Long-Term Funding in Startup - Debt vs Equity and Hybrid Instruments

Long-Term Funding in Startup - Debt vs Equity and Hybrid Instruments . Funding plays a critical role in nurturing and sustaining the startup ecosystem in India. This is essential for driving innovation, creating jobs, and fostering economic development. In this post, Compliance Calendar assesses debt, equity and hybrid instruments, while also highlighting the benefits of investment in startups for investors with varied risk appetites. 
Long-term Funding - Debt and Equity
Over longer terms, the crucial choice that an entrepreneur makes is between debt, equity or a mix of both. Debt financing involves borrowing funds from banks, or non-traditional sources. This allows a startup immediate access to funds albeit with interest costs that must necessarily be paid over the term of the loan. On the other hand, equity financing involves diluting a portion of founder’s equity to investors. The terms of equity often grant flexibility in payment of dividends. However, investors may exercise ownership rights and put in restrictive conditions. 
Using Debt for Funding your Startup
The decision to take a loan for funding your business would require the following considerations:

Accounting for mandatory outflows of principal and interest components of the debt in equal intervals. While this helps a business plan cash flows, it may be unsustainable for early stage companies that may not have enough revenue or capital.

The availability of collateral could be a key decision that influences loans. Non-collateral loans often come at higher rates of interest.

Securing a guarantee - Having an investor/family member/business partner sign up as a guarantor may also increase your chances of securing a loan of a higher amount at concessional rates of interest.

Exploring loans for MSMEs - All micro, small and medium company loans qualify under Priority Sector Lending limits that banks are required to meet. MSMEs may also be able to obtain loans at lower rates of interest under government schemes. For instance, under the Pradhan Mantri Mudra Yojana was launched in 2015, three classes of loans are available. These signify varied stages of growth, development and funding needs of the type of unit that is availing loan. The Shishu loans cover value up to 50,000. The Kishore loans cover values above 50,000 and up to Rs.5 lakh. The Tarun loans cover large companies with loans between five lakhs and up to 10 lakhs.

Equity investment - Funding versus dilution of stake

Equity investments involve buying a stake in the company in exchange for ownership of shares.

The investor becomes a shareholder and acquires a say in the company's decision-making process.

The Companies Act, 2013 extensively covers the process and voting rights for shareholders.

While there are a host of advantages - such as access to a large pool of funds without immediate payback obligations and mentorship from investors, the dilution of ownership stake for an entrepreneur is a crucial decision.

Equity ownership in early stage companies is typically considered more risky than debt.

Angel Investment and Venture Capital

An Angel investor is a high net worth individual investing their own money in startups in exchange for equity.

At a larger level, a venture capital firm involves institutional investors investing in startups that have a high growth potential.

Angel investors and venture capitalists take a bet on an early stage company that looks promising.

Since this is an investment at a rather early stage of the company, most angel investors contribute not just funds, but a valuable basket of resources such as mentorship, networking and management expertise to a startup.

For a venture capital investor, high gains are often coupled with high risks. Some of these include risks of the startup not being able to generate enough revenue to go public and offer an exit to the investor or having too many investors which may lead to decision dilemmas.

iSAFE notes
Assigning a value to a company that is still in its ideation, prototype , pre-production stage or early revenue stage is a difficult and ambiguous exercise for the valuer. iSAFE notes iSAFE stands for India Simple Agreement For Future Equity. These are ideal for companies that have just started out and are in their early stage by benefitting founders and investors alike. SAFEs are an internationally recognised way to raise funds. While it was popular in global markets, the VC firm ‘100X.VC’ is credited with popularizing iSAFE as an investment tool for startups in India. 
The following are the distinct advantages of iSAFE notes as a funding tool:

Allows founders the luxury of time to improve valuation - It offers more time to build the company to boost financial metrics, product, customer base and cash flows. All of these factors ultimately lead to better valuations.

Win-win for founders and investors - It’s an ideal situation for founders as well as investors. Founders can gain without diluting their ownership and building the company to a higher valuation. Investors can get richly rewarded when the valuation rounds are completed. Investors also benefit from the fact that their investment is frozen without any risk of dilution till the fixed price valuation round is completed.

Lesser legal complexities - It’s also a faster and less technical process compared to complex shareholders agreements. It’s also a one-document process that helps startups save on costs.

Convertible notes: A hybrid instrument where debt can change into equity
All startups recognised by the DPIIT, Ministry of Commerce can issue convertible notes. This includes private companies, limited liability partnerships etc. In order to be eligible to issue convertible notes, the entity must not only be recognised by DPIIT as a ‘startup’ but also remain within the definition. This means, the entity should neither have completed ten years from date of incorporation, nor should it have crossed INR100 crores in turnover.
Features of Convertible Notes

Convertible notes are a form of short-term debt that can be converted into equity at a later stage.

