ES-V: The Working Capital Dilemma for Startups

January 16, 2020

What is Working Capital?

Product manufacturing companies require money to manufacture goods and sell. The company has to invest in purchasing raw materials, manufacture the goods, sell them and collect money. There is a time gap between the starting of the expenses (on purchasing raw materials) and realization of sales money for the goods. The money required for producing goods and selling during this time gap is called the ‘Working Capital’. It includes expenses on raw materials, labor, electricity, other utilities, packaging shipping costs and taxes (GST) paid for all the items.

Pic Credit: Investopedia

The expenditure to make the product could normally start with the receipt of order in B2B segment. But that depends on factors like, how long the consumer is ready to wait, time taken to procure each and every item required for production; and finally manufacture the goods. Often, the consumer may want delivery immediately or soon after placing the order. In that case, the product company has to start working capital expenditure anticipating the order and the volume of the order. Furthermore the customer may not pay immediately even after the order is serviced (delivered). The payment may be realised much LATER, with the wait period in some cases becoming as high as a year in India [1]. The working capital is blocked till the payment is realised.

In B2C segment, the money is most often realised at the time of sales. However here, the sales and delivery must take place mostly exactly at the same time and the company has to anticipate volume of the order and keep the product ready on shelf of the outlets for the sales to take place. The working capital expense would start much earlier anticipating sales and taking into account lead-time for delivery[2] of each and every raw-material component. Further, once the goods are ready, it may sit on shelf for a long-time (both at the factory outlet as well as that of the distribution and sales-outlets). The goods on shelf blocks the capital expenses. Besides, it may happen that some of the goods on the sales-outlet may never be sold and be returned to the factory. All such returns would imply the working capital being converted to losses.

Thus the working capital is a major deployment of financial resources for a product company. It requires blocking of funds for considerable length of time. In India, the working capital requirement becomes very challenging as payment cycles are worse in B2B segment, due to delay in payments by large companies to smaller entities. In B2C it may be bad as produced good may sit shelf or go unsold which might even be partially returned.

Dilemma for the start-up

While working capital becomes a problem for all kinds of companies, it particularly become worse for startups. Established companies may be able to borrow funds for working capital from scheduled banks by (i) mortgaging their land and buildings, (ii) mortgaging raw-materials or (iii) against their receivables or (iv) simply using their past record, P&L and balance-sheet showing year on year profitability, past history of borrowing funds and paying back. Sometime the banks lend money due to personal guarantee or offering personal assets as collateral of the principal share-holder of the company or the director (when that person is wealthy and have all kinds of assets). Unfortunately, a startup may not have any of the four items listed above and would not be able to borrow funds from scheduled banks for several years. Similarly startup founders cannot be expected to be wealthy and have assets to mortgage. Their personal guarantee may not amount to anything. The startup would need to build a record to start borrowing. Till then it is stuck due to lack of working capital borrowing in the beginning.

The only other funds that a startup has is equity invested. No equity investor likes their investment to be stuck as working capital, especially if it is large amount. The problem is that more successful the company is and more it sells, higher will be its working capital requirement. If large part of equity is thus stuck, the company would find it difficult to spend funds continuously on R&D and developing product.

What is the way out?

Well, there is no easy way out for the startup. It is required that the start-up starts paying attention to this issue much before it starts manufacturing and selling products. As the product starts getting ready, it has to work out strategy for working capital. At the first sign of acceptability of its product in the market, it requires careful planning to ensure that it does not run out of working capital. It is a bad idea to scout for loans during the critical time as this might narrow down one’s options. On the other hand, borrowing too early might lead to spending money on unplanned and immediate expenses instead of what one borrowed for in the first place.

A start-up has to plan for the worst case and hope for the best. It should pay serious attention to reducing the working capital requirement and reducing the payment-cycle. One of the most important things about borrowing is to ensure the cash flow to service the loan. It is important that one should avail a loan only if one is confident of generating revenue to repay the loan consistently. The investors must be involved fully. Should the company slow its growth-rate so as to reduce its working capital, or should it expand rapidly, and investors would come up with funds required? There is no simple answer. The answer will vary from case to case. A mistake here either way can cost the company large.

Building relationship with a bank is the best way to open-up the working capital tap. The relationship needs to be built when the going for a start-up is good and it has received some funding. When one is in desperate need, the banks would just not help, unless prior relationship is good.

