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Can a start-up raise debt capital?

Updated: Nov 15, 2024

The Smart Approach to Funding Your Startup: Balancing Equity and Debt


New age enterprises or startups are mostly market innovators and disruptors. However, the underlying business often still requires significant investments in working capital, supply chain (both domestic and international), and capital expenditure for plant and machinery.


The Cost of Equity Capital   Equity capital is the most ubiquitous form of capital, but it is also the most expensive for startup founders. The Internal Rate of Return (IRR) expectations are typically north of 30% for business-as-usual scenarios. While equity investors support rapid growth, founders often dilute their stake with each equity round, significantly reducing their long-term ownership.


The Importance of a Healthy Debt-Equity Mix   To prevent excessive dilution and lower the total cost of capital, it is advisable to maintain a healthy mix of debt and equity in the capital structure. A balanced approach can generate incremental returns for founders and early equity backers, making it beneficial to raise debt right from the Pre-Series A stage. However, many startups equate raising debt capital with venture debt due to a lack of information on other forms of debt capital.


Evaluating Startup Credit Risk   Startups do not fit the conventional debt evaluation framework. Their credit risk needs to be assessed with a refined lens. Traditional security structures such as hard collaterals, personal guarantees, and minimum coverage ratios can make it impossible for a startup to raise debt capital. In the last 2-3 years, traditional debt frameworks have evolved to accommodate the unique circumstances of new-age businesses. While the startup debt ecosystem faces challenges, it is evolving quickly with increasing interest from lenders.


Characteristics That Help Startups Raise Debt Capital

  • Backed by a financial investor or strategic sponsor; completion of at least Pre-Series A or 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 or revenue growth.

  • Decent personal credit profile of the founders with no prior delays or defaults.


Use Cases for Startup Debt Capital

  • Meeting working capital requirements.

  • Financing inventory build-up in anticipation of growth.

  • Extending available runway before an equity raise.

  • Financing the supply chain.

  • Import of raw materials or inputs.

  • Financing monthly revenue growth.


Optimal Use of Capital   Equity capital should ideally be used for growth initiatives and marketing expenses, while debt capital should manage working capital requirements, operational expenses, and capex. The right amount of debt capital can reduce the need for expensive equity capital and ensure an optimal capital structure.


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