People wonder how entrepreneurs discover amazing ideas and start new ventures they couldn’t even think of. Did this question cross your mind too? Let me spill the beans – the ideas are right in front of you, it’s just that your perception restricted your vision. We all face problems in life, what makes entrepreneurs different is that they perceive the same problem differently, and are curious, passionate, and courageous to arrive at a solution. Thus, the problem becomes an opportunity for them, the curiosity leads them multiple ideas, their passion makes them persistent to arrive at results, the courage allows them to think and step out of the box, and in the end, the solution they arrive at is called a startup – let’s sell our ideas. What you said was a problem, the entrepreneurs saw it as an opportunity, and if more people call it a problem, the entrepreneurs call it a bigger opportunity. So, it all starts with a problem! Does that mean, more the problems, more the business? Probably yes, and that’s what makes India, a global consumer hub – more people, so more problems and thus, more business!
What are the stages of financing?
You sow a seed; it becomes a sapling. You water it properly; it becomes a plant and starts blooming flowers. You keep nourishing it; it becomes a tree and starts bearing fruits. The businesses work the same way.
Your idea is a seed, and with some basic financing you can start selling your idea i.e. it becomes a sapling.
However, for the sapling to grow into a plant, it would need proper watering and in case of business, this water is money, and watering is financing. This watering of ideas is called as ‘Seed Funding’. And as it is with watering, funding also needs to be done at appropriate intervals, in sufficient quantity and a proper manner. Besides, anybody can plant a sapling – your ideas cannot be copyrighted. Thus, often people with ideas are left thinking at their home, while people with funding capture the entire market even before anyone notices. It’s not illegal to copy an idea and this makes financing all the more important. Thus, “Fund your ideas, before others feed on your ideas”.
If you finance your idea properly, it will start blooming beautiful flowers – the market will start recognizing your startup. Marketing, sales strategy, product research, and its development, together form a cycle that needs to be repeated constantly till more and more consumers accept the product. However, none of it would be possible without adequate financing. These additional financing that the startups obtain are known as ‘Series Funding’e.g. series A for rapid growth, series B for scaling your business, Series C and above for dominating the market presence or becoming market leaders.
However, for a plant to grow into a tree, it has to strengthen its roots first. Similarly, for a startup to become a full-fledged business set up in India, there is a difficult road to travel – your product may be good, however, you have to develop a strong customer base and strengthen your market share.
Thus, you need to invest in additional plant and machinery to increase your production or more employees in case of services. Besides, your marketing requirements would also increase to reach different geographies and a bigger audience. All this would not be possible with the nourishment of financing. This financing for growth of the business is called ‘Business Financing’.If done right, the startup will soon become a full-fledged business bearing fruits i.e. profits. Since many enthusiasts would have already seen your product or service, funding at this stage is comparatively easier to obtain.
What are the types of financing?
There are various ways to finance your business set up in India. While family and friends may lend money without expecting anything in return, everyone else certainly expects a consideration. Thus, you can finance your business either by acknowledging a ‘Debt’ or allowing an ‘Equity’.
Debit simply means borrowing money and paying back in installments along with interest at a fixed rate to the concerned investors – usually banks. Over the years, you repay the debt and investor is out of your business.
Equity means allowing the financer a certain % share in the future profits– the startup may not be earning profits, however, in future it may earn and your equity partner is betting on the same. Over the years, your business will grow, the equity investor will keep taking a share of profits from the same. However, since businesses need funds to keep growing, often the profits are not distributed but retained in the business – this increases the value of the enterprise. At some point, the equity investor can exit by selling off his % share, at a price higher than he paid initially.
The choice of debt or equity financing lies with the entrepreneur and how he needs the finance, the number of funds required, and how long he wants the investors to be involved.
Why Debt can be preferred over Equity?
- The power to decision-making lies with the owner. Debt does not give any claim over the business and thus, the ownership of the entrepreneur is not diluted.
- The lender does not provide any claim on the future profits – only repayment of the principal amount along with interest at a fixed rate. If the business grows exponentially, the owners keep a larger portion of the rewards.
- Interest on the debt is a tax-deductible expense, lowering the actual cost of the loan to the business.
- Debt financing is comparatively simpler as the enterprise is not required to comply with various securities regulations.
Why Equity can be preferred over Debt?
- Debt has a fixed repayment schedule and has to be paid whether the enterprise makes profits or not. The lenders will only take a fixed portion of whether the enterprise makes profits or losses. Equity does not require repayment.
- It takes more time for the enterprise to reach a break-even point due to an additional burden on interest costs. Enterprises with heavy debts grow slower because the majority of the earnings are used to service the debt. Equity financing does not require a regular distribution of profits, the same is at the discretion of the investors.
- The enterprise has to ensure that it generates enough cash flow to repay the debt at the fixed interval. A portion of the cash flow generated from the business is routinely exhausted by the repayment of debt. Equity financing does not involve any impact on cash flows.
- Debt is usually offered against primary and collateral security, personal guarantee, etc. Equity financing does not require any security or guarantee, it is based on the perceived prospects of the business.
What are the methods of financing?
Self-starting your business without any external person financing your business is called Bootstrapping. At the beginning of every venture, one needs to evaluate whether the business can be self-financed by using savings, borrowings from family or friends, personal sources of finance like credit cards, etc. If your business can be bootstrapped, there is no need to involve other investors, since the same would come at a cost, involvement, and compliance. However, you can self-finance your business to an extent, and beyond a point, you will have to resort to other means of financing for larger funding. Besides, bootstrapping also comes at the risk of wiping out your savings.