In my experience in India, building a relationship with public sector bank [3] pays off better in long run than the private banks. The private banks (by and large) may give early loans more easily (when the going is good for the company and talk very nicely), but the minute the company is in stress, they would just not support the company. Instead they would demand early payment and add to stress. On the other hand, by and large, if one has already built relationship with a public sector bank, they may stay with the company and support them in their ups and downs.

What does building a relationship mean? When a company has money (investment), it deposits the money in the bank and carry out transactions with it. More important, it may mean visiting the bank-manager periodically and talking to them about what the company is doing. It will also mean taking a small working-capital credit (against the funds deposited by the company in Fixed Deposit), even when the company does not need it. It would mean timely servicing of the loans and taking a bit larger loan next time. As the bank sees more and more of a company, its credit terms would ease. Timely servicing loans is very critical. Regularly submitting how well the company is doing is equally important. Gradually the bank start believing in business and the good-values of the company. It is then the working capital will become easier. Bank may give some over-draft facility to begin with. It may be willing to give some bank guarantees on the company’s behalf.

Hence it is very important to prove to the lenders that the start-up is a strong borrower by showing the banks lots of evidence that the company is trustworthy. That comes with being able to present strong financial statements, predictable cash flow, and good credit month after month in business. Appendix I list some of the documents that may be required to avail a loan from a bank.

Are there government schemes for working capital for start-ups?

There are schemes certainly. In Appendix II, we are listing some. But most of them do not work well. Some facilitation is required. Startups are not usually geared up to it. More on it later.

Summary

Working Capital Loan may become one of the biggest obstacles faced by product startups, especially those involved in manufacturing. It will require very careful financial planning. This blog is an incomplete blog and will be revised till we figure out how to enable a startup get working capital.

Appendix I

Documents required to borrow from a bank

Listed are some of the documents required to avail loans. Though every funding institution have their own parameters, here are the most common ones:

Documents required for Private & Public Limited Companies

Certification of Incorporation
Memorandum of Association & Articles of Association
PAN Card
Certificate of Registration
Name of all the present directories on company letterhead
Loan statement along with the sanction letter of the previous banks in the last one year (if any).
Audit report and audit Financials for the last two years
Income tax return and income statement for the last three years

Appendix II

Government Schemes available for working capital loans for startups:

MSME Business Loans for startups in 59 mins: The contactless business loans for start-ups are currently provided for value from INR 1lac up to 1crore. The rate of interest starts from 8%. www.psbloansin59minutes.com/home
Pradhan Mantri Mudra Yojana - MUDRA provides refinance support to banks/Micro Finance Institutions (MFIs) for lending to micro units that have loan requirements of up to INR 10 Lakh. www.mudra.org.in
Sustainable Finance Scheme: Renewable energy projects such as solar power plants, wind energy generators, mini hydel power projects, biomass gasifier power plants, etc, for captive/non-captive use (i.e. power generated is sold/supplied to the grid/off-grid).
Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE): The scheme is applicable for new and existing Micro and Small Enterprises engaged in manufacturing or service activity excluding retail trade, educational institutions, agriculture, self-help groups (SHGs), training institutions, etc.
Standup India by SIDBI - Eligible for Enterprises in trading, manufacturing, or services. In the case of non-individual enterprises, at least 51% of the shareholding and controlling stake should be held by an SC/ST or woman entrepreneur. The borrower should not be in default with any bank or financial institution.
The Venture Capital Assistance Scheme by Ministry of Agriculture and Farmer Welfare: www.startupindia.gov.in/content/sih/en/government-schemes/venture-capital-scheme.html

Here are links listing various Government schemes:
https://inc42.com/buzz/startup-scheme-indian-government-startups/
https://iidt.edu.in/Articles/49Startup-Govt-Schemes.pdf

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[1] There are rules for payment by a company to MSME companies. Those rules make it mandatory for companies to pay in time. This, if implemented, could help start-ups, if registered as MSME. This will be added later in an appendix

[2] As this is a B2B transaction, the raw-material supply may also need a long lead time to even get the goods ready to deliver and could face working capital crunch.

[3] In recent times, public sector banks in India are under a lot of stress. What I have suggested may not work as well.