Funding, financing, capital provisioning, raising capital, investing in business, securing finance, equity funding, etc are some of the many terms used for the exercise of obtaining long-money for a company. The Indian small and medium businesses find the world of raising finance very complex and perplexing.
Apohan has explained below what is the viable business, what is an unviable business, how not being able to raise capital is not being unnviable, what is capital, how to calculate capital requirement, how to raise capital, what are the sources of capital, what is debt, what is equity, what are the advantages of equity capital, why should you prefer equity, what are the various parameters that one should keep in mind while raising capital, what are the typical misconceptions in the mind of small and medium enterprises in India regarding equity capital, why it is easy for a quality business to raise capital, etc.
Many businesses or business ideas, with the exception of R&D businesses, are not viable because the products and services they envisage cannot be produced with existing methods or technologies or at least cannot be produced economically using the existing technologies. There are some businesses which are not viable because their operations are not practically feasible. Many businesses are not viable because there is no market or hardly any market for what they manufacture and they can’t reach profitable scale. Many other businesses are not viable because their products and services are not available at economic prices.
Some other businesses are unavailable because they do not fit into the legal and regulatory framework of the host country. There are some businesses that are not viable because there is no feasible marketing way to approach and seek the potential customers. Some businesses are not viable because they can’t procure different kind of resources & expertises required for production. Some other businesses are not viable because the management is not capable of stitching together all these required elements to run a business successfully. Many businesses are not viable even if their structures and models, howevermuch refined, fine tuned, would fail because they intrinsically unviable. There is no point in pursuing any kind of these businesses.
You might have wondered why we have not spoken of the the financial angle of the viability. Capital is a very important resource to run a business successfully. Is it possible that a business is viable on all above accounts but is not viable because of lack of capital? Yes, off course. Inability of the management to raise adequate capital in time is also considered as one of the reasons for unviability of a business.
Here, we must make a distinction between two aspects: first that a business is not financially viable and the second that the management is not able to raise adequate amount of capital. These are two are entirely different problems and they need to be addressed in different ways.
A business is said to be financially unviable when it is not able to generate satisfactory returns through the operations at par with the expectations of the people who provided the capital in different forms. In case of some other businesses, it is possible to make the operations more efficient to turn them financially viable. In case of some other businesses, it is possible to make the business financially viable by renegotiating the terms and conditions of the various stakeholders that have provided capital in one or other form. However, some businesses maybe intrinsically financially unviable irrespective of any financial or operational wizardry.
Now, what about those businesses which are not able to raise the adequate capital in first place, forget generating adequate returns as per the expectations of the capital providers? The million-dollar question is can the inability of the management to raise adequate capital be termed as financial unviability? The answer is no! A vehement no!!
Then what this situation can be called? There is nothing wrong with or unviable about the business or its idea but there is something wrong with the actions if not competencies or philosophy of the management. When everything else is alright, shortfall of capital is a very easy to solve problem for a company.
Threshold minimum capital:
Every business has its own intrinsic capital requirement and it is completely unrelated to how much money the promoters have their hand. For every business to be successful, growing, thriving, profitable, rewarding, and scalable (or at least to be barely surviving), it does need a basic minimum amount of capital.
A business just can’t do without that threshold minimum capital. It is not necessary that the capital brought in by the promoters or the institutional lenders is adequate to meet the minimum requirements of a business. If this is the situation in the beginning, the business wouldn’t simply take off. If this is the case at some intermediate point, the business would suffer from financial distress.
Indian SME capital situation:
In almost all the cases of small medium enterprises, the capital available with the the business through all the conventional means and lenders is far lesser than the actual requirement.
There are a lot of misconceptions about the term “capital” among the businesspersons who are not from finance background. This is one of the major reasons why they are not able to estimate the right quantum of capital required for their businesses. many businesspersons misconstrue it as the capital expense made in the beginning at the time of setting up a production facility. Hence, many businesspersons treat capital only as their equity capital & bank loans in the books of accounts ignoring the size of net working capital have any proportion to the capital block.
Working capital too is long-term capital investment
The word capital has a long-term connotation. This leads to a major confusion in interpretation of the capital that has been invested in the business. Additionally, the amount of capital in the business always changes. A prudent business person always must know the the existing invested capital and the future required capital.
