What Startups and SMEs Need to Know

ABSTRACT

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

The central government has announced a series of measures in the 2024 budget aimed at increasing the availability of credit to micro, small and medium-sized enterprises (SMEs)

In addition to banks and non-banking financial companies, there are high-risk debt funds, which constitute a new type of debt financing.

Navigating the various avenues for raising capital has always been daunting for companies, especially startups and small and medium-sized enterprises (SMEs) with limited banking and finance knowledge. Many are now exploring debt financing as equity capital is becoming increasingly difficult to raise. The time is right as the credit environment is becoming increasingly favorable for startups and SMEs. However, to do so, companies need to improve their internal processes and increase their risk profiles.

A stable interest rate regime is expected to boost debt financing. Economists predict that the current cycle of high interest rates will end soon. Major economies, including India, have been witnessing high interest rates in the past few years. However, with inflation coming down, central banks have taken a more dovish stance on lending. As interest rates plateau, debt financing becomes an attractive proposition for companies.

In addition, the central government announced a number of measures in the 2024 budget to increase the availability of credit for micro, small and medium-sized enterprises (SMEs), such as the Credit Guarantee Scheme for SMEs in the Manufacturing Sector and Credit Support in times of financial stressAnother positive move is the proposal to allow public sector banks to adopt internal credit assessment methods, including incorporating data from a company’s digital financial footprint.

Choosing debt over equity

Traditionally, equity and debt have been the two primary types of financing. According to the latest Indian Tech Startup Funding Report According to 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.

Debt financing is gaining popularity for several reasons. Founders can keep 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 forecast cash flow.

But there are also disadvantages. Companies have difficulty finding the right partner for banking. In addition to banks and non-banking finance companies, there are debt funds, a new class of debt financing.

Second, although fixed repayments are beneficial for financial forecasting and modeling, they can deepen financial difficulties when a company experiences irregular cash flows.

Prerequisites for taking out a debt

It takes much more than a fancy marketing campaign to convince lenders of a company’s ability to honor repayment terms. Founders must demonstrate business viability and solid finances to lenders.

• Lenders require that companies have a proven track record of profits or a growing trend in their bottom line. This means that the borrower can comfortably repay the principal and interest.
• Business owners must contribute to the capital of the business. Their conviction in the business is evident when they have contributed a significant portion of the capital.
• Companies must provide assets of real value to secure their loans. The assets may be tangible or intangible, but their value should be such that they can be pledged or mortgaged in favor of the lender.
• The credit profile and risk assessment of owners and companies provide empirical credibility to the business. A good creditworthiness enables the business to obtain better loan terms.
• A new company that lacks performance data to support financial projections may rely on the references and credibility of its founders. A founder’s history of starting or running a successful business increases lenders’ confidence.

Establishing internal practices

The factors that determine whether a loan application will be approved include a company’s internal risk assessment and its ability to adapt its requirements to a rapidly evolving, complex lender ecosystem.

• Accounting practices: Lenders evaluate a company’s financial health by looking at a number of parameters, including past income and expense statements, balance sheets, cash flow statements, customer acquisition costs, cash burn rate, monthly recurring revenue, and projected financial statements. Companies must monitor these KPIs and establish accounting practices that will withstand scrutiny.
• Creditworthiness assessments of individuals: Business owners need to have a good personal credit score while also building a commercial credit score for their business. A strong personal score depends on factors such as the borrower’s repayment history, the size of the available credit limit, and the length of credit history. Advice from banking professionals is key to understanding how to assess and increase financial credibility.

• Building a relationship with a lender: Startups and SMEs struggle to keep up with and understand new government programs or a new class of debt instruments. They also need to be aware of different lender preferences and borrowing capacity. A lender may have industry preferences or a quota to match. Founders who have access to professional banking advice can benefit immensely.

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