The new growth mantra: diversifying sources of capital

Entrepreneurs should keep in mind that diversification of sources of capital is important as it lowers the real cost and provides more avenues for fund raising.
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The three resources which determine the journey of any entrepreneur are idea, capital, and people.

While the starting point of any great organisation is an “idea”, capital is king when it comes to putting things into action. Liquidity is key to the survival and success of any business. A good business can die if it does not get a lifeline of liquidity.

At the initial stages, it’s always beneficial to bootstrap the business with own capital and funds from friends and family. Institutional capital should ideally enter the venture at a stage when there is proof of product and some revenue traction.  

As Richard Branson has said: “Learn to raise capital by any means necessary. That's your primary job as an entrepreneur. You must continually raise capital from family and friends, banks, suppliers, customers, and investors.”

However, the secret sauce is tapping the right type of capital through the entrepreneurial journey. At a seed and early-growth stage, venture capital can provide the initial thrust. However, diversifying the sources of capital is an important capital raising and capital allocation principle.

As rightly said by the guru of corporate finance, Aswath Damodaran, as the business grows, it is prudent for an entrepreneur to explore debt or structured credit options.

US and European markets are very deep when it comes to credit products. In India, there is little awareness of non-bank credit that can be explored. The market is niche, but growing very fast. Banks and NBFCs are vacating the mid-market space due to their cautious attitude.

The mindset as well as the ability to create bespoke solutions to suit the growth phase of the business is the missing middle path that traditional lenders cannot take. Also the wave of startups and unicorns has just started in India, and a different mindset is required to provide credit to this new and emerging category.

Credit has several advantages, if structured appropriately. Not many entrepreneurs understand that the cost of equity is higher than debt. The cost of dilution in a growing company can be significantly high, especially if growth is going to drive increase in valuations on the path to IPO.

Diversification of sources is important as it lowers the real cost and also provides more avenues for fund raising. Further, credit can be structured in a fairly flexible manner to support the stage and requirement of the company – moratorium, pay in kind, coupons only at the time of redemption, bullet repayments, etc.

In 2001, we saw VC and tech investors falling over each other to back startups and late-stage ventures. India saw a record number of unicorns; promoters and management teams made loads of money through ESOPs. But the scenario is fast changing.

The current cautious macro environment is impacting operations and fundraising. There is a flight to safety across all classes of capital. The drop in available pools of private capital is especially stark for late-stage tech ventures. Also, public markets are fickle and the doors to IPOs are not always open.

Further, tech firms globally have lost significant value – Netflix lost over 70 percent market cap in the last six months, while IPOs at home like Paytm and Zomato have lost 40-70 percent value. In such an environment, defending the turf with alternate sources of capital seems to be the way to go for growth-oriented companies, especially new-age tech ventures.

As the market understands the relevance of credit, an ecosystem is emerging for the supply of capital. Earlier, plain vanilla lending was being done by banks. Then came NBFCs like Piramal, Edelweiss, and KKR, which started doing some structuring.

However, with the liquidity crisis, banks and NBFCs have become cautious. Over time some banks like Axis and Kotak are doing selective trades. Most NBFCs are playing it safe by doing small tickets, about Rs 50-100 crore.

However, a new pocket of structured private capital is emerging through funds like Barings, True North, Ambassador Capital Partners, and Investec. While Barings and Investec are credit arms of global funds, True North is homegrown, and Ambassador Capital is a UK-based investment firm with a focus on India. 

These credit funds wear the hat of an investor and provide long-term flexible capital to companies. Their ticket sizes are larger and they can provide solutions across the risk spectrum. They evaluate business like an equity investor and accordingly structure the deal as a combination of debt, equity, and convertibles.

This is just the start for structured capital, and there’s a long way to go.
Edited by Teja Lele Desai

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)