What startups and SMEs need to know

According to Inc42 data, debt investments in the first half of 2024 totaled $576 million, more than double the amount raised in 2023.

The central government has announced a series of measures in Budget 2024 to increase credit availability to micro, small and medium enterprises (MSMEs)

In addition to banks and non-bank financial institutions, there are also venture capital funds, a new category of debt financing.

Navigating different avenues to raise capital has always been daunting for businesses, especially startups and small and medium enterprises (SMEs) with limited expertise in banking and finance. Today, many are exploring debt financing as raising equity capital is becoming increasingly difficult. The timing is right as the lending environment is becoming increasingly conducive for startups and SMEs. But for that, businesses need to improve their internal processes and increase their risk profiles.

A stable interest rate regime is expected to encourage debt financing. Economists predict that the current cycle of high interest rates will end soon. Major economies, including India, have seen high interest rates in recent years. However, as inflation cools, central banks have taken a more dovish stance on lending. With interest rates stabilizing, debt financing is becoming an attractive proposition for companies.

In addition, the central government has announced a series of measures in Budget 2024 to increase credit availability to micro, small and medium enterprises (MSMEs), such as a credit guarantee scheme for MSMEs in the manufacturing sector and credit support during financial stressThe proposal to allow public banks to use internal credit assessment methods, including incorporating data from a company’s digital financial footprint, is another positive step.

Choosing Debt Over Equity

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

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

But there are also disadvantages. Companies find it difficult to find the right partner to bank with. In addition to banks and non-banking financial companies, there are venture capital funds, a new class of debt financing.

Second, while fixed repayments are good for financial forecasting and modeling, they can exacerbate financial problems when a company experiences irregular cash flows.

Conditions for incurring debt

It takes much more than a sleek marketing campaign to convince lenders of a company’s ability to meet repayment terms. Founders must demonstrate to lenders the company’s viability and robust finances.

• Lenders require companies to have a proven track record of profitability or an upward trend in their bottom line, which indicates that a borrower can easily repay the principal and interest.
• Business owners must contribute to the capital of the business. Their belief in the business is evident when they have contributed a substantial portion of the capital.
• Companies must provide assets of real value to back their loans. Assets can be tangible or intangible, but the value must be such that they can be mortgaged or pledged to the lender.
• The credit profile and risk rating of owners and companies give empirical credibility to the company. A good credit rating enables a company to get better terms on loans.
• A new company without performance data to support financial projections can rely on the credentials and credibility of its founders. A founder’s track record of building or running a successful business increases the confidence of lenders.

Establish internal practices

Key factors that ensure a positive outcome of a credit application are the company’s internal risk rating and its ability to align requirements with the rapidly changing, complex lender ecosystem.

• Accounting practices: Lenders assess a company’s financial health by looking at many parameters, including past income and expense statements, balance sheets, cash flow statements, customer acquisition costs, cash burn rate, monthly recurring revenues, and projected financial statements. Companies must monitor these key performance indicators and establish accounting practices that can withstand scrutiny.
• Personal credit ratings: Business owners need to have a good personal credit score while also building their business’s commercial credit score. A strong personal rating depends on factors such as the borrower’s repayment history, the amount of credit line still available, and the length of the credit history. Advice from banking professionals is crucial to understanding how to assess and build financial credibility.

• Relationship building with lenders: Startups and SMEs struggle to keep up with and understand new government regulations or a new class of debt instruments. Moreover, they need to be aware of the preferences and lending capacity of different lenders. A lender may have a preference for a particular sector or a quota to fill. Founders who have access to professional banking advice can benefit immensely.

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