Bank loans are the second easiest way of financing your business set up in India and the most commonly opted option by small businesses. There are many large public sector and private sector banks in India that have standard borrowings terms and regularly finance businesses. However, one may also opt to be financed from Small banks and Co-operative banks for easier borrowing and more power to negotiate the terms. However, all bank loans require security to be offered against the loan and thus, usually do not participate in seed funding or series funding. Business financing for the purchase of land and building or plant and machinery can easily be obtained from banks by offering the underlying asset being purchased as the security against loans. The bank has a lien over such an asset until the loan is repaid.
Apart from the formal banking system, India has a large array of Non-Banking Financial Companies (NBFCs) and other types of Microfinance institutions that provide different types of loans similar to those provided by banks. While banks are regulated by the Reserve Bank of India (RBI) and follow its norms, microfinance companies are not regulated and thus, the terms of loans can be negotiated here, subject to fulfillment of eligibility criteria and good credit score. Microfinancing institutions usually ease the process of lending and involve lesser paperwork, faster processing, and better customer services, as compared to banks, however, also charge a higher rate of interest and higher processing fees.
Line of Credit
While your capital purchases may occur in one big outgo, other expenses do not occur the same way. However, once you procure a bank loan, your interest expense begins right from that day while the funds are lying with you unused. To avoid such costs, you may opt for a line of credit – a bank loan where the bank offers you a credit limit which you can use as and when you require and also repay when you receive funds, and pay interest only on the outstanding amount. Line of credit can take various forms such as Cash Credit, Overdraft, etc. The procurement process is similar to a bank loan. This funding option is useful to finance your working capital requirements and short term needs.
While banking and non-banking institutions offer finance against repayment along with interest, some private investors offer to fund against equity. These investors are known as Venture Capitalists (VC) who take huge risks by investing in startups who are at the early stages of their business, after evaluating their potential and in expectation of extravagant returns in the future. Financing from venture capitalists is difficult as you must have a convincing idea or a startup to obtain financing from such investors. Thus, an entrepreneur has to prepare and deliver a detailed pitch on the business idea and prospects, to obtain funding from venture capitalists. This funding usually carries on in different rounds according to the business requirements and investors negotiate their terms and conditions for such financing. The venture capitalist being an equity investor would approve all major business decisions and also have a say in the future path of the business.
Accelerators and Incubators
Accelerators are organizations run by experts who help you in growing and scaling your existing business. On the other hand, incubators are also organisations run by experts, however, they work to help entrepreneurs at the idea stage and mould the same into a viable business model. Both organisations act as mentors for the entrepreneurs and organize programs, help in funding, and create hubs for various startups to help evolve together, in exchange for a small portion of the equity in your business. Many accelerators and incubators also offer office space until the idea is converted into a product-market fit. However, these organisations, similar to venture capitalists, are difficult to get into and incubators or accelerators would consider all the prospects of the business before accepting your application.
Similar to venture capitalists are angel investors who also invest in startups for a share in equity, however, while venture capitalists are companies procuring funds from other investment companies, angel investors are individuals who have excess funds available with them and desirous of earning returns by investing in other businesses. The quantum of investments is not as high as in the case of venture capitalists, however, the investments here are based on the interests of the investor, and thus, they also invest at the seed stage of a business and tend to take higher risks.
Capital Market Funding
When a business has reached the maturity stage and you want to take it further ahead, scale exponentially or repay your debt by raising equity, capital markets can help you raise money directly from the public, instead of institutional investors. This allows you to raise funding as per your need, by listing the company on the stock exchange through the process of ‘Initial Public Offering (IPO)’. However, this option involves valuations by merchant bankers, compliance with SEBI and Stock Exchange regulations, appointing IPO registrar, contacting banks for underwriting shares, etc. This makes this option of financing expensive than any other mode discussed here. No doubt why out of millions of companies in India, only approximate 5,000 companies are listed on stock exchanges.
Debt Market Funding
Capital market funding results in dilution of ownership as additional shares are issued to the market. However, in a debt market financing, one can raise money directly from the public by issuing bonds or debentures which pay interest at a fixed rate, without diluting the ownership. However, similar to capital market funding, this option also involved heavy compliance costs. Besides, regular payment of interest similar to bank borrowings applies here, except that the company does not require repayment of principal in installments. On the expiry date, the company has a pre-declared option either to repay the entire amount or convert the same into equity.
The government of India has also started its programs such as the ‘Startup India, stand up India’ which facilitates the funding of eligible startups in India. A company can obtain ‘DPITT Recognition’ and avail various benefits under the program. The Government has also started developing its accelerator and incubators under this program. ‘Pradhan Mantri Mudra Yojana (PMMY)’ is another program by the Government that facilitates loans of up to INR 10 lakh to small enterprises. Various ministries also offer subsidies for investment in plant and machinery and other projects backed by Government which can help in reducing the project cost.
Internet is a magical place and crowdfunding is a newly emerged concept. If you have an idea, product, or service which you feel people would support or be interested to buy, you can ask the crowd to fund your startup or else even take pre-orders. This concept is increasingly growing and the internet has been key to the same. You can reach out to your potential customers and ask them to fund or pre-order the product. If people love your idea or the product, you may raise considerable funds to finance your business, apart from the other funding options.