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Modes of Financing for Startups

Below are some of the ways to raise long term and short term capital.

Sources of Long Term Capital

Reinvestment of Profits

Profitable companies do not generally distribute the whole amount of profits as dividend but, transfer certain proportion to reserves. This may be regarded as reinvestment of profits or ploughing back of profits. As these retained profits actually belong to the shareholders of the company, these are treated as a part of ownership capital. Retention of profits is a sort of self financing of business. The reserves built up over the years by ploughing back of profits may be utilised by the company for the following purposes:

  • Expansion of the undertaking
  • Replacement of obsolete assets and modernisation
  • Meeting permanent or special working capital requirement
  • Redemption of old debts

The benefits of this source of finance to the company are:

  • It reduces the dependence on external sources of finance
  • It increases the credit worthiness of the company
  • It enables the company to withstand difficult situations
  • It enables the company to adopt a stable dividend policy
  • It increases the debt raising capacity of the company

Loans from Commercial Banks / Financial Institutions

Medium and long term loans required for setting up projects can be obtained from banks and \or financial institutions for all viable projects. Similarly, funds required for modernisation and renovation schemes can be borrowed from them. Such loans are generally secured by mortgage of the Company’s properties, pledge of shares, personal guarantees etc.

Public Deposits

Companies often raise funds by inviting their shareholders, employees and the general public to deposit their savings with the company. The Companies Act permits such deposits to be received for a period up to 3 years at a time. Public deposits can be raised by companies to meet their medium-term as well as short-term financial needs. The increasing popularity of public deposits is due to:

  • The rate of interest the companies have to pay on them is attractive.
  • These are easier methods of mobilising funds than banks, especially during periods of credit squeeze
  • They are unsecured

Risk Capital

Risk capital denotes the provision of capital where the provider reduces the risk burden of the entrepreneur, and in turn bears some part of the overall risk involved in a productive activity. As per a definition widely used in India – The term ‘risk capital’ includes equity as well as mezzanine/ quasi equity financial products that have features of both debt and equity. Risk Capital is an important instrument for not only start-ups and innovative / fast growing companies but is also critical to those companies looking at growth. Risk capital substitutes promoter’s contribution, thereby reducing the capital to be brought by the entrepreneurs. Under such cases, Risk capital is one of the most viable options for raising capital for MSMEs. Some of the major risk capital options available for MSMEs include Venture Capital, Angel Investment and Public Listing.

Issue of Shares

It is the most important method. The liability of shareholders is limited to the face value of shares, and they are also easily transferable. A private company cannot invite the general public to subscribe for its share capital and its shares are also not freely transferable. But for public limited companies there are no such restrictions. There are two types of shares :-

  • Equity shares: the rate of dividend on these shares depends on the profits available and the discretion of directors. Hence, there is no fixed burden on the company. Each share carries one vote.
  • Preference shares: dividend is payable on these shares at a fixed rate and is payable only if there are profits. Hence, there is no compulsory burden on the company’s finances. Such shares do not give voting rights.

To get more details on public listing by the MSMEs, click here .

Issue of Debentures

Companies generally have powers to borrow and raise loans by issuing debentures. The rate of interest payable on debentures is fixed at the time of issue and  the debentures have a charge on the property or assets of the company, which provide the necessary security. The company is liable to pay interest even if there are no profits. Debentures are mostly issued to finance the long-term requirements of business and do not carry any voting rights.

Sources of Short Term Capital

Trade Credit

Companies buy raw materials, components, stores and spare parts on credit from different suppliers. Generally suppliers grant credit for a period of 3 to 6 months, and thus provide short-term finance to the company. Availability of this type of finance is connected with the volume of business. When the production and sale of goods increase, there is automatic increase in the volume of purchases, and more of trade credit is available.

The amounts due to a company from customers, on account of credit sale generally remain outstanding during the period of credit allowed i.e. till the dues are collected from the debtors. The book debts may be assigned to a bank and cash realised in advance from the bank. Thus, the responsibility of collecting the debtors’ balance is taken over by the bank on payment of specified charges by the company. book debts may be assigned by the seller to a FACTOR, who who will provide about 80 – 85 % or more of the value of the book debt, as advance to the seller. The FACTOR will also undertake the task of collecting the amount representing the debt (credit sales) from the debtors. Factoring is an important avenue of raising short funds against the receivables for the MSME units. The charges payable to the FACTOR is treated as cost of raising the funds

Discounting Bills of Exchange

This method is widely used by companies for raising short-term finance. When the goods are sold on credit, bills of exchange are generally drawn for acceptance by the buyers of goods. Instead of holding the bills till the date of maturity, companies can discount them with commercial banks on payment of a charge known as bank discount. The rate of discount to be charged by banks is prescribed by the Reserve Bank of India from time to time. The amount of discount is deducted from the value of bills at the time of discounting. The cost of raising finance by this method is the discount charged by the bank.

Bank Overdraft and Cash Credit

It is a common method adopted by companies for meeting short-term financial requirements. Cash credit refers to an arrangement whereby the commercial bank allows money to be drawn as advances from time to time within a specified limit. This facility is granted against the security of goods in stock, or promissory notes bearing a second signature, or other marketable instruments like Government bonds. Overdraft is a temporary arrangement with the bank which permits the company to overdraw from its current deposit account with the bank up to a certain limit. The overdraft facility is also granted against securities. The rate of interest charged on cash credit and overdraft is relatively much higher than the rate of interest on bank deposits.

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