Start-ups require funding for their day to day expenses and also to expand and grow. One of the big funding gap any start-ups faces is to meet their working capital needs. It is broadly defined as the capital of a business which is used for its day to day operations.
A startup can raise money either through equity finance or debt financing. They work in different ways.
Explains S. Viswanatha Prasad, managing director, Caspian, a company that provides collateral free customised loans to professionally managed small or mid-market companies operating in high impact sectors. “The key difference between debt funding and equity funding for businesses is that debt is non-dilutive in nature for the entrepreneurs or owners. When an entrepreneur receives Equity Capital, he or she reduces their own stake and control of the business. Debt gets priority in payments and hence businesses have to bear less cost in comparison to equity.”
Equity is more suitable where the timing of cash flows are not certain like in new product development and filing patents. “When the timing of cash flows is more predictable (working capital, purchase of assets which result in immediate cash flows or bridge where equity is tied up) debt is more appropriate as it helps the business conserve valuable equity,” he adds.
Debt financing thus has several advantages. It is your obligation to pay them back the principal amount with the interest. However, the lender does not have a say in your business , or nor to they get to own a share of your business. You retain the ownership of your company and can make business decisions freely. Also the payments you make to repay your loan can be counted as a business expense, so you can get a tax deduction on it.
Viswanatha explains the various kinds of debt capital and how they work.
Revolving Credit Limit –Revolving Credit Limit is a dynamic financial product which works like a credit card with a fixed limit – you draw as much as you need based on your business working capital needs, pay interest only on the drawn amount and return it when your revenues are realised. Some businesses refer to a revolving credit agreement as a revolving line of credit. The lending institution grants you a maximum credit limit, which you can use to make purchases at any time and on any goods.
Term Loan - In a Term Loan, a fixed amount is provided by the bank to the borrower in order to meet expenses of working capital, capital expenditure or any other business need. The business pays interest on the whole amount and returns it in agreed instalments of principle and interest over a fixed duration of time. Most of our clients tend to prefer Term Loans for meeting their working capital requirements.
Venture Debt- Venture Debt is like a term loan, but businesses are given an option to convert full or part of the loan into equity of the business. This is used primarily by high growth businesses.