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SME corner

SME corner

pro101As an SME, whether you are a start-up or running a business for some time, you need cash flow to expand your business. As a business owner, you have two options to choose to secure financing for your business: debt financing and equity financing.

These are two very different financing options having their own advantages and disadvantages. They also have very different implications on your business. So we will discuss these two common financing options in this article and help you to decide the ideal option for your business.

What is debt financing?

Debt financing means borrowing money from a lending firm, usually a bank or financial institution. You need to repay the money within a specific period of time, with interest. The lender does not get any ownership or say in your business as long as you repay the loan on time as per the agreed repayment schedule. Generally, for small business, debt financing can be obtained by providing collaterals or personal assets of the business owners. The repayment tenure is 3 to 5 years.

What is equity financing?

Equity financing means getting money from an investor in exchange of a percentage of ownership of your business. In this funding option, you do not incur any debt, so you do not have to repay anything. But you need to share your business profits with the investor time to time. Also, you would need your investors’ go-ahead before you implement major business decisions, be it financial decision or operational decision.

In which scenarios I should take debt?

Debt is a good option of getting funding in the following cases:

  • You have some good collaterals or personal assets like lands etc. In these cases you can get debt funding easily.
  • You do not need a very high amount of money for your business
  • You need money urgently to invest in your business as your business is growing fast. Debt usually takes 1 to 2 months to procure.
  • You need complete ownership of your business and freedom of taking decisions
  • You are confident of generating necessary cash flow in the future to repay off the loan as per the repayment schedule.

Debt financing is an easy option for SMEs to generate funding quickly. In fact, under some Government schemes designed for SME, you can get a debt of 50 lakhs to 1 Cr without any collateral. You can take advantage of such schemes.

If you are sure about paying a debt on time, you can get good credit rating which in turn can help you to get similar funding easily next time. So its better to take an amount of debt, which you are sure to repay off.

The amount of debt you can get is dependent on the amount of collateral you have, your current revenues and your future projections. You can get up to 50% of your collateral or 20-25% of your current turnover which is less. The future projections help the Bank to decide whether to fund you or not. There are also other types of funding where you can get money against bills or debtors.

In which scenarios I should go for Equity?

You should consider an equity funding option in the following cases:

  • You do not have any assets that you can use as collaterals or you are unsure to give personal guarantees to the lender
  • Your business is at a very early stage and so Banks are not comfortable to give you debt
  • You need a large amount of funding compared to your current earning from business
  • You do not want to take any repayment obligations or terms of paying high interest. If you have a business which does not yield cash flows immediately then Equity might be your only option.
  • You are open to advices and at time involvement of investors who can potentially bring expertise and experience to run companies in similar industries.
  • You are open to share your future profits from the business by giving some percentage of your business to investors.

A good equity funding is comparatively easier to get for a new business than debt, but the process of identifying and contacting an investor to finally getting the cash in the system may take 3 to 6 months, or even more time. So, you can go for equity option if you have that patience to go through that process. It’s also better to hire a professional company who can help you get in touch with a potential investor.

The amount of equity fund you would receive is dependent on 4 parameters: growth stage of your company, revenue of your business, profit of your business and future growth prospects.

If it’s a very early stage of business with no product development or operations in place, you may get funds at a valuation of Rs 1Cr to 5 Cr. If you have started the company recently, developed prototypes of your products or you have done some pilot projects, you may get anywhere between 3Cr to 10 Cr. If you have already started generating some revenue, you can fetch more than 5 Cr. If you are already running a business for a while, you may get a funding in multiples of your revenue.

Why debt is cheaper than equity?

In the short term, equity looks cheaper than debt, but the fact is, debt is cheaper than equity in long term.

For example, you can take a Bank loan of Rs 1 Cr at a 15% rate of simple interest. So for every year you have to pay Rs. 15 lakhs as interest. So at the end of 5 years, you would pay in total of 1 Cr 75 lakhs for the debt taken.

Compare that with equity. Say, your business has currently a valuation of 4 Cr and you want to take the same 1 Cr from an investor by giving 20% equity stake. Assuming your business will grow 3 times in next 5 years, after 5 years your business valuation would be 15 Cr. So that investor’s share would be 3 Cr.

So, for the same amount, debt is cheaper than equity in the long run.

How much you spend to get debt financing?

  • You need to put up all required collaterals and personal assets to get a debt funding.
  • It is usually difficult to arrange Debt Funding on our own. A Chartered Accountant or a consulting  firm who helps you in doing all the processing and arrange the fund for you would charge a fees  of the fund raised.
  • You also would need to pay around 12% – 18% of interest depending on negotiation and the lender’s perception of risk in funding your business. Typically a bank or financial institutions would charge higher interest rate from a start-up than a company who has shown cash flows and profit over a few years.
  • You need to start paying back part of your principal after 1-2 years post you receive the fund.

How much you spend to get equity financing?

  • Your primary cost is the equity you give to the investor
  • If you use investment banking firm to get an investor, they will charge a fee  of the final funding amount that you are allotted from the investor. They might also charge some amount upfront to build your business plan and estimate your valuations.

Overall, as we seen in this article, both debt and equity funding options have their own set of pros and cons and in many cases it’s a good idea to have a mix of debt and equity financing. Also how much funds you should raise, how much equity you should give, what sort of debt funding you should take are all difficult questions and needs the help of experts. It’s better to hire a financial advisor firm who can give you valuable advices on when and which financing option to go forward.

SMEJoinup works with many financial firms both debt and equity to help startups and SMEs get funded. Once you fill the Service Request Form, we will give you a call. We will collect the information regarding your requirement, your business and most importantly your budget. We will then find the right financial advisors for you and connect you to the most suitable Financial Advisors.