Banking Article, Banking Finance 2023, Banking Finance September 2023

Startup Financing: Opportunities and Challenges for Banks

With the growing of economy and fast paced developments the banking sector has undergone many changes. As the financial activity gained pace and the market opened for competition, the innovation in the financial sector has increased and so have the revenue and profitability avenues for the banks and financial institutions. The 21st century has been the century of startups. With an unconventional approach to problem solving, an unrelenting zeal to succeed and an open approach to new ideas, startups have truly disrupted the business landscape. India has had umpteen startups in the last few years of whom some have been able to make their mark while the others could not, which in way is understandable as it is in the nature of startups who follow a high risk high return approach.

Banks have now opened up to the possibility that going forward startups would constitute a significant source of revenue and profitability growth for the banks and are keen to seize this opportunity. Earlier the possibility of 9 out of 10 startups failing made the banks weary of advancing finance to them. However considering their potential and the risks involved banks have now opened up avenues of financing to them.

It’s not that startups have just touched one or two segments of the industry, they have instead ventured in all those spheres that had the scope of making things better and improving the processes.

The role and support of Banking Sector:

On 6th January, 2016, ‘Startup India’ initiative was launched by the Government of India to cater to the needs of the budding start-up eco system in the country. In view of the country’s young manpower and with an aim to promote employment opportunities, it has been a commendable step in the right direction. The entrepreneurs in India have received funding from various private institutional and non-institutional investors and also from Banks. When we talk about startups the picture that flashes in our mind is of an untested idea which could disrupt the way the business is done and if successful could be worth millions or billions of dollars and if unsuccessful the investment could go down the drain. They are not the only kind of startups, the loan given by the banks to an entrepreneur is also a startup although with a less level of disruption, none the less such a venture is generates employment and aids the country’s GDP growth. Such ventures until recently were more synonymous by the name of entrepreneurship than startups.

The banking industry in India had and is having a very active role in encouraging the startup culture by promoting and handholding entrepreneurship. This endeavor on part of the banks has now expanded to the funding of new ideas based on their disruption potential. Country’s leading banks have now launched separate schemes to promote the startups in the country and have formulated a well drafted policy for the same. Country’s largest bank State Bank of India has recently opened a branch exclusively for catering to the financial needs of Startups in the silicon valley of India, Bengaluru.

Seed stage startups though risky, provide a business opportunity that has an increased probability of a either a high payoff or no payoff at all. The risks are there and so are the chances of return. There has been a shift in the way startups have been viewed as a business opportunity.

The government has also been very proactive and supportive of startups and has been leading to ensure that the funding requirements of startups are taken care of. Along with that the state governments are going all out to provide these budding entrepreneurs the right infrastructure and administrative support so that the promoters only focus on their project.

Promotion of startups has dual benefits, firstly they provides an impetus to the economy by promoting GDP growth and increasing employment and secondly they provide a solution to the problems faced by the public by transforming the solutions into a business idea. The regulator has also pitched in with a number of awareness and policy initiatives to promote the startup sector along with the government that has undertaken number of steps for ease of doing business.

It is also a fact all the developed economies have a major contribution of entrepreneurs. And as we grow on the path towards being a developed nation the proportion of entrepreneurs and startups is bound to increase exponentially and so will the opportunities for the financial and banking sector.

Some examples of Operational Challenges (Risks) to Funding:

  • One of the startups which disrupted the taxi and mobility business across the world, in its quest to grow, became promoter of a toxic work culture leading to complaints and grievance by many employees. The investors had to ultimately intervene and asked the founder to step down. That startup today is a significant contributor to our daily mobility solution.
  • Another example is of an Indian Startup which was the first to enter the real estate market with a data and analytics based approach. This startup which was initially very promising, a trend setter of sorts and had the first mover advantage in the industry eventually lost its sheen due to dispute between one of the founders and the investors.
  • One of the recent examples is of a financial startup whose founder was accused by the investors of unethical practices and causing loss to the company. This founder also made counter allegations. The investors have since taken control of the company and appointed a different management team to steer the company clear of the controversies and drive it to the next phase of growth.

Disputes between founders and investors / financers is not new, they have happened before and would continue to happen as long new businesses are created. In fact the late founder of a company who was ousted by the other stakeholders, came back after 10 years to make the company one of the most valuable companies in the world. He introduced the world to touch screen mobiles and change the way we carry and listen to music. This is the nature of business and especially businesses engaged in technology. Most of the startups in the recent times have been technology startups who promote on an idea that may or may not work.

Most of the time it’s the difference of perception regarding the future path of the company that leads to dispute. Startups have very little tangible assets and their valuation is solely based on the assumption that the idea would work. This makes the debt financing of startups by banks / financial Institutions a challenging task.

