How Can Hybrid Instruments Help Indian Start-ups to Raise Funds
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For any start-up, it's not just their passion that drives the business. What turns their ideas into businesses is funding. However, as any entrepreneur would know raising funds is not an easy task. From running behind investor, following up through meeting after meetings, fundraising often becomes a harrowing process for the entrepreneur.
Once done, the inflow of funds means the outflow of equity. Startup founders often have to give up a majority of their stakes in their own business to accommodate investors.
In a bid to make fundraising an easier process and to allow them to retain control of their business, the Modi government is looking at introducing Hybrid instruments. As it is in developed markets, hybrid instruments are designed as debt-type instruments with exposure to the equities markets with differential voting rights.
Entrepreneur India takes a look at how hybrid instruments will help Indian start-ups.
What Are Hybrid Instruments
Alok Mittal, CEO, Indifi Technologies, who serves as President of Digital Lenders Association of India, explains that Hybrid instruments have a mix of characteristics of equity and debt. "Typically, debt is fixed price and doesn't provide any control, whereas equity has risk/reward and provides control proportionate to shareholding. Hybrid instruments mix and match these," he said.
Explaining the same with examples, Mittal said that a company can have two classes of shares - say, Class A which provides risk/reward and control, whereas Class B which provides the same risk/reward but no control (no voting rights, or very low voting rights). "These can let entrepreneurs stay in control by owning Class A shares, whereas investors are given Class B shares. These are typically used when a company goes public - Class B shares can be issued to public shareholders, thereby allowing entrepreneurs to stay in control," he said. Another instrument is the variable interest debt, which can provide some upside to debt holders depending on company performance, without giving any control.
A founder faces funding challenges at each stage of a startup's life cycle be it Angel funding, the VC round or roping in an Private Equity Fund, believes Rahul Agarwal, Director Wealth Discovery/EZ Wealth, as he added that the amount of startup funding at present has gained some traction however the quantum of early stage risk funding that Indian startups need is not enough. "Therefore it becomes imperative to find innovative methods such as hybrid instruments, which not only help increase the geographical reach in terms of fundraising as well as the quantum of these funds," he said.
How Will it Help Start-ups
Currently in India, a start-up can go ahead with funding either through debt or equity funding. However, Agarwal explained that due to the cumbersome processes involved and the usual high interest rates, debt as a source of funding is also not a viable option in the initial stages. Equity therefore is the only viable option when it comes to raising funds however it comes at a cost of relinquishing control over the day to day affairs, he added. "Right now, India allows just one class of equity shares when it comes to startup funding, in this process every equity share gives its owner one vote in deciding the company's operation and eventually if the founder dilutes significant amounts of equity he effectively loses control over the company affairs. In this regards the hybrid way of funding is a boon to entrepreneurs as it allays one of their biggest fears," he said.
Most of the start-ups have huge funding needs in the initial stages and it is not easy for them to raise funds through debt instruments to fulfill their capital needs, as they are short of proven cash flows, believes Agarwal. The other feasible option is to raise equity through VC/PE funding, but they are dilutive hence the founder loses control if he is a minority stakeholder, he added.
"To address this problem hybrid instruments have been conceptualized that help a founder to retain control in the decision making process even though they are minority holders. Although a lot of clarity is still needed in the policy framework however the differential voting right aspect addresses the concern of the founders over loss of control," he said.
Agarwal explained that funds raised through hybrid funds would have differential voting rights which are not equivalent to the voting rights of the founders hence this type of funds would not be restrictive to the founders autonomy. "This effectively goes beyond the realm of a typical debt or equity way of funding and with these instruments the government plans on redefining the traditional of equity and debt investments norms under the current FDI policy," he said.
Currently, instruments that are fully and mandatorily convertible into equity within a specified period are regarded as equity under the FDI policy and hence it is eligible to be issued to persons residing outside India. Any instrument that is not mandatorily convertible is considered debt and governed by external commercial borrowing rules. "The proposed hybrid policy is expected to go beyond this categorization with built-in pricing freedom, some of the hybrid funding options that currently are under consideration are Compulsory Convertible Preference Shares (CCPS), Compulsory Convertible Debentures (CCD) and Convertible Notes (C-Notes)," he said.