DEBT FINANCING FOR BUSINESS FUNDING – WHAT IS IT? IS THERE AN ALTERNATIVE?

February 23, 2024February 23, 2024 Anuradha C Personal Finance

When any entrepreneur ventures out on their own for the first time, they already have a business idea in mind. They also have a small, committed team of friends/colleagues/family members to support them on the human resource front. But most new business ventures struggle when it comes to the third and most critical input to their business – managing finances.

There are several aspects to finance management of a new business entity – initial funding, working capital, purchase of assets and machinery, tax considerations, salary payments and so on.

There are 2 widely prevalent methods of seeking funding – debt financing and equity financing. Most business entities choose a hybrid mix of both these methods depending on their present position.

What is Debt Financing?

When a company borrows money either to fund its capital expenses or to source working capital for operational expenses, it has to be repaid with interest within a stipulated time frame. This is known as debt financing.

When a company chooses debt financing, there is no loss of ownership. A growing business would like to keep all the decision-making powers within the promoters team. When they take a loan for funding their business, the bank or NBFC remains just a passive partner and never interferes in the internal business matters of the company. This is one of the main reasons why debt financing is popular among new business entrepreneurs.

The flip side of debt financing is the massive monthly burden of interest payments. Quite apart from actually returning the principal, the business has to set aside a large component of its monthly earning towards the EMI for the debt. This is especially painful when the business is facing a temporary slump in revenue. Irrespective of whether the business is profit making or loss making, the loan repayment is a fixed part of the working expenses. And that can be a big drag on companies. This was widely seen during Covid days.

Debt financing can be secured or unsecured. This is an issue that occurs if the borrowing business goes bankrupt and is unable to repay. Secured loans can be recovered by the loaning agency through the guarantor who provides security to the loaned amount. On the other hand, repayment of unsecured loans are difficult to enforce during insolvency/bankruptcy, and generally command a greater percentage of interest for repayment.

What is Equity Financing?

Equity financing is about selling a part of the stake in the business to the person/institution willing to invest money in it. So, if presently a business is worth Rs 20 Crore and the business owner is seeking a funding of Rs 2 Crore, it effectively means a 10% stake in the business will have to be sold to the investing partner.

The most important advantage of this method of financing is that there is no interest liability. Businesses can simply invest the funding received in expansion plans and meet their growth plans with ease.

However, dilution of stake in the company beyond a certain percentage means lack of decision-making powers for the promoters. For every critical business decision, they have to get a nod from all their investors. And that could slow down the growth of the company plans. When investors start to demand dividends or returns on their investment, then it adds to the overall management burden of the promoters.

Does a hybrid financing model work better?

Most businesses try to balance the pros and cons of both these funding methods. They may seek partial funding through debt and also sell a small minority percentage equity stake. The goal is to keep the interest component under control and also ensure very little loss of equity or executive decision-making powers.

Is there another funding alternative for businesses?

Yes, there is. Chit Funds – an attractive alternative for businesses to raise money.

Chit funds may sound like a completely different kind of financial instrument. But in many ways, chit funds can help you in getting rid of the loan debt trap, and at the same time not lose equity control over your company. How, you may ask. A quick summary below:

Chit funds by design are a dual-purpose financial instrument. They are an easy mode of saving as well as borrowing.

For known expenses that you are likely to incur in the short to medium term, you can plough in your excess revenue into an appropriate chit fund scheme for a tenure of 2-3 years. So, when it’s time for the actual expense, your money is ready to use! No debt, no interest.
If in the mean-time, you are faced with a financial emergency, the chit fund gives you a quick liquidity option to tide over the crisis.
In a chit fund scheme, even if you pull out the entire amount early, your monthly payments cover both the principal and interest. Thus leaving you debt free at the end of the tenure.
It’s your own money that you are withdrawing at a later date, so there is no external investor. No fear of losing stake or control over your company.

Interested? Want more information? Get in touch with us. We will be glad to help.

About Us

Shanthala Chits has been in the business of chit funds for over 2 decades now. We are a Government approved chit fund company with a 27 year successful track record and thousands of satisfied customers. Shanthala Chits is registered under the Chit Fund Act of 1982, Government of Karnataka. We are one of the most popular chit fund houses based out of Bengaluru, known for our customer satisfaction and secure investments. Get in touch with us and start with an investment scheme. We will be glad to help you out with the right scheme that matches your needs.

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Anuradha C

Anuradha is a freelance writer cum corporate trainer in the IT/telecom domain with over 18 years experience. She served in senior technical and management positions in Huawei and TCS for 10+ years. Then gave up the traditional corporate ladder to go solo - in order to escape horrendous city traffic and to be at her own boss!