Consensus on Valuation?

What makes the methodology of valuation somewhat disputed is that the revenue generated has a very significant weight in determining whether a startup is a unicorn or not. In the midst of this race for valuation the actual business sometimes takes a backseat. Money is pumped into promotions and discounts to increase the gross merchandise value in the short term. This leads to the companies having high valuations together with high losses. Most of the startups that have even got listed are still running into huge losses however their valuations have shot up multiple times, of course due to metrics other then profitability. Recently the founders of one of the startup had a dispute regarding the future path of business, which has led to various rumours of the startup winding up operations.

This kind of methodology actually runs against the very principle of traditional business which is profitability. No business could survive running in losses, however in the case of startups the profitability is looked deep into the future. Startups are all based on a disruptive idea, something that alters the existing business landscape altogether, the more disruptive the idea the more the risk, more are the chances of the startup scaling billion dollar valuations. One of the major telecom company offering mobile telephony in India today was called a startup by its promoter considering the disruption it made in the market and the scale at which it was launched. Of course no prizes for guessing that it worth a few billion dollars now.

Such valuation metrics often poses problems while considering debt based financing by financial institutions to such startups.

One reason why the unicorn culture fascinates businesses and investors alike is because eventually the higher a company is valued the richer the investors become. This is after all the financial goal of any enterprise and then it works in a loop as more valuable a firm becomes the more investors get attracted to it. This principle of valuation however works in contradiction to the principles of traditional finance largely followed by financial institutions that considers a consolidated picture of a firm’s financials along with profitability and other ratios.

Business Model:

The concept of startups has its own set of critics as well. The critics argue that in the rush of attaining sky high valuations the companies are running short on foundations which are a necessity in case of long term viability. Another section says that this rush for valuations culminates in the company being sold to other growing startups in the merger and consolidation process. Many of the young startups eventually fade away in the process and some of them grow multitude in valuations.

Startup is a high risk business and the promoters are entering an area not much traversed before and thus there is the urgency to grow and outsmart everyone else in the field. This explains the importance of the valuation mathematics. This sometimes is the reason for difference of opinion between founders, investors and financers.

Almost all the sectors have had the impact of startups but the most prominent and disruptive impact has been in the fields of mobility, e-commerce, education and banking and finance and all of these fields have produced one or more unicorns. But are all of these businesses profitable the answer would be vehement ‘no’ at least for the time being but it is also a fact that they do command huge valuations. This valuation game is something that has resisted some of the great investors / financiers of our time in investing in startups. We have even witnessed as to how fragile these valuations could be as was the case with some of the crypto and metaverse startups. The valuations of these companies rose significantly during their boom and when the tide turned against their favour, the companies became much less valuable that what the investors had believed while making an investment. This led to investors losing huge amount of wealth in a very short span of time.

Another reason for this wide variation is that these technologies are relatively unproven and the valuation is all dependent on its success with a certain revenue level. In the event the projections do not work out as envisaged the valuations drop significantly as there are very less or almost nil tangible assets to support their valuation.

The aim of any business is to be profitable and add value to shareholders wealth and startups are no exception to that fact. However startups have an added responsibility they promote growth by disruption, by challenging the status quo. All the big companies today were once a startup and once can just fathom as to what would have been our economy had these companies not been there.

Startups stir up economic activity and promote growth. They have a direct impact on the country’s GDP and have a tremendous indirect impact on job creation and economic activity through vendors and suppliers. The wheels of the economy gets rolling as the banking system gets involved to fund the startups and ancillary units / vendors, also the credit uptick happens as money starts coming into the hands of the employees. It is imperative for us to understand that all aspects of the economy are related and when one aspect is buoyant it automatically pulls up the rest thereby increasing the economic activity.

Having discussed the importance of startups in the financial and economic prosperity of a country it is also important to note that when a startup goes bust it also makes a negative impact on the banking system and the economy as a whole.

Opportunities:
Startups provide an alternative source of revenue and there is an increasing potential in startups as they cater to the ‘new economy’.

  • Majority of the startups are technology firms with a focus on the bottom of the pyramid and an opportunity to target a mass segment of the population.
  • Financial Institutions who start early would be at an advantage as they would become startup compatible early and would have a better chance to participate in rapid growth and expansion.

There is also no denying the fact that startups have been and continue to be a backbone to business development. It is because of the will and vision of the founders that a lot of services and benefits that were unheard of and not thought about in the past are a reality today.

As we progress into the feature, entrepreneurship and startups will gain more importance which would open new opportunities for the banking sector as well. With the banks also entering the game it means more disruption, better opportunities, a healthy competition and a plethora of financing options for the entrepreneurs to convert their ideas into successful business ventures.

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