So what is capital? In general course of business, capital is the amount of money that cannot be withdrawn and always remains in the business to keep operating it (and keeps on generating returns if managed well).
Apohan provides strategic financing advisory services to compute the capital required for a business. Roughly speaking, it would be sum of the net asset block, various provisions such as gratuity PF, and the net working capital including the minimum required cash and bank balances. A business must make provision of capital before a liability is due for payment. It also should make provision for additional capital to make provisions for expenses on on the business initiatives.
Additionally required capital:
An incremental capital is required by a business to undertake new growth initiatives, to fund additional requirement of working capital, to undertake new projects, to repair the loans, to replace old equipment, to make provisions for certain unpredictable events, to recoup certain business losses, to expand the scale of business, to undertake new initiatives on strategic front, to acquire companies for business synergies, etc.
Amount & time:
It is important to understand both the quantity as well as the timing of requirement of the the business capital. Taking into account both of these and investment schedule needs to be prepared.
The options for raising capital are numerous. Some of them are from internal initiatives. Some other are from external resources. Apohan is listing here various sources & initiatives of capital that are available to a business for various activities it can undertake to make available a question of capital.
Promoters’ equity capital
Equity capital from non-promoter initial shareholders
Equity capital from directors
Equity from general public fruit initial public offer (IPO) for follow-on public offer (FPO)
Private institutional equity
Private individual equity
Wealth management companies
Purpose specific equity funds
Seed funding, angel funding, venture capital, crowdsourcing
All other forms of equity
Other institutional loans
Loans from friends and family
Credit from various types of funds that lend businesses
Preference equity capital
Interest free loan from directors
Inter corporate loans from related companies or and related companies
Interest free advances from several stakeholders
Project Finance with minimum margin money
Working capital finance
Unsecured personal loans by the directors
Loan against pledged shares by the shareholders
Grants from government or private institutions
Financial benefits from several schemes of the government
Area specific incentives by shifting operations
Foreign currency loans through external commercial borrowings
Foreign currency bonds
ADR and GDR
Foreign direct investment
Refinance benefit through shifting loan to a bank with better terms
Changing the nature of capital instrument
Enhanced credit from the same bank or different bank
Extending repayment period
Rights issue to the existing shareholders
Reduction in dividend payouts
Reduction in overheads
Reduction in compliance consultancy costs
Reduction in directorial remuneration
Reduction in remuneration of key managerial persons
Mergers and acquisitions and other types of business transfers
Demergers and divestitures some verticals of the business
Sale of strategic assets or fixed assets
Dropping Greenfield and brownfield projects
Shutting down unviable projects and product lines and project locations
Stopping the research and development works
Disposal of inventory
Liquidation of investments
Selling the real estate and leasing back
Leasing plant and machinery instead of buying them
Leasing key tools
Selling the brand or similar intangible assets
Franchising or reducing the role in value chain
Past internal profit accruals or reserves
Revenues or payments from clients or income from operations
Advances from clients
Increase in prices
Increase in operating volumes
Bidding through joint ventures if the company is not eligible standalone
Shortening the cash conversion cycle
Exploring more profitable markets
Engaging in contract production by outsourcing the capacity to other brands
Exploring exports and international business
Exploring new businesses new products replacing the existing ones
Increased credit amount & period from suppliers
Employee stock option plan
Finding alternate economical competing suppliers
Balancing between cash flow timings and net life cycle cost of procurement
Layoffs and salary cuts
Reducing the marketing costs
Suppressing the supply chain margins
Lowering the quality standards removing the unnecessary features in the products and services
Outsourcing management services to reduce corporate overheads
Outsourcing labour services to reduce long term liabilities
Limited resources to raise capital
We can see that there are a plethora of options for capital funding available with business. Not all the options are available with each of the businesses. If you rank all these options in the order of preference, one would find that most of the practical, feasible and available options are already exhausted. many measures suggested above are not practical for small and medium size of businesses. Also, the management of these small companies is not experienced in carrying out this type of “capital creation activities”. They may not have sufficient time for these activities as the leadership team is very very small. The remaining options either do not provide adequate amount of capital or are having unreasonable conditions in terms of cost of capital, interest rate, term of repayment, requirement of security, etc.
