Answers for all the financing questions you had and didn’t know who to ask
Did you know that the biggest challenge MSMEs face today is the question of financing? The questions that keep MSME owners awake at night are how to raise funds, from whom, for what tenor, and at what rates. In this blog, I will give an overview of the types of financing available to MSMEs and their pros and cons.
Money or capital available to businesses can be broadly classified into Equity and Debt. Equity is the money the owners have put into the company on which no interest is paid. In return, the owners get shares in the company and have a claim on the company’s profits in proportion to their shareholding. The other kind of money is called debt or borrowing or loans. Unlike equity, MSMEs have to pay interest on debt, but lenders who provide the debt have no claim on the company other than the interest and the principal.
Another way of classification is based on the tenor, viz., short-term (12 months or less) and long-term (more than 12 months).
Debt Financing:
Types of Debt:
Debt can be further classified as Working Capital Debt and Term Debt, depending upon the use of funds.
- Working Capital Financing: This is debt taken to meet the working capital requirements of the MSME and is a short-term source of funds generally given for 12 months or less. My blog on working capital financing contains a lot more information on this topic.
- Term Financing: This is the kind of debt that is taken for a more extended period and used to finance projects that will yield returns over a much more extended period. Term financing is usually used to set up plants and factories, buy new equipment or replace old or obsolete equipment. Term financing is generally secured by primary security in the form of the assets financed as well collateral in the form of immovable property.
Term Financing is usually repaid in equated monthly installments over 3-7 years. As the credit risk of a loan (the likelihood that the borrower will not repay the loan) increases with increases in tenor, banks like to keep tenors as short as possible. However, the tenor should not be so short that the borrower cannot service the debt and keep the business running. So, the lender works out a repayment schedule that is long enough for the borrower to repay comfortably without increasing the credit risk considerably.
Pros of Debt Financing:
- Debt financing comes with a contract specifying the terms and conditions stating the interest rate, repayment schedule, the uses of the funds, etc.
- As long as the borrower abides by the terms and conditions of the contract and repays the principal and interest on schedule, the lender has no role in the operations of the company
- Interest payments on debt are tax-deductible in that interest is deducted from profits before the tax liability is calculated. This brings down the cost of debt due to the tax-shield effect of interest.
Cons of Debt Financing:
- Only companies that earn enough profits to make interest payments are eligible for debt financing. This means that early-stage ventures do not qualify for debt financing.
- Lenders usually require collateral before providing debt financing. MSMEs which cannot provide adequate collateral will be able to obtain debt financing.
- The potential for financial distress (aka bankruptcy) is very high in companies that cannot make their repayments as per the schedule.
- In case the business is unable to repay debts, the owners of the company may become liable in their personal capacity (depending upon the terms and conditions of the debt financing).
Equity Financing:
Equity is the other kind of capital that is available to an enterprise. By definition, equity is long-term funding in that the providers of equity own shares in the company and are in it for the long haul. The shareholders are not eligible for periodic interest payments from the company but have a claim on the share of profits. The company can pay out a part of the profits to the shareholders as dividends if it does not need the funds for its operations. Should the company decide against paying a dividend in any particular year, the shareholders will have to go without it.
Equity financing can be sourced from private investors willing to invest in the company in exchange for a stake in the company or from the public by going for an initial public offering (IPO). If a company is looking to raise a small amount of equity, the company may choose to tap private investors who may be interested in coming in as financial investors who only provide the capital but play no role in the operations of the company. These financial investors can be angel investors, venture capitalists, or high-net-worth individuals looking to invest in fast-growing MSMEs.
Alternately, the company may also choose to get equity from other players in the industry, their suppliers, or customers who would come in as strategic investors who play an active role in the company’s operations and provide equity capital.
The other option is to go for an SME IPO by offering the public at least a 26.5% stake in the company. More details can be found in my blog on SME IPOs.
Pros of Equity Financing:
- Equity financing is very well suited to companies in industries with rapid growth as debt capital with its collateral requirements may not be able to keep up.
- Since there is no requirement of a fixed payout to the capital providers, the company can retain its profits to fuel further growth until it finds that it can spare money to pay dividends
- Equity can be used to finance both long and short-term uses of funds as equity is the steadiest source of funds in a company.
Cons of Equity Financing:
- Equity is a riskier form of capital when compared to debt. In case of bankruptcy, the equity shareholders are last in line for a share of the assets of the company. Therefore, equity funding is more difficult to raise.
- All shareholders have a say in the running of the company through the board of directors. This may prove to be challenging as all large shareholders will get actively involved in the operations of the company to try and protect the value of their investment.
If you are an MSME that is looking to raise funds and need help in deciding the quantum and type of funds to raise, please do reach out to us at +91-900 855 7845 or at joe@tjconsulting.in for assistance.