsecured Loans

Where the loan is not backed by any asset the lender can levy high interest, penalty for default a low CIBIL score which can cause a problem while taking loan in future, and the lender can file a lawsuit for recovery.

Banks can reschedule the debt where some time is given and the monthly instalments are extended accordingly by adjusting the interest. Banks can also opt for debt restructuring wherein based on the cash flows of the company an amount of the debt is structured and the rest can be converted into equity[11].

PE

In case of PE, hybrid instruments like CCD (Compulsory Convertible Debentures) or CCPS (Compulsory Convertible Preferential Shares) are used to convert their equity into debt if the company is incurring losses or its market value is depreciating or the clauses in the Share Purchase Agreements like the Put option, Tag Along Rights, Drag Along Rights, Anti-Dilution to safeguard their interest.

Conclusion

To choose a method for raising capital for a start-up depends on various factors like the sector, stage and monetary need of the start-up. With government scheme, the option of bank loans is boosting amongst promoters. For a start-up in the field of technology or services and the promoters do not have tangible assets and the breakeven point can take few years, private equity is the best option as not only finance but also networking and mentorship is provided, whereas if a start-up is in regular field and the promoters have assets to mortgage and have good networking and guidance they can avail bank loan without diluting the equity.

Sources

[1] https://www.startupindia.gov.in/

[2] https://inc42.com/resources/mirraw-boostraping-journey/  How We Grew From 1 Lakh To 100 Crore – The Bootstrap Way! 24 Dec’15 by Anup Nair

[3] https://inc42.com/buzz/angel-investor-sanjay-mehta-exits/ The Art of Exiting: Angel Investor Sanjay Mehta On Angels Not Relying On IPOs, Defining Healthy Exits And More Shweta Modgil 15 Nov’16

[4] https://inc42.com/features/pankaj-makkar-of-bertelsmann-india-tells-us-which-four-risks-hes-willing-to-take/

[5] https://medium.com/finance-buddha/pradhan-mantri-mudra-yojana-for-startups-1dc47bdb11a2 Pradhan Mantri Mudra Yojana for Startups

[6] https://cleartax.in/s/financing-options-available-to-startups Financing Options Available to Startups Updated on Oct 23, 2018 – 04:41:21 PM

[7] https://en.wikipedia.org/wiki/Venture_debt

[8] https://www.indiafilings.com/learn/bank-loan-startup-business/  Bank Loan for Start-up Business
[9] https://www.dummies.com/business/fundraising/venture-capital/10-things-venture-capital-investors-look-for-in-your-company/ 10 THINGS VENTURE CAPITAL INVESTORS LOOK FOR IN YOUR COMPANY Nicole Gravagna, Peter K. Adams
[10] https://inc42.com/buzz/saif-exits-makemytrip/ SAIF Partners Pulls Off 16x Return – Exits MakeMyTrip at $400 Mn Aparna Mishra 16 Feb’17

[11] https://economictimes.indiatimes.com/industry/banking/finance/banking/tackling-bad-loans-banks-can-now-take-equity-in-debt-laden-companies/articleshow/52738636.cms Tackling bad loans: Banks can now take equity in debt-laden companies Updated: Jun 14, 2016, 04.48 AM IST

RELATED ARTICLESMORE FROM AUTHOR

2 COMMENTS

LEAVE A REPLY

Please enter your comment!
Please enter your name here