Moving beyond equity! How startups shift to debt financing fuel business growth?

Securing the right funding is critical for startups to foster growth and achieve sustainability. Traditionally, equity financing has been the go-to option for many young businesses. However, amid a significant dip in equity fundraising, they are now turning to debt financing as a viable alternative to fuel their growth. This shift shows a better grasp of diverse financial strategies that support a startup’s growth without diluting ownership.

Before diving deep into them, let us understand the difference between equity and debt financing. Equity financing involves raising capital by selling company shares, which dilutes ownership but doesn't require repayment, while debt financing entails borrowing money that must be repaid with interest without giving up ownership but adding financial liability to the company.

‘Ownership control, strain cashflow’

Debt funds have many advantages as founders can retain control of their decisions and future financial benefits, said Avishek Gupta, MD and CEO of Caspian Debt. Besides this, the overall cost is lower with fixed interest rates, flexible repayment schedule, and quicker to get access to debt funds, he told LiveMint. 

Gagan Aggarwal, CFO of Clix Capital, stated that founders can also reduce tax outgo since interest payments are business expenses. He said that easy budgeting due to monthly repayments and timely repayment of debt borrowings strengthen the bureau score, making it easier to take additional borrowings for growth and at better rates. 

However, the industry players noted that some risks and challenges are also associated with debt funds. “Excessive leverage can increase financial risk and strain cash flows. The situation of missing a debt payment can harm the company's creditworthiness and impede future financing options,” Gupta said. 

“Debt incurs interest, which must be paid regularly, even if your business is not making a profit. In a down-cycle, it may increase your financial stress. If repayments are not made in a timely manner, the credit score can be impacted, leading to higher borrowing costs in the future or even potentially restricting borrowing capability,” Aggarwal told us. 

‘Debt funds to equity fundraising ratio’

Hence, experts suggested that startups should clearly understand their risk tolerance, cashflows, and growth trajectory to determine an appropriate balance between debt and equity financing for their business models. They said it is crucial for entrepreneurs to recognise their cashflow projections and other obligations to repay their debt on time. 

“A capable finance head is essential for startups. Outsourcing to a quality CA or CFO firm is an option if hiring isn't possible. When considering external debt funding, this role becomes as crucial as technology or marketing leads, helping forecast future cash flows and evaluate borrowing options suitable for growth stages,” Gupta recommended. 

On the other hand, the Clix Capital CFO asserted that it's crucial to minimize borrowing costs, as growth often requires substantial debt financing. “Lower costs can enhance profitability and overall company health. Comparing with peers helps businesses find the right balance of debt and equity for optimal growth and stability.”

‘Bank loans, collateral loans’

They further advocated for different types of debt financing for startups, including bank loans, term loans, working capital loans, loans against collateral from NBFCs, vendor financing or invoice financing, corporate bonds, debentures, and trade credits. 

“Banks offer the lowest-cost debt but may not suit startups without mortgage collateral. Often, startups get frustrated chasing bank loans. Instead, focus on lenders known for funding startups and meeting their criteria. Not every lender should be a target,” Gupta said. 

“Ideally, loans should go to companies with a profitability track record, repayment capability, and collateral. Startup lenders use proxies for these parameters, so data transparency is crucial. Mature startups may explore term loans or hybrid financing for growth, while early-stage startups often use venture debt, convertible notes, lines of credit, or asset-based loans for flexibility and favourable repayment terms,” he added. 

Early-stage MSMEs may find bank loans challenging and should consider term loans, working capital loans, or collateral loans from NBFCs, Aggarwal said, adding that vendor or invoice financing is also an option if they supply to large businesses. "Mature MSMEs have more options, including bank loans, NBFC loans, corporate bonds, debentures, and trade credit.”

‘Debts reliable source amid funding winter’ 

Venture debt funds crossed the $1 billion mark in 2023, while equity fundraising, including private equity and venture capital investments, declined by about 35% to around USD 39 billion in 2023 from USD 62 billion in 2022, according to a joint report by Bain & Company and IVCA released last month. 

Experts believe that debt financing can be a reliable option for entrepreneurs who want to scale their businesses amid funding winter. “In case of funding winter, where there are limited options available for equity investments, startups can resort to debt capital to help them scale,” said Gupta. 

“Startups can maintain their equity value by using debt to seize strategic opportunities and defer raising equity until it's more accessible. However, they must ensure they can repay the loan. In short, startups shouldn't resort to debt simply because equity isn't available; they should do so with a clear repayment plan in mind,” he added. 

The Clix Capital CFO stated that equity poses a risk of reduced investments due to an uncertain environment and heightened risk aversion among investors, which may delay the growth plans of startups and result in loss of business. 

“Debt financing is a faster and more reliable source of funding for businesses, which can help them grow their businesses without losing ownership of the business. It helps companies to leverage a small amount of money into a much larger sum, enabling more growth, which may otherwise be difficult. Hence, they should positively look at debt financing amid funding winter,” Aggarwal added.