Indian start-ups have a way to raise funds without losing control of their firms

Indian startups have attracted billions in private equity and venture capital funds from across the world, but loans are another story altogether. Without collateral and often with unproven business models, it’s quite a struggle.

Banks have mostly avoided startups, while the number of private investors facilitating debt financing is negligible. Mumbai-based Innoven Capital, Gurugram’s Trifecta Capital, and Alteria Capital’s upcoming Rs 1,000 crore ($154 million) fund are exceptions.

On November 20, early-stage startup investor Unicorn India Ventures joined this short list with the launch of a Rs 600 crore debt fund. Unicorn India will use the corpus to back around 10 startups across several sectors. This comes two years after the Mumbai-headquartered venture fund announced its maiden Rs 150 crore equity fund. Since 2015, it has backed furniture rental platform GrabOnRent, media company Inc42, IT security and data management firm Sequretek, at-home beauty parlour services company VanityCube, and micro-lending startup SmartCoin, among others.

“The fire in the belly (of entrepreneurs) has been matched by the shared optimism of persons willing to sign cheques to ensure that the dreams turn into reality. But there’s at least one missing piece,” said M Damodaran, a former chairman of the Securities and Exchange Board of India who now chairs Unicorn India. “Startups are getting funding from private equity, venture capitalists, but that’s leading to a dilution of ownership. They don’t want to share the spoils too early. So, the missing piece is venture debt.”

Debt versus equity

So far, equity financing, which involves raising money by selling a stake in the company, has been the norm for Indian startups. The downside is that every time a startup raises equity, the founders have to give up some control. Eventually, in some cases, the ones who started the firm are left with stakes in the single-digits, said Sudip Bandyopadhyay, a managing partner at Unicorn India. Soon, founders lose interest and decision-making powers, leading to failure, he added.

Therefore, after nearly a decade of going all-equity, Indian startups need to add debt to the mix. “Without debt, you can’t continue to run any business,” Bandyopadhyay said. Venture-debt financing provides growth capital to extend the cash runway of a startup while minimising equity dilution.

Typically, even though they prefer debt financing, young firms have a tough time securing it. New Delhi-based The Moms Co, a startup creating toxic-free products for expecting mothers, new mothers, and infants, raised a $1 million series A funding in an all-equity round led by Saama Capital and DSG Consumer Partners in September this year. “As a young and emerging brand, with no profits to show yet, equity was easier to raise. We are hopeful that access to debt capital will open up soon, as we scale,” co-founder Malika Sadani told Quartz. “As founders, we would always prefer debt where we would only be giving up a part of the company we’ve worked so hard to build.”

There are many such examples. Overall, the market potential for venture debt in India is around $500 million per annum, according to Unicorn India.

However, one type of financing is not independent of the other. “The question is not either equity or debt. It’s ‘why should you top up equity financing with debt financing?’,” Zishaan Hayath, founder and CEO of e-learning platform Toppr and an angel investor, told Quartz.

Venture debt turns out to be cheaper as firms can avail of tax benefits on the interest they pay, which is not possible with dividends paid to equity holders. Debt investors are also far less involved in the day-to-day operations. Though they still mentor and provide strategic advice, they give business leaders more freedom than stakeholders who own a part of business and, therefore, partake in the decision-making.

“The negative is that you have to return the capital right now and it’s not embedded in the value of the company…and the interest tends to be very high,” said Hayath. Yet, there are certain scenarios in which a loan makes more sense. “Say you’re a Starbucks and need to set up 50 cafes...or if you need to acquire a company,” said Hayath, “You have your spend front-loaded right now and the returns will come over the next few years. Debt financing makes sense (then).” Typically, debt amounts to around 20% of a company’s equity financing, Hayath added, depending on the EMIs the companies can afford to pay regularly.

For debt financiers, the risk associated with bankruptcy is low – equity holders can potentially lose everything but debt holders have the first claim on company’s assets. Equity holders, however, get a share of the profits and they can exit at a premium within a few years. Debt holders are limited to fixed payouts.

For the founders, all the equity funds can be used without having to repay loans. With debt, they need to ensure cash flow for timely repayment. Racking up too much debt can be costly. So, each organisation needs to find its right equity-debt balance.

In the US, the venture-debt financing wave rose in the 1980s, with estimates pegging the annual market value at between $2 billion and $4 billion today. In the UK, it began in the 1990s and has raised close to £1 billion (Rs 8,615 crore) since. From Facebook to YouTube to Kayak to SoundCloud, none has made it to the top without debt.

This article first appeared on Quartz.