The Economics Behind: Integrating debt into the capital mix [Startup Debt Series - Part II]
In most discussions regarding funding for early-stage startups, the predominant focus is always on equity. Within the Indian startup ecosystem, equity plays a crucial role in fostering an environment conducive to the growth of new ventures. It serves as the lifeblood of a company, enabling it to establish its foundation during its formative stages. This process allows companies to develop gradually, experiencing and learning from early challenges before achieving stability and growth.
Equity financing also has certain advantages over its counterpart, debt.
- Equity financing does not impose fixed repayment obligations with undesirably short tenures
- It does not restrict the use cases for which the funds can be utilised, so long as they are integral to the growth of the business.
- Additionally, equity financing does not include onerous covenants that could limit growth prospects,
- Nor does it require personal guarantees from the founders as collateral.
However, with great equity comes great responsibility!
When a startup integrates equity into its balance sheet, it assumes both the financial investment and the associated liabilities related to investors' interests and expectations. Although not always explicitly stated, equity investors generally seek a predetermined return on their investment, commonly known as the equity cost of capital. In exchange for capital infusion, founders typically must relinquish a substantial portion of the company’s ownership. Additionally, founders are often required to consult with external investors on major strategic decisions, which, despite seeming like a constraint, can be advantageous. The liability associated with equity capital persists until investors have received their invested capital along with a substantial return.
The purpose of the preceding discussion is not to pit one form of funding against the other but to highlight the potential synergies that can be achieved when both equity and debt are used in a balanced manner.
Debt is not a substitute for equity but rather a complement to it.
Should You Integrate Debt?
Beyond the previously discussed pros and cons of debt financing, the suitability of this approach for a startup will depend on the specific purpose for which the debt is being raised. Debt financing is generally not an appropriate source of funding for the initial exploratory phases of defining business models or for the research and development of a product.
Debt financing should be considered when a startup seeks to scale a business model with stable and profitable unit economics or has a specific use case justifying the need for debt.
Use Cases for Debt
1. Debt as a Substitute to Equity in Working Capital Management
Most startups struggle with managing working capital. Accumulation of customer receivables, a lengthy production cycle leading to an inventory buildup, and the requirement for upfront payments to suppliers all contribute to a challenging working capital cycle. This cycle, coupled with fast-paced nature of a growing business, results in significant cash blockages that early-stage startups cannot afford.
Let's understand the cost to the company basis an example:
Company X is a health supplement brand engaged in the production of protein bars & powders. It sells its products exclusively to offline retail stores in major cities.
With a credit period of 15 days offered to stores (days sales outstanding), average inventory holding period of 16 days (days inventory outstanding) and average credit period provided by suppliers (days payables outstanding) of 10 days, the company is engaged in an average cash conversion cycle of 21 days.
If the company generates sales to the tune of ₹1,000Cr in a fiscal year, with COGS of ₹400Cr, and other cash costs of ₹300Cr, the company’s working capital requirement is estimated at ~₹40Cr.
Without Working Capital Facilities (fully Equity financed)
In the above scenario, assuming the company does not avail working capital financing, the company’s stands to lose ₹8.80Cr each year in notional/opportunity cost loss on account of equity financing (Implicit Cost of Equity is assumed to be 22%).
Working capital financing can be raised to help a startup alleviate cash constraints and meet all short-term expenses, including inventory, payments on short-term debt, and day-to-day operational expenses. Working capital is critical for maintaining smooth business operations and meeting financial obligations, as it adapts to the fluctuations in operational expenses while offering a comparatively lower cost of capital.
Let’s look at the same example with the inclusion of working capital financing
With Working Capital Facilities (Overdraft)
Assuming the company avails OD facility at an average cost of 12%, finance cost arising out of the aforementioned working capital requirement transpires at ₹4.80Cr economizing the company by ~45%.
Such a reduction in overall cost of capital enables startups to instill confidence in investors by optimizing the return on capital employed [ROCE is an important meaure of the capital efficiency of a company] and would also result in extended runway as equity reserves are not blocked in the working capital cycle.
2. Debt as a Means to Extend a Startup’s Runway
While the equity funding downturn persists, many startups view debt as a default option to strengthen their balance sheets and extend their runway. However, this assumption is fundamentally flawed. Debt financing typically follows equity financing, with lenders deriving comfort from the amount of equity capital to mitigate risk exposure. Consequently, a low equity runway often reduces access to high-quality debt opportunities.
Nevertheless, raising debt in the form of a term loan can extend a startup's runway considerably. There are several reasons why a startup might delay entering the equity markets to raise funding and look to debt as a viable alternative:
- Limited accessibility to equity due to the ongoing funding downturn.
- The desire to meet certain operational and financial targets to enhance its competitive position in the market.
- A bridge to profitability if the company is nearing breakeven, thereby eliminating the need for further capital infusions.
- Unnecessary dilution of the founders' ownership position on the cap table
Term loans from banks and venture debt play a crucial role in helping startups extend their runway.
Using the same example of Company X, let's understand the use case for runway extension:
Company X is a venture-backed company and is looking to raise its Series D round of equity funding having raised its Series C at a post-money valuation of ₹4,500Cr.
