Manipal group chairman Ranjan Pai recently emerged as the saviour for two prominent privately-held start-ups, Byju’s and PharmEasy. With an infusion of Rs 1,400 crore into Byju’s subsidiary, Aakash Educational Services, and a substantial pledge of Rs 1,300 crore for PharmEasy’s rights issue, Pai deftly averted impending debt threats for both entities. However, these rescue missions were not without their nuances—marked by significant valuation markdowns and the concession of attractive terms, including multiple board seats. The once-soaring trajectories of these category-leading start-ups, now grappling with debt challenges, cast a discerning spotlight on the looming debt crisis within India’s dynamic start-up landscape.
A lot of it can be attributed to the 2021 funding frenzy and the subsequent deceleration, leaving several Indian unicorns—start-ups with a valuation of $1 billion or more—with a substantial debt burden on their cap tables. According to PrivateCircle Research, a private market intelligence platform, 115 unicorns have collectively amassed over Rs 50,000 crore of debt in 2022 alone, and for many, the burn of this debt burden is already being felt.
As the spectre of mounting debt looms over these businesses, it serves as a marker of their evolution, having attained significant size, scale, and valuation in recent years. However, the intricate and convoluted debt structures they adopt, via various debt instruments including term loans, convertible notes, and structured transactions, raise a critical question about the viability of debt for start-ups. Many of these ventures, having envisioned a path to liquidity through an IPO (initial public offering) or a large equity infusion, secured debt financing with specific objectives in mind, such as to avoid 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, and they change quick and fast. A host of global macro events, leading to an excruciating funding slowdown from the second half of 2022, have thrown these strategies into disarray. A lot of the debt-related challenges stem from delayed IPOs and anticipated funding rounds, resulting in the unfortunate reality that debt, needing repayment, becomes harder to refinance if collateral is impaired or the company’s valuation takes a hit. This predicament often forces companies into a cycle of raising more equity on increasingly burdensome terms—a challenging and, at times, inescapable loop.
Yju’s, for instance, faces a current crisis rooted in its $1.2 billion Term Loan B (TLB), secured during the peak of its 2021 growth to support an aggressive acquisition spree. Post-pandemic, as growth slowed and equity became scarce, the anticipated equity rounds failed to materialise, entangling the company in the consequences of its high-risk gamble. Today, the company has put two key assets, Epic and Great Learning, up for sale to raise cash and settle this loan. Similarly, PharmEasy, the e-pharmacy unicorn, borrowed $285 million from Goldman Sachs in August 2022 to pay off an earlier debt incurred from Kotak Mahindra Bank to bankroll its $612-million acquisition of Thyrocare. However, after its fundraising efforts failed and its IPO had to be postponed, the company was compelled to conduct a rights issue at a valuation of $500-$600 million, significantly lower than its peak valuation of $5.6 billion, in order to pay back the debt. In both cases, the start-ups breached loan covenant terms, leading to an escalated debt crisis.
“In general, start-ups should avoid debt because the only sustainable way to service and repay debt is from your cash flows. Since most start-ups are unprofitable, I don’t see how they can repay debt. If you are a large, profitable start-up, debt is an excellent, non-dilutive source of capital. But if you are loss-making like most start-ups, you are just adding on risk you have little control over. Many entrepreneurs don’t realise that they risk losing the company when the creditors come calling,” says Ritesh Banglani, Partner at Stellaris Venture Partners.
Securing debt, whether in the form of venture debt, TLB, convertible notes, or other structured loans, carries consequences for loss-making start-ups. Particularly, when undertaken with the expectation of a future equity round, such bold moves become precarious, given the swift and unforgiving fluctuations often witnessed in the private capital markets. “Heavy reliance on high-risk debt without a clear plan for future financing or profitability may deter investors from future funding rounds, creating uncertainty and caution. Additionally, market perception is crucial; investors may interpret the use of high-risk debt as a sign of financial distress, triggering negative sentiment and impacting the company’s market standing,” points out Ankur Bansal, Co-founder and Director of BlackSoil, an alternative credit platform.
