Mar122019
Posted by:Sushant Bhatia
When should an early-stage enterprise NOT borrow money?
There are many reasons for an enterprise to borrow money: working capital, capital expenditure, project finance, avoiding excessive dilution of equity. There are also reasons not to borrow. Debt is a good supplement for fueling a business, and like any health supplement, it needs to be taken in the right dose at the right time. Remember, debt is inflexible when compared to equity. There is a fixed repayment schedule that needs to be followed, and even the businesses that seem potential winners might die premature deaths due to an overdose of this supplement. The simple rule for borrowing is to borrow only when one has clear visibility of repayment. While that might appear common knowledge, we still get a lot of queries from early-stage enterprises. Debt for this article means borrowing from formal sources (Banks, NBFCs, Debt Funds).
Why/when should an enterprise not raise debt?
1. The enterprise is yet to see cash from operations. If you have not realized cash from your first few customers, you should stay away from borrowing money, even if you have a sizeable order book that you were able to grab due to great relationships and /or an amazing product built through seed capital and grants. Getting cash in hand is different than revenue. Most B2B start-ups would know the pain of waiting for cash from customers. This wait becomes longer if you have government (or govt-related) buyers. Money raised by issuing equity to friends, family and angel investors needs to be used at this stage of the business. Project Finance is one type of situation, where banks do fund at the stage when cash flows have not started. However, the typical expectation from such situations is that mortgage of the property will be available as collateral and the promoters have significant experience of implementing such projects. If you don’t have either, you need to raise equity.
2. Unproven unit economics Or Gross-margins are not yet positive. The enterprise should focus on getting the unit economics profitable before expanding. The debt should ideally not be utilized towards setting up the core product/service; it needs to be done through funds via equity dilution.
3. Surplus cash-flow from operations enough to fund aspired growth. Ok, you have great customers and a manageable cash-flow that is enough to fuel your growth aspiration. No need for debt! However, it may also be argued that this is the best time to borrow because you have a larger market to tap into. Counter-intuitive?
4. When the cash-in-hand is negligible. The company should have sufficient cash in hand so that it is not in a hurry, and gets the best deal out there. It needs to be done in a planned manner and not as a knee-jerk response to low cash. Often, after having raised equity, start-ups burn through the cash and when they are not able to raise the next round of equity in time (before achieving profitability), they look for debt. While both debt and equity bring cash, they are of very different nature and cannot be thought of as interchangeable. It is not.
5. High Leverage. The balance sheet needs to maintain a healthy Debt to Net-worth (share capital and reserves) ratio, also known as Financial Leverage. This is because a highly leveraged balance sheet puts the firm at the risk of inability to pay down the debt when the time arises. We talked about this in our earlier blog. Most lenders would be wary of a highly leveraged balance sheet, but even if a lender is willing to fund, the venture should be careful, and borrow money only if it comes with the flexibility in repayment.
5. When next fund-raise is the only way of repaying debt. Of course, one can go for bridge funding through debt if the money through equity is a sure shot, and it is just a matter of a few weeks or months. But if the next fund-raise is uncertain (and slight distant in future) and is the only way to repay debt, I would not recommend it, no matter what Venture debt players say. Remember, you raised the debt to grow a little more for getting a better valuation. You would not want to raise funds just to repay the loan; which is unlikely to come at a desirable valuation. Please note, having a signed term sheet doesn’t mean that you will certainly get the funds, it only means that the fund is actively “considering” investing in you and may decide not to fund, after evaluation.