Banks don’t understand business:
Financial institutes such as banks are simply incapable of understanding the quality of Management and the financial merit of a business. They simply go by the rule book and refuse capital to small businesses. Each of the financial resource has its own criteria of selection of the borrower or customer and they have their own procedures for availing the funds. Small businesses are not aware of the complexities of the financial world. Note that in the opinion of the management of the business, the business is an attractive investment, but this argument is not bought by the financial institutions. It is the reality of the world that deserving businesses also remain deprived of capital.
Role of Apohan
Now, this is a serious time to explore equity funding. Apohan shall provide you end to end customised service in availing equity funding.
The fruitfulness of revenues of a business are captured in terms of profitability and the fruitfulness of and business investment is captured in terms of returns or yield. These two terms need not be confused with each other. The money is seen as capital from the business perspective and as an investment from the investor perspective. It is important to bear in mind these two perspectives while analysing aspects of capital. It is desirable that the terms and conditions of availing capital are written down in an explicit contract rather than later bickering on them. Apohan helps a business in jotting down a professional balanced investment contract with its investor such that all of its interests are taken care.
List of Aspects:
Following is the list of the aspects or questions of the key considerations in the the financing contracts:
These are the aspects of business should analyse before selecting a type of capital source. Every fund source has its own advantages and disadvantages. Depending upon the circumstances of the business, confidence in profitability and growth, confidence in ability to repay or give satisfactory returns, affordability, amount of capital required, probability of default, etc, a business should carefully select fund resource. Apohan will compare debt and equity options in a separate section to guide a business the specific situations in which it should go for equity funding.
Maximum wealth is invested with very poor returns
You may be thinking that most of the investors putting their money where there is maximum rate of return for highest yield on their investment. To your wonder you will find that the real world scenario is exactly opposite. Maximum wealth or money in this world is invested in the assets that have hardly any attractive rate of return. You can find many statistics on this on the internet. Then, what are these other aspects that govern the psychology of the investors?
Business equity investment risks:
The first aspect is risk of the business investment opportunity. Apart from ethics, transparency, competence, quality and intentions of the business’s management, there are many other internal and external factors that govern the ability of a business to generate sufficient returns or to keep the investor capital safe. Another aspect is liquidity. A private limited business is the most illiquid asset among all asset categories, even more illiquid than real estate. There is no ready market to sale a private business. Very few people understand buying and running a private business. Another aspect is duration of investment. Equity investment cannot have a duration of investment. That is why financial investors are very particular about the exit clause in the investment contract. Strategic investors are least bothered about the duration of investment and their main interest is to keep on growing the business forever.
Control of management
Another important factor that investors Looks for his control of the organisation. Why the original promoters and management is more acquainted with the business and very well network with all the stakeholders, they can’t be done away with for running the business successfully. However, new equity investor may perceive risk of siphoning of the fund by the people who were call controller of the business before his entry. That is why an investor may seek to appoint himself or his nominee directors on the board of the company and monitor the financial and operational activities. Another reason for control is decision making power in case of differences of opinions or frictions among various shareholder groups.
Rigorous due diligence:
An equity investor would also require sufficient time to carry out all the due diligence and mobilize all the requisite funds. An investor would expect the business to be flexible enough accept the business structure and capital structure related suggestions. Certain investors have inclination for certain sectors or products or geographies. Some other investors are guided by investment philosophies, i.e. no investment in vice businesses such as alcohol or investment only in basic human needs such as food & health. Certain institutional equity investors very huge chunks of funds and they are limited by their ability to assess small businesses. Hence, businesses invest only more than a certain minimum investment ticket size.
Importance of valuation
Finally comes valuation of the equity. While equity investors are flexible in general and flexible on many of the parameters discussed above, the ultimate objective of an investment is to multiply the capital in the shortest possible time. The value of a business is not based on the market price of the individual assets in the business at the given moment. It is based on the ability of the business to generate additional cash which is many more times the capital infused in the business from time to time. First of all, the business and the equity investor need to reach an agreement on what is this value the business can generate in its future lifetime if equity funding is done.
