The Reserve Bank of India (RBI), in its recent circular dated 4th September 2020¹ has brought startups under the purview of Priority Sector Lending (PSL). As per the current regulations, an entity is considered a startup if it has been in existence for not more than a period of 10 years from the date of incorporation and if its annual turnover has not exceeded INR 100 crores in any preceding financial year².

Priority Sector Lending refers to lending to specific segments that have traditionally been unable to receive timely and adequate access to debt capital. These sectors, such as agriculture, micro and small and medium enterprises (MSMEs)³, renewable energy etc., are quintessential for an economy’s overall growth. The Government and the RBI, in an effort to ensure timely credit flow, have mandated banks to lend a minimum of 40% of their Adjusted Net Bank Credit⁴ to these segments. This has helped entities operating in these segments raise adequate debt at affordable pricing.

The revised guidelines provide for PSL classification for loans up-to INR 50 crores extended to the following categories of startups: 

• engaged in agriculture and allied services
• entities that conform to the definition of MSME and
• others – provided they meet the startup definition criteria

Current debt landscape for startups

Primary sources of debt for the startup ecosystem has been:

• Venture debt
• Invoice discounting by Fin-techs
• NBFCs
• Banks

Venture debt has been an important financing avenue for startups in India. Venture debt comes with warrants (i.e. the right to subscribe to a company’s shares at a later point), which gives investors a possible equity upside along with the fixed income returns in the form of interest. Venture debt is typically availed by borrowers along with/ close to an equity capital raise. This allows startup founders to retain ownership in the company (viz. diluting more by raising additional equity). Loans typically have a tenor ranging between 18-36 months with a monthly amortizing structure.

In a pandemic struck world, with equity investors getting selective, credit flow from this channel could slow place; albeit temporarily.

Invoice discounting is a source of short-term working capital financing for startups. This is done by unlocking the capital tied up in unpaid invoices. This has enabled startups manage their working capital and has helped them free up equity capital. These offerings however attract high rates, making them less alluring in the long term.

Banks and large NBFCs financing have eluded startups as these companies do not fit the traditional underwriting framework. Key reasons include limited business vintage, first generation entrepreneurs as promoters with limited personal assets, absence of collateral, lack of profitability track record and external credit rating. Further long-term finance has been a challenge for asset light companies (absence of hard assets such as land, building and heavy machinery) despite strong cash flows. That said, some of the larger NBFCs and Banks have selectively taken short term exposures on some of the bigger startups in the recent past. This is through their Cash Credit (CC) and Bill Discounting (BD) offerings. CC products however require startups to lock in their high cost equity capital in fixed deposits as margins. This is a deterrent for companies in a growth/cash burn phase. Further, banks are open to discounting bills of only higher rated anchors/parties, leaving startups scouting for additional working capital funding channels.

What does this mean for Banks?

Lending to emerging businesses requires a tweak in the diligence process of banks with a nuanced understanding of every business model, its unit economics and its path to profitability. Typically, startups incur losses in their formative years as they front load costs to build a strong team and a technology enabled system to bolster revenue growth backed by equity capital. Thus, this necessitates banks to adopt a slice and dice approach to understand margin profiles better. It also requires close monitoring on a periodic basis viz. the annual exposure review done by banks. Banks would need to build dedicated teams with the required expertise to assess and monitor these businesses closely.

A sizeable opportunity for Banks

Venture Capital (VC) investment in India has grown at a robust pace with USD 32 billion⁵ being infused into 3,500+ companies over the last 5 years. India focused VC funds continue to garner strong interest. This provides an enormous opportunity for banks to cater to emerging businesses with strong corporate governance structure and unit economics. These startups also have a sound reporting framework which provides transparency and comfort with respect to internal controls and corporate governance. A bank’s strong control over a borrower’s operating cashflows bodes well for them as they can structure and monitor their exposures effectively.

Apart from building a good quality loan book, banks can offer cash management and other associated services to build its liability book. Catching these companies’ young gives them exclusive access and ensures long term stickiness. Also, as these companies scale up, banks would be favorably placed to cater to their growing requirements on the asset as well as on the liability side.