If Company X at present has cash & cash equivalents of ₹300Cr, with an average monthly net burn of ₹31.25Cr, the company has an effective cash runway of 8 months [setting aside a buffer cash reserve of ₹50Cr] and needs to raise fresh equity capital to sustain its operations by the end of the eighth month. Considering the stage of the company and its growth plans, the company would need to raise and close a prospective Series E round. Company X’s fresh round relies on the company meeting the following target-
# Reaching an ARR of ₹1,500Cr (the company currently is at an ARR of ₹1,200Cr, and with the company’s current CMGR at 1.73%, the management expects to reach the target in 13 months)
Thereby, owing to the lag of 5 months, Company X shall avail runway extension financing [term loan] as a form of bridge financing which shall in turn assist the company in achieving the targets it desires in order to achieve a successful future fund raise.
A lag in 5 months [inclusive of a margin of safety] dictates a requirement of ₹164.47Cr in debt inclusive of the finance cost arising from availing the runway extension debt [₹156.25Cr burn for 5 months + ₹8.22Cr finance cost at 12% p.a for 5 months], averaging at a post-burn of ₹32.89Cr.
By avoiding a bridge equity round, the company mitigates the risk of diluting its shares at the company’s prior valuation or lower and positions itself well to raise a successful round at its desired valuation, having met the targets predetermined.
3. Debt to Facilitate Asset financing
An often overlooked aspect of a startup’s cash flow management planning is asset-liability management (ALM).
When a startup's economic model necessitates substantial capital expenditure on fixed assets, its cash balances are likely to experience considerable strain, causing a mismatch between the lifespan of a fixed asset and the company’s ability to fund that asset over its useful life.
Startups also generally raise equity capital for periods ranging from 24 to 36 months. However, outside of the ALM mismatch, significant cash outlays for machinery or other essential assets can critically deplete cash reserves, thereby necessitating another round of equity funding.
Asset financing provides a solution by enabling businesses to acquire these vital assets without placing further stress on their cash flow. This financing product allows a business to use the assets on its balance sheet as collateral to fund the acquisition.
Popular debt products under the asset financing model include:
- Sales and lease back
- Term loans matching the economic life of the asset to be purchased
- General financial or operational lease
In continuation with the earlier example, Company X intends on purchasing a line of machinery for the purpose of packaging its products. With primarily two options on its table, it may either choose to leverage debt to finance the purchase or use cash reserves from its prior equity raise [the option to use lease financing does not exist for the company since the equipment is of specialized nature]. The economics of each of the above case are laid below:
Company X wants to purchase the equipment for ₹8Cr.
Without Term Loan (fully Equity financed)
Company X would expend ₹1.76Lakhs p.a in notional cost of capital and ₹5.28Lakhs over 3 years at an average cost of equity of 22%.
With Term Loan (Debt financed)
Since the purchase price of the asset is ₹8Cr, assuming that banks provide asset-financing loans with a loan to value [LTV] of 90% on the secured asset, Company X would expend ₹0.90Lakhs in finance cost p.a, at an average rate of interest of 10% p.a on the term loan portion and 22% p.a on the remaining 10% of the cost of the asset [Term loans for the facilitation of a purchase of a secured asset are typically offered in the range of 9% p.a to 11% p.a.]
Thereby, assuming that the loan tenure is a standard case of 36 months [the economic life of the asset], the amount of expenditure incurred towards the purchase of the asset would actualize at ₹2.69Lakhs over a period of 3 years.
In financial cost savings, by leveraging debt to finance the purchase of equipment, Company X stands to save ~49%.
In addition, by availing debt for the purchase of the aforementioned equipment, Company X does not alter its runway cycle and the requirement for dipping into the company’s buffer reserves is removed.
4. Debt Used as a Leverage for Acquisition Financing
Acquisition financing pertains to the capital obtained by a company with the explicit purpose of acquiring another company. Several methods are available for financing acquisitions, including:
- Equity through fresh issuance
- Share swap
- Cash acquisition
- Leveraged buyout
- Debt
Each of these methods serves as a viable option for purchasing a company. Nevertheless, debt is frequently regarded as the most economical option to facilitate an acquisition.
Back to Company X, which seeks to acquire a company (target company) involved in the production of packaged food and beverage products in an attempt to backward integrate its operations, thereby establishing control over its supply chain and quality operations. The acquisition of the target company is projected to materialize at an enterprise value of ₹200Cr with Company X purchasing all of the target company’s existing shares (100%) in a cash takeover.
The company may execute the above transaction by either opting for a further equity raise specifically for the acquisition, or by leveraging debt to facilitate the investment.
In the event of an equity financed deal, assuming a notional cost of equity of 22% p.a, finance cost for a year effects at ₹44Cr p.a
In case the same deal is financed by a debt raise, the financing cost for the same purpose is significantly lower, at ₹20Cr p.a.
Over a 36-month timeline [since leveraged acquisitions take upwards of 2.5 years to mature], the differences in finance cost between the above modus operandi grows excessively large [₹132Cr - Equity; ₹60Cr - Debt]
Conclusion
Whether it’s to extend your startup’s runway or preventing an asset-liability management (ALM) mismatch, debt plays a crucial role in the capital mix of your company. Through proactive planning and efficient utilization of debt, complemented by the existing equity on your balance sheet, startups can optimize their capital structure, enhance their competitive position, and achieve sustainable growth. This balanced approach enables early-stage companies to navigate financial challenges, seize opportunities, and attain long-term success.