Importance of investment contract
Note that we are not discussing share purchase between two individuals which will have no impact on the cash position of the business. Before entering and investment contract, the business and the private investor shall discuss and negotiate the ratio of their monetary and non-monetary contributions towards this value, their rights, obligations, assets, liabilities, risks, relative bargaining powers, alternate options, market trends, etc. Both the parties should feel that the transaction is mutually beneficial. While the business gets all the capital to undertake all those activities that were otherwise beyond its control and the investor gets an opportunity to grow his capital at a much faster pace than it was growing previously.
Available in distress as well
The biggest advantage of equity capital is that it could be available even in the worst circumstances of a business. Equity funding is provided based on the the intrinsic potential of the business and merit of the offer. Request for equity funding may not be rejected only because a certain rule book doesn’t permit to do so. Equity funding is also very useful when a business suffers a one time misfortune and has potential to turnaround and excel again.
No stress on cashflow
There is no fixed guaranteed, permanent, periodic return on equity funding. Hence, the business has no tension of of monthly repayment of any interest amount.
No repayment, exit provision for some
More importantly, the capital provided need not be returned at any point of time in the future to the investor. There is no requirement of any guarantee or any security.
No restriction on amount
Practically there is no limit on what is the the maximum amount that can be availed. There is no risk to the corporate assets or personal assets of the original promoters even if the business fails. This is because the equity investors joins on profit sharing and ownership sharing basis.
Benefits of synergies and financial experience
If the investor joins in management of the company, his experience in financial management it and corporate management may come handy and the business may become very professional. Equity funding is very useful in preparing the growth projects when sufficient amount of fund is not provided by a bank.
The organic growth of business through internal accruals is very slow and equity funding provides avenues for rapid growth of a business. There is no specific term of equity funding and hence even if the growth initiatives are delayed, even if the projects take longer than usual, there is no question mark on the existence of the company.
Hectic due diligence at entry
Unlike bank loans, equity funding is provided after a hectic due diligence of the business. The investor satisfies himself assessing the technical, marketing, business development, intellectual property, brand value, legal, financial, corporate, regulatory, human resource, contractual, etc aspect in detail through a hectic due diligence. This is because once the equity is provided the investor has to be here all the risks of the business without any recourse. Hence, it is very difficult for an unprofessional, incompetent business without any profitability or growth potential to get equity funding form third-party unrelated investors.
Sharing of control and financial fortunes
From the perspective of the previous shareholders, investment dilutes their ownership and control of the company. They have to share all the fortunes with the new investors in a fixed proportion. If the parties have not entered into a professional shareholding agreement and if they have not defined the roles and responsibilities of each of the individuals, equity funding may bring in friction in the board of directors and shareholders of the company. The decision making in the company may not be smooth.
Role of Apohan
Apohan provides corporate management services to businesses to draft professional shareholding agreements and implement a decision making mechanism. Disharmony in the board or among shareholders is not the intrinsic demerit of equity funding, but it is indication of incompetent management. Generally, the cost of raising equity fund is higher and the time frame required to complete the process is longer.
We are covering these for completeness sake & to give an Indian SME business the clarity of comparison.
Usually a business should prefer taking a bank loan if the same is available in the adequate quantity and on right terms and conditions in place of equity. This is mainly because typically loans are cheaper than equity. The return on equity is typically much higher than the interest rate on a loan. Because of equity funding a business ends of sharing its fortunes with the investors for eternity. The same is not the case with a loan. Also, the bank don’t interfere in the day-to-day operations of a company. Getting a bank loan is a standard procedure with minimum documentation, shorter time frame and relative lower cost of the process of raising debt fund. Banks don’t do rigorous due diligence of all aspects of the business and follow a simple rule book.
Stress on cashflow
The biggest disadvantage of a bank loan is the fixed guaranteed periodic interest payment and repayment of the principal amount. Don’t understand circumstances of the business and any non payment is considered as default.
Eligibility is rule based & not merit based:
Don’t look at the merit of the business, quality of the management or potential of the business sufficient criteria to lend. They must be provided some or other type of security on margin money which becomes a serious limitation on the amount of fund that can be raised. As an institutional lender, bank officers have very less flexibility in processing the loan applications and they made turn down and application even for frivolous reasons. They will not provide loans to new businesses for businesses with poor credit history. Technically, a business is a client of the bank but there is hardly any tendency to sell more.
