Posted by : Nishanth Nandakumar, Sushant Bhatia, Emmanuel Murray Working around working capital – Would your parents say yes?
This blog was written for startups in The Craft Catapult cohort, but the content is relevant for most early-stage startups
Parents being protective of their progeny, would never let anything adverse happen to their child. Right from recording those first baby steps, to lining up all kinds of direct and indirect insurance plans, they do their best to prepare their children to face the world.
Start-ups are like children to the founders/parents. Craft enterprises, like other start-ups, are fragile and delicate in their infancy. The good thing though is that they are usually run by very passionate parents who want the infant to grow into a healthy all-rounded adolescent.
As we know, the right quantum of nutrition provided at the right time is the key to growth. Amongst multiple nutrients required by a start-up, funding is critical, and one of the key growth factor in it is working capital (WC) required for day-to-day operations.
In an ideal world, suppliers get paid on time, and everyone is at peace. Every enterprise’s wish is to minimise the gap between receivables and payables, ideally receive first and pay later, but this is difficult to achieve for most start-ups, especially for craft start-ups, where they have to pay either in advance or in a few days to their vendors (usually artisans), and the buyers end up paying after a credit period of 30 to 90 days in case of B2B models, or need to hold inventory in case of B2C models. Craft enterprises also have an additional responsibility of helping these artisans not just earn more, but also reduce their drudgery, and help them become part of the formal financial and social security systems, challenges that lead to an even bigger working capital gap.
The funds available for start-ups to grow are limited. Most entrepreneurs obviously want to tap friends, family and well-wishers to pitch-in. The external well-wishers and investors ready to take a bet at this stage are few.
When investors put-in money as Equity, they want the funds utilised for aspects like hiring key persons & product development, to enable exponential growth, and very little to be utilised for day-to-day operations (WC).
The other source is Debt. Let’s say someone is willing to lend money to resolve your WC issues without requiring property as security, and in lieu charge a higher rate of interest. Sounds fair? It may be, and may appear like a great option due to its non-dilutionary (ownership stake of the entrepreneur remains undiluted) and tax-deductible nature of interest expense, a loan is an inflexible commitment, that, if not evaluated properly, can cripple one’s business. But equally, you don’t want your kids to be left behind, and want the best future for them
Hence, some amount of self-evaluation by the parents can clear the haze in evaluating whether debt is the right option.
Here are some questions for promoters of startups to consider before they say yes to debt
- Cash is the King and Queen. What about everything in between?
The simple rule of borrowing is to borrow only when one has ‘clear’ visibility of cashflow. Despite having a sizeable order book, realizing cash in hand is the cornerstone of the ability to borrow and subsequently repay debt. What does ‘clear’ mean? As you move from left to right of below sequence, ‘clarity’ reduces
Cash-in-bank > Invoices to repeat customers > Invoice to new customer > Formal Purchase Order
2. Am I managing information well enough?
Can I share my previous month’s Financial Statements (P&L) within 5 days of the month-end? Am I aware of yesterday’s sales numbers? Are my statutory dues paid on-time regularly? Do I track the debtors and payables religiously?
If the answer is yes to all these questions, rejoice! You don’t need to have an ERP and highly paid professionals to achieve this. You need the right people with some skills and 100% transparency. You may begin with an available template or a self-developed excel sheet that tracks various financial and operational indicators. Your baby has to be transparent while showing this homework
- What is the real cost?
If a lender offers financing at 20% per annum rate of interest, it might seem formidable, and even lead you to reconsider borrowing. However, the “real” cost of the loan and what one intends to do with the money needs to be carefully thought through. Compared to a personal loan of 12-13% pa, sure, it does seem expensive, but if the money is going to be utilized to churn-out a product which gives a margin of 30% or more, a 20% interest rate loan may be definitely worth considering.
Though options of low-cost financing for the craft sector are at the moment limited, schemeslike Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE which offers collateral free credit facilities to SMEs must be first explored with your bank, before moving on to options like NBFCs and venture debt funds.
Another cost that is often not factored-in is time. If you require funds in 60 days, but you foresee the loan being available not before 180 days, or an unclear time line, the rate of interest might become a secondary consideration
- Do I have positive unit economics?
Unit economics refers to the direct revenues and costs of a business expressed on a per uni of product/service basis. This can be quite different from profit being made at the gross level. Profit at the unit level usually indicates sustainable profits, whereas one-time cutbacks to expenses (for example start up founders forgoing salary) and lesser employees at the early stages, could temporarily reflect in marginal aggregate profits. Since it is highly likely that founders will not be willing to eat just Poha for the rest of their lives, unit level profitability is a crucial long-term profitability factor for self-evaluation (and credit evaluation!).
- Do you want a partnership or a loan transaction?
Do you feel the lender understands your business? Can he become a long-term partner? Do you value the interaction and people? If the answers appear negative on two or more questions, you should reconsider. Afterall, you wouldn’t want to share your baby with someone who doesn’t understand and appreciate your aspirations
Acknowledging how serious you are about the future well-being of your baby, we are confident you will make an informed choice. We hope the above insights help you in taking a decision that best works for you, and more importantly, prevents throwing your baby out along with the bath water!
Good Luck
Team Caspian Debt. For more information on the offerings of Caspian Debt and how we could be partners in your entrepreneurial journey, please reach-out to Sushant at sushant@caspian.in .