Financing a business depends on a host of factors including the type of business, economic scenario, the stage of the business, and the risk appetite of the promoters. The situation has improved in both debt and equity market but lenders and investors are still cautious.
Deciding on the source of capital to start or expand your business is a major challenge. All businesses—whether they are small, medium or large, face different issues relating to financing. Major issues are control, cost of financing, optimal ratio of debt-equity, history of business, market conditions and future prospects of the business. There are three main routes to finance a business—debt, equity and internally-generated funds (like profits).
| Debt is good when |
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| Equity is good when |
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Equity financing and the current scenario
During the last one year, equity financing has lost its sheen and has not been very successful in attracting customers to invest in equity. However, the recent surge in the equity market is giving out better signals. For example, National Hydroelectric Power Corporation (NHPC) IPO got fully subscribed within minutes of opening. According to T. Jagannadham, head of equity, SMC Capitals, “Revival in the IPO market seems to be round the corner but a company should have a good image, a good business model, a feasible plan, integrity in management, etc to make it a success.” Public offer issue size varies from industry to industry. However, public offers are feasible to meet the requirement of at least Rs 200-250 crore.
Jagannadham points out that in 2008 markets came to a standstill and equity market dried up. But when revival started in April 2009, companies have come up with qualified institutional placement (QIP), American Depository Receipts (ADRs) and Global Depository Receipts (GDRs) and now when the market has recovered and signs are optimistic, companies are thinking of taking the IPO route.
Also, private equity players are getting active now though they are not as active when the markets were at their peak. According to Venkat Subramanyam, Founder Director, Veda Corporate Advisors, “Markets are looking up though the equity markets are a bit volatile. Private equity players have a huge interest in power, healthcare, education sectors and so on and there are chances that their interest will continue in the future.”
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| The right combination of equity and debt is the key in terms of financing. However, this combination varies from industry to industry and the climate in which the businesses are operating.
Venkat Subramanyam |
With regard to venture capital, Venkat points out that VC funding is the option if one needs Rs 20-30 crores and above. However, for this kind of funding, one needs to have a good business, attractive business plan, must be able to articulate and convince and so on. Funding by venture capitalists has gone down significantly during the slowdown but would pick up once the economy revives. Unlike ten years ago, there are now plenty of VCs. Also, there are enough opportunities to tap money from high net worth investors and angel investors.
ADRs and GDRs are instruments to raise capital in America and other countries respectively. In the last 45-60 days, activities in ADR and GDR markets have picked up but the situation is still not good for small companies.
Debt financing and the current scenario
Debt financing is the common mode of financing for small start-ups that cannot attract equity investors. According to Jagannadham, to get the public to invest in debt instruments, interest rates offered on these instruments should be more than interest rates prevailing in the bank industry. For example, if the interest rate on fixed deposits is eight to nine percent then the rate of return on these debt instruments should be three to four percent higher, that is around 12-13 percent. However, he said “to get the public to invest in these instruments, a company should have a good track record, high credit ratings, they should have integrity in the management, etc. Simply three to four percent extra interest won’t justify the public business point and the public won’t respond to the deposit issue.”
According to Venkat, convincing people for debt is relatively easier than convincing people on equity, because equity is capital and high risks are associated with it. Also, banks these days are flushed with funds. So liquidity does not seem to be a problem. Interest payments on debt are often tax deductible, which is an added advantage. Furthermore, debt financing is easy to administer in case of small firms. However, the difficulty faced by start-up in case of debt financing is qualifying for a debt as they do not have cash-flow history, credit rating and often collaterals are inadequate on which loans are dependent.
| Sources of Debt |
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| Sources of Equity |
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Debt norms and interest rates also play a crucial role in determining financing of a business. However, according to Jagannadham, interest rate movements should not be given too much importance. If debt is sought by a business and if that is available, then the entrepreneur should go for that and should not wait for interest rate markets to improve. Venkat says “interest rate is just one part of the whole story. The other important factors are the nature of the business, payback period, returns and optimum debt-equity structure.”
What type of financing to go for?
Most often a combination of debt and equity is considered most desirable for a business. However, the proportion of both varies from industry to industry and firm to firm depending upon the needs of the business like desirability and requirement of control, availability of the kind of finance, cash-flows of the business, the overall state of the markets and the economy.
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| Revival in the IPO market seems to be round the corner but a company should have a good image, a good business model, a feasible plan, integrity in management etc to make it a success.
T. Jagannadham |
Equity financing is advisable for high growth, high risk businesses like newly established entities which have high prospects of growth but at the same time there are fair chances of negative returns or losses. Another source of financing for new start-ups is equity financing from non-professional source like family members, friends, etc. This source of financing is common with small businesses. But equity financing suffers from problems like loss of control, valuation of the company, tax on dividends and so on.
On the other hand, debt financing is recommended for those businesses that have good future prospects or at least stable earnings. For new small ventures, borrowing is a feasible option. Loans from informal markets are another major source of finance for small businesses. Also enough liquidity has been pumped into the banking structure in the past one or two years. Banks are now ready to lend but the only thing is that they are now more cautious.
Financing is highly dependent on the state of the economy and the markets. For example, during 2001-02, only six equity issues by non-governmental public companies were there while the number jumped to 116 during 2006-07 when the market was bullish.
Financing a business either through debt or equity or both depends on a lot of factors. According to Venkat, “the right combination of equity and debt is the key in terms of financing. However, this combination varies from industry to industry and the climate in which the businesses are operating.” Also, financing is situational in the sense that the best source of finance may change from time to time for a particular business due to factors beyond the control of business like interest rates, economic situation, etc. So, the source of finance should be chosen carefully as it plays a crucial role in the functioning and future prospects of a business.
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