Personal property as security
In India, there is good degree of corruption in the sanction process. The corporate form of business is to basically segregate the the owners from the management of a company in terms of any rights and liabilities. But the bank requires the promoters and the directors are the shareholders to provide personal guarantees putting their personal properties at risk. We can see a number of cases in the market, where the banks are auctioning the personal assets of many businessmen. The plight of such honest businessmen is the last thing one would like to see. The phenomenon of these options discourages a layman from undertaking any business venture.
Not available in hard times
Another aspect of bank loan is that it becomes more difficult to avail any money in difficult times. So banks are only good weather friends. In the history of long existence of a business, they do suffer a once in a lifetime misfortune due to circumstances beyond control of management. The business is still very much viable if certain relaxations or or additional credit is provided. The worse the situation of a business, the worse the behaviour of a bank! Payment to bank takes the first priority, and if a good opportunity is is passing by, the business cannot use its money to pursue that opportunity. Occasionally, this does cause a very serious opportunity loss to a business. Bank loan repayment in most of the cases must start almost immediately. For businesses with a long gestation period, this becomes as good as borrowing from the bank to pay the bank.
Banks are very rigid when it comes to provision of enhanced credit or credit with second charge even if the value of the security has increased. The financial expertise is of the banks is of absolutely no use to a business. The rules of the banks are very stringent when it comes to to providing better terms on request of a borrower. It is most likely that most of such requests are rejected by the bank. Bank is simply not bothered with the cash flow situation of the seasonality of a business. They are very particular about the date of payment of the installment amount. One may lead to think that bang doesn’t interfere in the day-to-day operations, but when a business defaults the bank takes complete control of the business intends to be driven by the sole objective of realising its own dues without any regard to future of all other stakeholders of the business. A bank does not have business competence, and hence mostly fails to to sale the business as a going entity. This results in liquidation of a business resulting in huge economic value loss. Banks are protected by a very solid legal framework and the entire machinery of the state for law and order is there hands to recover the dues.
No difference between wilful and innocent defaulters
One more disadvantage of bank lending is that the banks cannot distinguish between wilful default and a circumstantial default. Their treatment of the good, bad and the ugly is the same. This leads to emotional and psychological distress of a genuine businessman. The banks have their own rules of sector exposure, single account exposure, etc. With the increase in Corpus of the loan amount, the process of bank loan becomes equally tedious as equity funding. The small local, rural, cooperative, district, urban, etc banks have relaxed credit norms but their interest rates are very high. This kind of disadvantages more or less apply to all other types of institutional lenders.
Apohan helps a business in negotiating the bank loan contract and having a successful borrowing strategy. However, unlike we provide end to end services in equity funding, we don’t provide end-to-end services for business loans from banks and other institutions. Apohan’s unique selling point is its ability to successfully generate equity funding.
Aspects such as documentation
Miscellaneous reasons for no equity funding
Many businesses are simply not eligible for many of the external equity funding options. Businesses continue to remain under financial duress without exploring the option of equity finance.
Nature of Business
opportunities expire and hence must be tapped creating infra — no regard for control
Only cliennts pay
earns cash at constatnt rate hence postpone payment time
Each business is unique
Money is denomination of …
Time aspect of capital
Growth & Ownership & control
Internal accruals & M&A ; time aspect
Growth & control
Sharing of ownership of the profits
Sharing of the control of the operations
Sharing of control of the decisions
Private Limited business is the most liquid asset more liquid than really state
It is only the client who brings net cash to the business
Capital has a a long-term cannot intrinsic to it
Short term capital deficit needs to be made and is called net working capital
Business is not a consumable good and has intrinsic zero value
It must keep operating to generate consumable value
Unknown operating business keeps on building liabilities
Business must have a request cash to meet all the liabilities and requirement
Money is denomination of all the transactions it has no intrinsic value
Excess money in the business is also not good
There are a variety of options to make available finance for a business. All of them come with certain advantages and certain disadvantages. For all practical purposes, no business can avail Finance at unreasonably low cost and terms and conditions.
Most of the Indian businesses are capital starved. There are a lot of misunderstanding and misconceptions about availing Business Finance in Indian Business communities. This misconception start from not availing any external finance at all to not exploring any equity options.
It is not possible that a business will not happen only because there is no capital.