TLBs offer more flexibility compared to traditional loans, featuring elements like “payment-in-kind” coupons, variable interest rates, and diverse collateral forms. Unlike amortising loans, TLBs typically follow a bullet profile, accumulating repayment until the end, posing a refinancing risk. If companies lack the cash flow for lump-sum repayments, covenants may be breached, prompting debt providers to protect their capital.
Meanwhile, convertible notes are gaining favour among growth-stage start-ups due to their unique approach of not assigning a fixed valuation to the funding round. Investors benefit from a discount when the debt converts to equity in the subsequent funding round. This structure allows start-ups to safeguard their valuation by avoiding a fixed price for the funds raised through notes. Convertible notes come in handy in situations where equity is hard to come by and inside rounds are common. It provides existing investors, facing the challenge of fairly pricing a new round, the means to navigate a delicate balance to avoid undervaluing the company or unjustly pricing themselves. Moreover, it presents them a window for more market-driven benchmarks or priced events to emerge, allowing for a more informed valuation at a later date.
“When covenants get breached, debt providers have to do what it takes to protect their capital. That means enforcing their charge on things like brand or IP. That has happened in a few cases. Debt is a very powerful instrument but it needs to be used judiciously. Founders and companies need to appreciate that it (debt) has a very different profile than equity. Sometimes what happens is when money is flowing easily, people tend to think of it as fungible. That discipline maybe was not as clear. Now it’s much more obvious to people that debt comes with obligations to repay and people just need to be more responsible,” says Rahul Khanna, Co-founder and Managing Partner at Trifecta Capital.
As per Khanna, when opting for debt, start-ups must align their sources and uses to match the specific needs of their business, whether it involves funding an acquisition, supporting working capital, or enhancing credit. While debt can be a suitable source of capital for such needs, the challenge lies in determining the extent to which it can be leveraged, especially for loss-making companies. Prudent and careful consideration is necessary to avoid overleveraging, recognising the eventual need for more equity in such cases. Both debt providers and founders need to be mindful of potential value destruction if the company struggles to service the debt.
“The alignment of sources and uses, thoughtful consideration of leverage, and awareness of tight liquidity are crucial factors. It’s not that equity is expensive and debt is going to be cheap. It doesn’t work like that. If equity is expensive, then all cost of capital goes up. So, the pricing of debt has to reflect the risks in the market and it also has to reflect the real cost of capital in the industry,” he says.
For venture capital (VC) investors on the cap table, the introduction of debt is viewed as instilling a level of discipline. The monthly repayment schedule imposes a structured cadence, fostering an enhanced appreciation for operational discipline within companies. Debt, unlike equity financing, also allows for different flavours based on how it’s structured, collateralised, influencing pricing and conversion implications.
Herefore, as Khanna emphasises, debt should be perceived not as a demon but rather as an evolution of the asset class. As companies mature, their needs become clearer, and the credit ecosystem in the new economy has evolved accordingly. Companies and boards must thoughtfully consider the applicability of different financial instruments and stay aligned with market trends. The risk lies in an influx of debt capital flowing too rapidly, akin to what occurred in the equity domain. Venture debt or private credit, tailored for the new economy, must walk alongside equity. Without a flow in equity markets, credit markets won’t follow suit; they are complementary rather than substitutes, especially for loss-making start-ups.
“And I guess in a way, lessons have been learnt that prudence on capital structure is very important. The next generation of founders, gearing up for liquidity events, would obviously be more thoughtful and take into account [the fact] that things could take longer, and therefore how much leverage is appropriate, how they should be structuring it, and over what timelines it needs to be repaid in relation to an IPO or exit event,” adds Khanna.
The crucial point is that—in the case of loss-making start-ups—debt cannot replace equity; it never has and never will. It can, however, stroll alongside equity.
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