The startup ecosystem of India is the third largest in the world today with more than 20 unicorns (compared to 200-plus for the U.S. and China), 6,500 private capital seeded companies and approximately $10 billion in capital deployed by venture capitalists (VCs) in 2019 across various sectors, according to Bain & Co’s “India Venture Capital Report 2020”. Giants such as Paytm, BYJU’s, OYO, and Flipkart proliferate today with valuations crossing $10 billion, but these were once small seeded businesses which stand tall today having received investor, customer, and government support over time.

Fundamentally, banking institutions are the engine of an economy and an indispensable part of the financial ecosystem of any country. In the absence of support from these financial institutions, the growth prospects of the startup ecosystem has always remained undeniably restricted. Traditionally, banks have not extended their gamut of financial products to startups, considering the combination of credit history of these young companies not being the most robust and the risk-averse nature of these lending institutions. With the announcement on August 6 by the Reserve Bank of India (RBI), a befitting change has been proposed: to bring startups under the ambit of priority sector lending (PSL) norms. This comes as a significant boost for the ecosystem as new financing avenues have now opened for these young innovative companies. This decision has been met with a positive outlook from all parts of India Inc. and a firm belief that it will propel the development of the Indian startup ecosystem.

What does this entail?

Even today, a large segment of the Indian business ecosystem does not have access to sizeable credit opportunities. This announcement would enable financing institutions to tap into their reserves and provide an opportunity to the underutilised startup ecosystem of the economy. While banks and financial institutions are inclined to cater to young stage companies, more often than not they are unable to structure a framework and requisite deal flow for such startups as their concentration on this ecosystem has always been significantly low. This move by the RBI would provide financial institutions with an impetus to capitalise on funding opportunities whilst propelling the business growth for such young companies. A key to boost this initiative is to find the right structure by enabling various working capital arrangements within the ambit of MPBF (maximum permissible bank finance, wherein banks fix the working capital finance limits of a firm). Banks and financial institutions can provide startups with short-term financial products, thereby minimising their risk exposure and achieving desirable returns as their investee company expands its business operations over time.

In the last decade, India has witnessed a surfeit in the number of startups, with many establishing their place in the market. Many of them have seen an influx of capital from private investors such as global VCs such as Sequoia, Accel, SAIF, and the like, which also helps ensure strict corporate governance as a non-negotiable practice at these companies. Many Indian startups operate on high gross margins and positive unit economics, with a substantial percentage now targeting profitability, making it a ripe time for the financial ecosystem to thrust into this opportunity. There exists a plethora of cross-sell opportunities with scaleable businesses enabling banks to build a sizeable liability franchise with selective startups.

Finding the right ‘fit’

The advantage of raising debt is that it can be tailor-made to suit the cashflow requirements of startups, helping them meet their financial milestones yet maintain a desirable level of equity. Finding the right ‘fit’ in terms of gross margins, unit economics, and revenue while financing early stage companies requires a core focus on these businesses and related underwriting capabilities. That is where another participant of this ecosystem might become pivotal for banks to identify stellar startups for investments—venture debt funds of India. Since the turn of the last decade, venture debt funds have been providing debt finance to startups in the ecosystem which have portrayed certain qualities and passed certain parameters. Typically, the NPAs have been observed to be low whereas the expectation of IRRs has been comparatively high, making it a very attractive asset class. venture debt funds that employ a rigorous screening process, methodical underwriting capabilities and apply a strict benchmark for future scaleable and profitable businesses could be the ideal partner for banks to underwrite innovative new-age models. Banks can leverage the network and procedures of such funds to create a scaleable franchise and fulfil the need for deserved credit in these startups of India.

Leaping forward, we see a big opportunity knocking on the door for the ecosystem with the announcement by the RBI acting as a catalyst for change. Long-term associations are here to be built with banks benefitting massively through various cross-sell opportunities as they see their investee companies scale and become the country’s next unicorn.

Views are personal. The author is founder and managing partner, Stride Ventures.

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