New age enterprises or start-ups are mostly market innovators and disruptors, having said that the underlying business may still require investments in working capital, supply chain both domestic and international, and capital expenditure for plant & machineries.
Equity capital is the most ubiquitous form of capital; however, it is also the most expensive form of capital available to startup founders. The IRR expectations associated are typically north of 30% for business-as-usual scenarios. While equity investors continue to support quantum leaps in growth of their portfolio companies, the founder typically ends up diluting stake with every equity round thereby reducing the ownership in the business significantly in the long run. With this perspective, it is always advisable to have a healthy mix of debt capital along-with equity in the capital structure to prevent excessive dilution and lower the total cost of capital.
Any start-up maintaining a healthy debt & equity mix in their overall capital raise will also generate incremental returns for founders as well as early equity backers, hence raising debt right from Pre-Series A stage is advisable. However, for most start-ups raising debt capital means raising venture debt, given the information asymmetry on other forms of debt capital.
Start-ups typically do not fit the conventional debt evaluation framework and their credit risk must be evaluated with a refined lens. For instance, most security structures demanded by lenders from traditional businesses such as hard collaterals, personal guarantees, minimum coverage ratios, profit matrix etc. will make it impossible for a start-up to raise debt capital. Therefore, over a period of last 2-3 years traditional debt frameworks have evolved to accommodate the unique financial and non-financial circumstances of new age businesses. Start-up debt eco-system is still constrained by several challenges but is evolving fast with consistent interest from lenders with a view to addressing the needs of a large and growing startup ecosystem.
Typically, the following characteristics can help start-ups raise debt capital:
Backed by a financial investor / strategic sponsor. Completion of at-least Pre-Series A / Series A stage
Minimum monthly run rate of INR 1 crore or higher
Minimum equity runway of at-least 6/12 months at the time of raising debt capital
Sustained month-on-month business growth / revenue growth
Decent personal credit profile of the founders / no prior delays or default by the founding team
Start-up Debt Capital raised can be used for one of the following use cases:
Meeting working capital requirements
Financing inventory build-up in anticipation of growth
Extending available runway before equity raise
Financing the supply chain
Import of raw materials / inputs
Financing monthly revenue growth
Equity capital raised must ideally be used towards various growth initiatives, marketing spends etc whereas debt capital must be used to manage the working capital requirements, other operational expenses, and capex. Right amount of debt capital raised would reduce the use of expensive equity capital and ensure an optimal capital structure.