Startup Finance 101: When should you approach banks?

As a startup founder, knowing how to navigate different sources of finance for your startup is a pivotal skill. Not all sources of finances augment your business in the same way, neither do they have similar costs nor do they offer the same level of freedom. Strategically applying each source of capital at the right stage to the right set of expenditures is key here.

Let's begin with the sources.

Bootstrapping

This is when you tap into your own savings, or that of your friends and family circle, to get your business started. This is the stage where you need maximum freedom to try new things, and work out whether or not your business idea has the potential to become a real business.

What this means is that this is also the stage when you're going to make a lot of mistakes. Your 'investors' can't (and shouldn't!) question your every move. That level of trust, however, usually comes from your own bank account, and from the friends and family who implicitly trust you, and your idea.

This is your source of funds when you are an early stage startup.

Angel Investors

There is a reason these are called 'angel investors'. These are the investors who step in way before every other type of investor, and typically, their investment doesn't involve as many strings. The angel investor knows that there is a good chance that your business may not make it, and their equity may turn to dust. Yet, they invest because they believe in the potential of your idea, and that the risk will be worth it, in the returns their investment will generate, should you succeed.

This is your source of funds when you are an early stage startup.

Venture Capitalists and Institutional Investors

Now, you're in the big leagues (almost!). Your startup is officially a growth stage startup, and you've begun generating some revenue. Your idea is a proven one, and you probably have a couple of anchor customers who swear by your product or service. The difference between VCs and angel investors is one of timing: angels often come in during early stages, whereas VCs usually enter during growth stage funding rounds.

VCs and Institutional Investors also bring with them enormous expertise. Most have their own incubators, and offer warm introductions to their networks. This creates a win-win for both, by helping propel the business forward at a faster rate. These investors often also help startups with several other services that help them navigate taxes, regulations, permits, and other administrative tasks that can take up enormous swathes of the entrepreneurs' time and attention.

However, VC funding comes with strings. Yes, they're taking a risk, and yes, they're sharing your equity, but they also expect supernormal returns. Moreover, they expect that all of their funding go towards growth generating activities - not the day to day running of your business.

This is your source of funds when you are a growth or mature stage startup.

Debt

That's where debt comes into the picture.

Debt comes with all the strings. You have to pay it back. You have to pay interest (in case of Venture debt companies, this is usually high and often comes with warrants that get converted to equity, further exacerbating the cost of capital), and in some cases, you can only use it for the purposes it has been disbursed for. Term loans, for instance, can only be used for the purpose they are disbursed for. If you take out a term loan for capex investment, you can't use it to pay salaries. There are, of course, term loan products out there that don't have this caveat.

The other option is working capital loans. Unfortunately, to avail a working capital line, you need to meet eligibility criteria that may exclude you. To avail a working capital facility from a bank, you need to have a credit profile, steady funding from an institutional investor, you need secured collateral (either a soft collateral like FD or a hard collateral like land) and you need to be profitable, with steady and growing revenues. For startups that are growing, that usually isn't the case.

This is your source when you are a growth or a mature stage startup.

The Gap

This, unfortunately, is the gap that hobbles many startups. A growth stage startup with a proven idea, with VC funding that is targeted towards growth, is usually not generating profits. This doesn't mean that your revenues are poor - far from it. It just means that whatever you're earning, you're plowing back into the business.

However, you have no source for your working capital needs. The gap between paying for your inputs and realizing revenue can seriously hobble your cash flows, and often lead to uncomfortable situations with suppliers and employers on the one hand, and the VC (who doesn't want their funds used for working capital) on the other.

Also, it is important to note that this gap usually exists for growth stage and mature stage startups. Mature startups are able to source working capital loans from banks, as they meet all the criteria. However, mature startups often also have the cash flows and profits, and may not need working capital loans in the first place.

Moneycontrol journalists were not involved in the creation of the article.