Ranjan Pai, head of the Manipal Group, has recently emerged as a savior for two prominent privately held start-ups, Byju's and PharmEasy. Pai deftly avoided potential debt risks for both firms by investing Rs 1,400 crore in Byju's subsidiary, Aakash Educational Services, and pledging Rs 1,300 crore for PharmEasy's rights offering. However, these rescue attempts were not without complexities, such as major valuation markdowns and the concession of favorable terms, including numerous board seats. The once-soaring trajectories of these category-leading start-ups, which are now facing debt issues, have shed light on India's dynamic start-up landscape's oncoming debt catastrophe.
A lot of it can be ascribed to the 2021 financing frenzy and subsequent downturn, which left some Indian unicorns—startups valued at $1 billion or more - with a significant debt burden on their balance sheets. According to PrivateCircle Research, a private market intelligence platform, 115 unicorns would owe more over Rs 50,000 crore in 2022 alone, and many are already feeling the effects of this debt burden.
The threat of rising debt lurks over these businesses, serving as a marker of their evolution, as they have grown in size, scale, and valuation in recent years. However, the sophisticated and convoluted debt structures they use, which include term loans, convertible notes, and structured transactions, call into doubt the viability of debt for start-ups. Many of these ventures, having envisioned a path to liquidity via an IPO (initial public offering) or a large equity infusion, secured debt financing with specific goals in mind, such as avoiding an equity event just before an IPO, adjusting the capital structure, or complying with statutory requirements to increase ownership to send the right signals.
However, financial cycles change quickly. A slew of global macroeconomic developments, culminating in a painful funding slowdown in the second half of 2022, have thrown these initiatives into turmoil. Many debt-related difficulties emerge from delayed IPOs and planned funding rounds, resulting in the unfortunate fact that debt that needs to be repaid becomes more difficult to refinance if collateral is impaired or the company's worth falls. This dilemma frequently leads businesses into a cycle of obtaining more equity on increasingly burdensome terms—a difficult and, at times, unbreakable loop.
Byju's, for example, is currently facing a difficulty stemming from its $1.2 billion Term Loan B (TLB), which was taken during the zenith of its 2021 expansion to support an ambitious acquisition binge. Following the epidemic, when growth slowed and financing became scarce, the anticipated equity rounds did not materialize, trapping the company in the repercussions of its high-risk gamble. Today, the firm announced the sale of two important assets, Epic and Great Learning, in order to acquire funds and repay the loan. Similarly, PharmEasy, the e-pharmacy unicorn, borrowed $285 million from Goldman Sachs in August 2022 to pay off a previous debt from Kotak Mahindra Bank to fund its $612-million acquisition of Thyrocare. However, after its fundraising attempts were unsuccessful and its IPO was postponed, the business was forced to execute a rights offering at a valuation of $500-$600 million, much lower than its peak valuation of $5.6 billion, in order to repay the debt. In both situations, the start-ups violated loan covenant restrictions, resulting in an escalating debt crisis.
"In general, start-ups should avoid debt because the only sustainable way to service and repay debt is through cash flow. Most start-ups are unprofitable, so I don't see how they can repay debt. If you are a huge, profitable start-up, debt is a great, non-dilutive source of funding. However, if you are losing money, as most start-ups are, you are simply increasing risk over which you have no control. Many entrepreneurs are unaware that they risk losing their businesses when creditors come calling," says Ritesh Banglani, Partner at Stellaris Venture Partners.
Securing finance, whether in the form of venture funding, TLB, convertible notes, or other structured loans, has ramifications for struggling start-ups. Such aggressive measures become especially risky when made in anticipation of a future equity offering, given the quick and severe changes that are common in private capital markets. "A heavy reliance on high-risk debt without a clear plan for future financing or profitability may deter investors from future funding rounds, resulting in uncertainty and caution." Furthermore, market perception is important; investors may view the usage of high-risk debt as a sign of financial difficulty, causing bad sentiment and affecting the company's market standing," explains Ankur Bansal, Co-founder and Director of BlackSoil, an alternative finance platform.
TLBs provide more flexibility than standard loans, with features such as "payment-in-kind" coupons, variable interest rates, and a variety of collateral types. Unlike amortizing loans, TLBs often have a bullet profile, with repayment accruing until the end, posing a refinancing risk. If corporations lack the cash flow to make lump-sum repayments, covenants may be violated, prompting debt providers to safeguard their assets.
Meanwhile, convertible notes are becoming popular among growth-stage start-ups due to their novel technique of not assigning a predetermined valuation to the investment round. Investors gain from a discount when the debt is converted to equity in the next funding round. This structure helps start-ups to protect their valuation by not requiring a set price for capital raised through notes. Convertible notes are useful in situations when stock is scarce and insider trading is prevalent. It enables existing investors, who are faced with the challenge of appropriately pricing a new round, to strike a fine balance between undervaluing the company and unfairly pricing themselves. Furthermore, it provides a window for more market-driven benchmarks or valued events to emerge, allowing for a more informed valuation in the future.
"When covenants are breached, debt providers must do all it takes to defend their capital. That entails enforcing their fees on things like brand or IP. That has occurred in a few cases. Debt is a great tool, but it must be utilized responsibly. Founders and companies must recognise that it (debt) has a completely different profile than equity. When money flows quickly, people tend to consider it fungible. That discipline may not have been as evident. People now understand that a loan comes with repayment obligations, and they just need to be more responsible," says Rahul Khanna, Co-founder and Managing Partner of Trifecta Capital.
According to Khanna, while using debt, start-ups must match their sources and uses to their business's specific needs, whether it's funding an acquisition, boosting working capital, or improving credit. While debt can be a viable source of finance for such purposes, the problem is assessing how much it can be leveraged, particularly for loss-making businesses. Prudent and thorough thinking is required to avoid overleveraging, with the eventual requirement for increased equity in such instances. Both debt suppliers and entrepreneurs must be aware of the potential value destruction if the company struggles to fulfill its debt.
"The alignment of sources and uses, careful evaluation of leverage, and knowledge of low liquidity are all critical variables. It is not true that equity is expensive while debt is inexpensive. It does not operate like that. If stock is expensive, the overall cost of capital rises. So, debt pricing must reflect market risks as well as the true cost of capital in the industry," he explains.
On the cap table, venture capital (VC) investors see debt as creating discipline. The monthly payback schedule establishes a regulated cadence, encouraging a greater awareness for operational discipline inside businesses. Debt, unlike equity funding, can take on multiple flavors depending on how it is structured and collateralized, which has price and conversion consequences.
As Khanna underlines, debt should not be viewed as a monster, but rather as an evolution of the asset class. As businesses develop, their needs become more evident, and the credit ecosystem in the new economy has evolved in response. Companies and boards must carefully examine the appropriateness of various financial instruments and be current with market changes. The risk is an influx of loan capital moving too quickly, similar to what happened in the equity arena. Venture debt or private finance, designed for the modern economy, must coexist with equity. Without a flow in equity markets, lending markets would not follow suit; they are complementary rather than substitutes, particularly for loss-making start-up companies.
"And, in some ways, lessons have been learned that prudence in capital structure is critical. The next generation of founders, preparing for liquidity events, would obviously be more thoughtful and consider [the fact] that things could take longer, as well as how much leverage is appropriate, how it should be structured, and over what timelines it needs to be repaid in relation to an IPO or exit event," Khanna adds.