It allows investors to invest in a startup without having to determine the company's valuation upfront. It benefits investors by helping them secure a fixed and often high rate of interest and an equity stake later.

Typically, investors convert their debt into equity when the company raises a new funding round.

However, this route is not risk-free, as investors may feel a lack of control. Often, early stage companies may also find it hard to repay debt obligations. A lack of proper deal structuring can lead to financial hassles between investors and other stakeholders at the conversion stage.

Tracing advantages of convertible notes

Quick and easy - One advantage of convertible notes is that they are typically quicker and easier to execute than other forms of financing.

Troubles of fixing valuation are not needed - Convertible notes do not require the startup to agree on a valuation with investors, which can be a time-consuming and difficult process.

Offers flexibility in pricing, valuation - Unlike shares issued at fixed price valuations or debt issued at fixed rates of interest, an advantage of convertible notes is that they offer more flexibility for both the startup and the investors. For example, issuing a convertible note may allow the startup to delay setting a valuation until a later funding round. It also allows investors to convert their debt into equity at a discount to the valuation of the subsequent funding round.

Online Crowdfunding

With the mushrooming of several online startup funding routes, including easy access to loans and pooled investments, online crowdfunding is a novel and unconventional funding source.

This involves raising small amounts of money from a large number of people through an online platform.

There may or may not be upfront fees, but an additional advantage not available via any other funding route, is a wider access by a startup to the general public, which can provide valuable insights on traction, trust and direct feedback from the public.

Systematic Investment Plans for Investors and REITs
Due to the recent rise in ease of investing, thanks to multiple apps - Systematic Investment Plans (SIPs) are now preferred by over 55% of all retail investors. India was one of the few stock markets in the world that delivered favorable returns in 2022. Experts suggest SIP over other equity investment schemes for the following reasons:
- Small, regular investments
- Helps average out returns in a highly volatile market
- Builds a momentum of savings
Traditionally, large caps have done well in India. This was also the preferred option for investors to safeguard themselves from volatility in the market in 2023. It is speculated by experts that 2024-2025 could witness a boom in small and mid caps.
Similarly, Real Estate Investment Trusts is an investment that pools small amounts from investors to fund a larger real estate project. It allows individual investors to contribute to, and earn from large scale projects in housing, construction or similar projects. It also allows large companies to raise funds for funding heavy infrastructure projects.

Funding plays a critical role in nurturing and sustaining the startup ecosystem in India. This is essential for driving innovation, creating jobs, and fostering economic development. In this post, Compliance Calendar assesses debt, equity and hybrid instruments, while also highlighting the benefits of investment in startups for investors with varied risk appetites.

Long-term Funding - Debt and Equity

Over longer terms, the crucial choice that an entrepreneur makes is between debt, equity or a mix of both. Debt financing involves borrowing funds from banks, or non-traditional sources. This allows a startup immediate access to funds albeit with interest costs that must necessarily be paid over the term of the loan. On the other hand, equity financing involves diluting a portion of founder’s equity to investors. The terms of equity often grant flexibility in payment of dividends. However, investors may exercise ownership rights and put in restrictive conditions.

Using Debt for Funding your Startup

The decision to take a loan for funding your business would require the following considerations:

Accounting for mandatory outflows of principal and interest components of the debt in equal intervals. While this helps a business plan cash flows, it may be unsustainable for early stage companies that may not have enough revenue or capital.
The availability of collateral could be a key decision that influences loans. Non-collateral loans often come at higher rates of interest.
Securing a guarantee - Having an investor/family member/business partner sign up as a guarantor may also increase your chances of securing a loan of a higher amount at concessional rates of interest.
Exploring loans for MSMEs - All micro, small and medium company loans qualify under Priority Sector Lending limits that banks are required to meet. MSMEs may also be able to obtain loans at lower rates of interest under government schemes. For instance, under the Pradhan Mantri Mudra Yojana was launched in 2015, three classes of loans are available. These signify varied stages of growth, development and funding needs of the type of unit that is availing loan. The Shishu loans cover value up to 50,000. The Kishore loans cover values above 50,000 and up to Rs.5 lakh. The Tarun loans cover large companies with loans between five lakhs and up to 10 lakhs.

Equity investment - Funding versus dilution of stake

Equity investments involve buying a stake in the company in exchange for ownership of shares.
The investor becomes a shareholder and acquires a say in the company's decision-making process.
The Companies Act, 2013 extensively covers the process and voting rights for shareholders.
While there are a host of advantages - such as access to a large pool of funds without immediate payback obligations and mentorship from investors, the dilution of ownership stake for an entrepreneur is a crucial decision.
Equity ownership in early stage companies is typically considered more risky than debt.

