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Debt funding: Addressing mismatch in expectations between yourself and lenders

Debt EquityBy Simmi Sareen,

New Delhi : Scaling up a business is hard work. While launching a start-up and raising initial seed capital is tough, things get more complex once you are past the proof-of-concept stage and are set to scale. The funds to start a business are almost always equity capital, but a business looking to grow is also looking to choose between debt and equity.

For most entrepreneurs, this is their first time dealing with a lender and it can get confusing. Here are the top five questions start-up founders have as they set out to look for their first loan.

* Why should I take a loan?
Because it’s cheaper. Equity capital is dilutive, which means that investors get a share in all your future profits and future valuation growth and expect to make multi-fold returns if things go well.

A loan, on the other hand, has a fixed interest rate and thus will always be cheaper than equity. So whether you take a 12 per cent bank loan or an 18 per cent unsecured business loan, that’s the final cost of the loan to you.

* What kind of loan can I get?
Start-ups usually take loans for working capital. As the business expands, precious cash gets stuck in inventory and receivables. The three most common forms of working capital debt are:

Unsecured Business Loan: This is what lenders call a term loan in which you get a certain amount of loan. Just like a home loan, you pay a monthly EMI.

Invoice Discounting: Receivables are likely your biggest cash drain. In invoice discounting, the lender pays you as soon as you raise the invoice. When your customer pays 30-60 days later, the lender takes his money back. At this point, you have more invoices to discount and hence the cycle continues. This is useful for B2B start-ups.

Cash credit limits and overdrafts: Offered by banks as a line of credit so you can use the loan whenever you need. Typically for businesses that are a few years old and can potentially offer a collateral security.

* When can I get a loan?
Lenders vary in their perception of how soon a start-up can get a loan. But irrespective of which lender you go to, you need to have some cash flows. Remember that the loan has to be repaid, with interest, on time — so the more visibility you have on your future cash flows, the easier it is for you to get a loan. At least six months post-revenue is a good benchmark.

* How much loan can I get?
It depends on your working capital cycle, especially when you are looking at invoice discounting or other cash flow-backed loans. We have found that 1-2 months of current revenue run rate is a good benchmark for most start-ups.

* What do I need to do?
Lending needs paper since lenders won’t spend months with you like equity investors. They need to analyse documents to build trust in your business and your ability to repay the loan. Lenders are only looking for documents you have easy access to; financials, tax returns and bank statements.

Also, whether or not you are planning to take a new loan today, keep your credit history clean. Every lender does a credit check on both the company and the founders. With the credit report in shape and armed with documents that show cash flows your business can make, you will be all set to get your first business loan.

(Simmi Sareen is CEO and Founder of Loans4SME. The views expressed are personal)

—IANS

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