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With the Indian Government’s favorable policy regime and robust business environment, foreign investments have been on a rise in India leading to an influx of foreign companies.
However, foreign companies often require external funding for growing aggressively in India. Some of the challenges which foreign companies face while opting for external sources of funds is a lack of knowledge of the available sources of funds, along with final effect of external funding on their business operations going forward.
Debt and equity are the two types of funding a foreign company may choose, depending on their requirements - both offering their own set of advantages and limitations.
In this Q&A session, we speak with Business Advisory Services Senior Associate Vikas Saluja to discuss some of the commonly asked questions that we receive from our subscribers related to the funding options available to them, process to obtain funding, and the key considerations for businesses planning to secure external funding.
How do I select the right funding option for my business?
There are two modes of funding options available to a company – equity financing and debt financing.
Based on the features of debt and equity, one can choose the right funding option for their business as per their requirements.
In equity funding, a company offers a portion of ownership in order to raise capital.
The ownership is retained with the company while raising funds.
The costs are in the form of dividend, which is payable only if the company has enough profit and is on the discretion of Management.
The cost is in the form of interest on debt and the company is liable to pay interest.
There is no repayment of equity capital to the shareholder.
Repayment of loan on its maturity date.
The dividend is to be paid only if the company is profitable.
Timely interest has to be paid and repayment needs to be made at the time of maturity, whether company is earning profit or not.
Under what circumstances should the company select debt funding? What are the advantages of debt funding options?
Debt funding can be selected when the company is ready to commence the sale of fixed income products such as bonds, bills, or notes, to investors to obtain the capital needed to grow and expand its operations.
Advantages of Debt Funding:
- Retention of Ownership: The company raises capital without giving any ownership to the lender and only the principal amount and interest is required to be paid back. Hence, lenders have no say in operations of the business.
- Tax deductions: Unlike private loans, interest fees and charges on a business loan are tax deductible. The interest paid is tax deductible and hence reduces the tax payment.
- Accessible to all types of business: Debt financing is an easy and accessible source of finance for all sizes of companies.
- Efficient Planning: The payment of principal and interest is fixed, which helps in planning the budget for every month, quarter, or year.
- Retaining profits – The only obligation company has to its lender is making repayments within agreed time frames. They do not have to share their business profits, i.e. once your debt is paid, your liability is over.
What are the different types of debt funding options? Which option is advisable in which situation?
Below are the major types of debt funding in India:
- Bank Loan: A bank loan is the most common type of debt financing. Bank loans can be:
- Secured Loans: The company’s assets are kept as a collateral or safety deposit with the lender. Secured loans have low interest rates as the lender’s risk is reduced due to the collateral.
- Unsecured Loans: There is no collateral asset against the loan. The lender gives the loan after carefully examining the financial condition and growth prospects of the company.
- Debentures: Debentures are a debt instrument used by companies and government to issue the loan. The loan is issued to corporates based on their reputation at a fixed rate of interest.
- External Commercial Borrowings (ECBs): ECBs are loans raised abroad by Indian companies by way of foreign currency convertible bonds or loans. The funds raised through ECBs are generally used for purposes like working capital finance, purchase of capital assets, repayment, or refinancing of existing debt.
Companies may choose the debt funding option which is most easily accessible depending on the state of their cash flow and considering the importance of maintaining ownership control.
What is the process for obtaining funding under debentures?
A debenture is a type of debt instrument that is not backed by any collateral, and usually has a term greater than 10 years. Debentures are backed only by the creditworthiness and reputation of the issuer. Both companies and governments frequently issue debentures to raise capital or funds.
Below is the process of obtaining funding through debentures:
- Calling a Board meeting to decide which types of the debenture will be issued by the Company and passing the necessary Board Resolution
- Based on the decisions of the Board Meeting, preparing the required documents such as a Debenture Subscription Agreement, Offer Letter for private placement in Form No. PAS – 4, among others, and issuing notice for extraordinary general meeting
- Hold extraordinary general meeting and enable special resolution to issue convertible secured debentures
- Prepare and file required documents including Form No. PAS – 4 and PAS – 5 with the Registrar of Companies (ROC), Offer Letter in Form No. MGT – 14, among other documents
- Issuing the certificate of debentures
Are there any key considerations that should be considered when financing a business in India?
There are various ways to finance your business set-up in India. The choice of debt or equity financing lies with the business and why it needs the finance, repayment plan, and how long it wants the investors to be involved, among several other factors.
Following are the factors one should keep in mind while financing their India business:
- Income generated by the company
- Purpose for which the financing needs to be made
- Right amount to be raised for their business
- Amount of capital required
- Whether complete ownership needs to be retained or not
- Risks involved
- Duration/ Period of financing
- Current capital structure
A company should carefully study and choose the type of funding required for their business. If a small company is planning to expand, and is looking for funding, then private equity may be recommended as the small company would not be able to fulfill the lender’s requirements. Also, a private investor can help the business grow by sharing their market experience and knowledge.
However, if a business is established, it may look for debt funding because it would be able to align with the lender’s requirements and the ownership of the business would remain with the business. So, it’s very important to consider all the factors before choosing a source of finance and the decision should be aligned with the objective and success of the business.
What are the consequences / penalties if a company is unable to pay off the debt?
The consequences of not being able to pay off the debt may depend on the type of funding option one had chosen.
- Bank loan: Banks will take action as per the loan agreement. If the loan is secured and the company fails to pay the loan back, the lender can sell the asset and recover the loan money. In case of unsecured loan, lenders can sue the company for defaulting on the loan repayment terms.
- Debenture: As per Companies Act, 2013, where a company fails to redeem the debentures on the date of their maturity or fails to pay interest on the debentures when it is due, the Tribunal (National Company Law Tribunal) may, on the application of any or all of the debenture-holders, or debenture trustee and, after hearing the parties concerned, direct, by order, the company to redeem the debentures forthwith on payment of principal and interest due thereon.
The debenture holder may also take action as per the debenture trust deed, if any.
A company can opt for the right funding option by carefully analyzing their business goals and requirements along with proper knowledge about both the funding options.
To get more information about various funding options available for your business in India, read our India Briefing article - Debt Funding in India: Options Available to Foreign Investors, Entrepreneurs
Further, our team of experts can help you in understanding and selecting the right funding option for your business and thereafter provide assistance in obtaining the funding for your business as per the selected option.
Contact us today to discuss financing options for your India business.
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