Angel Investment and Venture Capital

An Angel investor is a high net worth individual investing their own money in startups in exchange for equity.
At a larger level, a venture capital firm involves institutional investors investing in startups that have a high growth potential.
Angel investors and venture capitalists take a bet on an early stage company that looks promising.
Since this is an investment at a rather early stage of the company, most angel investors contribute not just funds, but a valuable basket of resources such as mentorship, networking and management expertise to a startup.
For a venture capital investor, high gains are often coupled with high risks. Some of these include risks of the startup not being able to generate enough revenue to go public and offer an exit to the investor or having too many investors which may lead to decision dilemmas.

iSAFE notes

Assigning a value to a company that is still in its ideation, prototype , pre-production stage or early revenue stage is a difficult and ambiguous exercise for the valuer. iSAFE notes iSAFE stands for India Simple Agreement For Future Equity. These are ideal for companies that have just started out and are in their early stage by benefitting founders and investors alike. SAFEs are an internationally recognised way to raise funds. While it was popular in global markets, the VC firm ‘100X.VC’ is credited with popularizing iSAFE as an investment tool for startups in India.

The following are the distinct advantages of iSAFE notes as a funding tool:

Allows founders the luxury of time to improve valuation - It offers more time to build the company to boost financial metrics, product, customer base and cash flows. All of these factors ultimately lead to better valuations.
Win-win for founders and investors - It’s an ideal situation for founders as well as investors. Founders can gain without diluting their ownership and building the company to a higher valuation. Investors can get richly rewarded when the valuation rounds are completed. Investors also benefit from the fact that their investment is frozen without any risk of dilution till the fixed price valuation round is completed.
Lesser legal complexities - It’s also a faster and less technical process compared to complex shareholders agreements. It’s also a one-document process that helps startups save on costs.

Convertible notes: A hybrid instrument where debt can change into equity

All startups recognised by the DPIIT, Ministry of Commerce can issue convertible notes. This includes private companies, limited liability partnerships etc. In order to be eligible to issue convertible notes, the entity must not only be recognised by DPIIT as a ‘startup’ but also remain within the definition. This means, the entity should neither have completed ten years from date of incorporation, nor should it have crossed INR100 crores in turnover.

Features of Convertible Notes

Convertible notes are a form of short-term debt that can be converted into equity at a later stage.
It allows investors to invest in a startup without having to determine the company's valuation upfront. It benefits investors by helping them secure a fixed and often high rate of interest and an equity stake later.
Typically, investors convert their debt into equity when the company raises a new funding round.
However, this route is not risk-free, as investors may feel a lack of control. Often, early stage companies may also find it hard to repay debt obligations. A lack of proper deal structuring can lead to financial hassles between investors and other stakeholders at the conversion stage.

Tracing advantages of convertible notes

Quick and easy - One advantage of convertible notes is that they are typically quicker and easier to execute than other forms of financing.
Troubles of fixing valuation are not needed - Convertible notes do not require the startup to agree on a valuation with investors, which can be a time-consuming and difficult process.
Offers flexibility in pricing, valuation - Unlike shares issued at fixed price valuations or debt issued at fixed rates of interest, an advantage of convertible notes is that they offer more flexibility for both the startup and the investors. For example, issuing a convertible note may allow the startup to delay setting a valuation until a later funding round. It also allows investors to convert their debt into equity at a discount to the valuation of the subsequent funding round.

Online Crowdfunding

With the mushrooming of several online startup funding routes, including easy access to loans and pooled investments, online crowdfunding is a novel and unconventional funding source.
This involves raising small amounts of money from a large number of people through an online platform.
There may or may not be upfront fees, but an additional advantage not available via any other funding route, is a wider access by a startup to the general public, which can provide valuable insights on traction, trust and direct feedback from the public.

Systematic Investment Plans for Investors and REITs

Due to the recent rise in ease of investing, thanks to multiple apps - Systematic Investment Plans (SIPs) are now preferred by over 55% of all retail investors. India was one of the few stock markets in the world that delivered favorable returns in 2022. Experts suggest SIP over other equity investment schemes for the following reasons:

- Small, regular investments

- Helps average out returns in a highly volatile market

- Builds a momentum of savings

Traditionally, large caps have done well in India. This was also the preferred option for investors to safeguard themselves from volatility in the market in 2023. It is speculated by experts that 2024-2025 could witness a boom in small and mid caps.

Similarly, Real Estate Investment Trusts is an investment that pools small amounts from investors to fund a larger real estate project. It allows individual investors to contribute to, and earn from large scale projects in housing, construction or similar projects. It also allows large companies to raise funds for funding heavy infrastructure projects.