Nothing is available for free, even the air we inhale necessitates exhalation. Similarly, a startup requires funding in order to uplift itself from the nascent stage to a mature one. As an aid to the upliftment process, the Government of India has put forward an overture for hybrid instruments deviating itself from the traditional way of funding that was mainly either through pure equity or pure debt.
In order to expand, it is necessary for entrepreneurs to tap financial resources. Business owners can utilize a variety of funding resources, primarily broken into two categories, debt and equity. “Debt” involves borrowing money to be repaid, plus interest, while “equity” involves raising money by selling interests in the company.
The answer to the question of whether to go for debt or equity depends on various factors, like, the purpose of raising funds, tenure, liquidity, ability to service the investor and so on. Therefore, the answer to the question is very subjective.
If the issuer does not want its equity to be diluted, then it should better go for debt rather than equity. Also, from investors’ perspective, debt happens to be less risky than equity and it also offers a fixed rate of return. Some of the factors influencing the choice between debt and equity, with respective pros and cons, have been discussed below:
Debt is preferred over equity because interest on the debt can be deducted on the company’s tax return, lowering the actual cost of the loan to the company. Debt does not dilute the owner’s ownership interest in the company. A creditor is entitled only to repayment of the agreed-upon principal of the loan plus the interest component, and has no direct claim on future profits of the business. If the business is efficacious, the owners reap a larger portion of the rewards than they would if they had sold stock in the company to investors in order to finance the growth. However, unlike equity, debt has to be repaid at some point. In order to avail debt, the company is usually required to pledge assets of the company to the financier as indemnity.
Equity funding is well suited for startups in the innovation or technology sectors. Besides requiring a strong corporate network, it also requires a sound business plan. However, it does not put constraints on cash flow. Entrepreneurs can distribute the financial risk among a larger group of people through equity financing. In case, an organization is not making profit, it does not have to make repayments. In case of profit, the company may opt to reinvest the same in business for the purpose of expansion instead of distributing the dividend.
Typically, equity has risk/reward and provides control proportionate to shareholding whereas debt is fixed price and doesn’t provide any control. For example, a company can have two classes of shares, namely Class A shares accompanied with risk/reward and control and Class B shares accompanied with same risk/reward devoid of any control or voting rights. Business owners can retain control by owning Class A shares while the Class B shares can be issued to public shareholders.
In order to overcome the paucities underlying pure debt and pure equity, often hybrid financial instruments are explored for raising funds. Hybrid financial instrument is an instrument that partakes some characteristics of debt and some characteristics of equity. Hybrid instruments contains embedded equity component as well as debt component. Hybrid instruments lure foreign investments or private equity firms in several niche areas, especially in the start-up space.
Hybrid instruments principally include preference capital, optionally, partially convertible debentures, Foreign Currency Convertible Bonds, structured note- which are intrinsically debt-instruments. Each type of hybrid security has unique risk-reward traits. The same have been discussed below:
Pros & Cons
The rationale underlying hybrid financing is to offer the investors a blend of positive factors of both the debt and equity instruments. Equity instruments give the sense of ownership to the holder, and a residual claim over the cash flows while the debt instruments are issued to raise capital in the firm that could be used in its development.
The axiom “more the power, greater the abuse” aptly sums up the hindrances that hybrid securities might generate. Generally speaking, some hybrids will behave more like shares, and others more like bonds. Hybrids exhibit bond-like returns with equity-type risks. In a wind-up scenario, hybrid investors are among the last to recover their funds since they generally rank behind senior bondholders and other creditors. Besides being a complex instrument, not all hybrids are created equal.
Hybrid Financing could be used as a sophisticated financial instruments to entice foreign investors as well as high net worth individuals. With days to unfold, we are to see whether hybrid financing would serve as a boon or a bane.
(Author is associated with Vinod Kothari & Company)