Financing Options For Business

An overview

A brief overview of traditional and hybrid financing

options available to businesses
Financing Options For Business
Contents Page No.
1.0 Background 1
2.0 Normally Used Funding Options in India 2
2.1 Equity Financing
2.2 Debt Financing
2.3 Internal Accruals / Generated Funds
3.0 Exchange Control Regulations 4
3.1 Equity Financing
3.2 Debt Financing

4.0 Tax Regulations 5

4.1 Equity Investments
4.2 Debt

5.0 Option Evaluation: Equity vs. Debt 6

6.0 Certain Instruments which Balance Exchange 7
Control and Tax Regime
7.0 Accessing Capital Markets: Key Aspects to be Noted 8
- Opportunities and challenges
7.1 Key Advantages
7.2 Modes of accessing Capital Markets
7.3 Investor Requirements Required for Generating Investment
Interest
 1

1.0 BACKGROUND

With the growth of the Indian economy at over 8 % in GDP being targeted
consistently over the next few years, the opportunities for business growth
and consolidation through mergers and acquisitions, demergers, value
unlocking of existing businesses etc. is set to grow manifold. The stronger
and smarter players in the business space are set to take advantage of the
opportunity and grow and expand their business manifold.
For all this growth and consolidation to happen, one of the key requirements
is the astute use of funding options available in the market. Ability to raise
cost effective funds in flexible modes on a consistent basis is today one of the
key milestones for success in the market be it for organic or inorganic growth of the business. Consistent and robust growth of
individual businesses only shall ensure growth at the regional and national level.

The choices, then, refer not to if, but rather how, businesses must raise funding to ensure that both current plans and future
goals are realized. In the post liberalization scenario, India has metamorphosed into a premium destination for foreign investors
to put in money.

As such, it would be essential to have a thorough understanding of the alternative funding options available. India with its maze
of regulations / regulators, poses a unique and interesting challenge to potential investors. It is only with a proper knowledge and
understanding of the regulatory requirements and the market landscape can a stake holder (be it an investor or a fund raising
entity) be able to navigate successfully.

This paper on ‘Funding Options for Business’ first evaluates the more traditional options available in funding (Equity and Debt
Financing). Further, it proceeds to examine alternate funding options available (including hybrid options) and some of the
challenges and implications, namely from an exchange control and taxation perspective. Some of these alternative options
would be of interest to foreign investors who are looking at options in a constantly evolving and dynamic market place, in order
to get an optimum solution.

Factors Influencing Financing Options

} Type of Business Entities: Sole Proprietorship; Partnerships, Companies, etc.

} Type of Business: Manufacturing, Services, etc.

} Economic scenario: Recession, Lows or Highs

} Stage of evolution of the Business: Nascent or at a take off stage, etc.

} Duration of the financing requirement: (Short-term, medium term or long term).

} Risk appetite and profiling of the promoters

All the above factors have a significant impact on the fund raising initiatives. The most commonly used funding alternatives by
investors to raise funds for business in India include – equity financing and debt financing. We have tried to discuss the various
positives and limitations of these options and explore other possible alternatives.
 2

2.0 NORMALLY USED FUNDING OPTIONS IN INDIA

} It is generally seen that all businesses, whether small, medium or large face different types of issues
relating to financing their operations. Some of the issues generally emerging are those of control,
cost of funds raised, leveraging ratios, history and track record of the business / Promoters,
future prospects, etc.
} As such, before any funding option is decided by a business, various alternate options possible
should be objectively evaluated to know the pros and cons of each and decide on the optimum
mode of funding under the given circumstances.
} The normal modes of raising finance are Equity financing, Debt financing and / or Internal accruals / generated funds.
2.1 Equity Financing
} The initial funding for any business is normally through equity financing.
} Equity is given in the form of stock in the Company.
} Equity funding is risk capital which is invested by the owners of the business / entity and as such it does not involve a
direct obligation to repay the funds invested.
} Being risk capital / owners’ capital it gets is return at the end, after all the stake holders have been paid their returns.
} As owners of the business, the investors get to exercise certain degree of control.
} The return on equity is in the form of dividend which is paid depending upon the profitability and the future cash flow
requirements of the business.
} The investor, on his part, trades an assured return on the ‘safe’ instrument, example, a bond or debt, in return for the
opportunity to grow his wealth through equity capital in a far more substantial manner.
} Equity financing may be by way of
− Equity Shares
− Preference Shares
− Fully and Compulsorily convertible Preference Shares
− Fully and Compulsorily convertible Debentures (Quasi equity)
Investment by way of equity infusion by non-residents from outside India is regulated by the Exchange Control regulations under the
Foreign Direct Investment (FDI) policy. The trend of FDI inflows into India has been steadily increasing over the years. The trend is
expected to continue over the coming years too. India is today a preferred destination for investment globally given the robust growth
of the economy and the growth pointers over the coming years. With the recession still looming large in developed markets of the
United States, United Kingdom and the European Union, significant capital from these markets is flowing into India in search of
relatively safe and attractive returns.
Financial Year FDI inflows into India
The table (right) and the chart (below) highlights the total FDI inflows in India (April – March) (US $ Billion)
for the years 2006-07 to 2010-11.
2006-07 22.826
2007-08 34.835
2008-09 37.838
2009-10 (P) 37.763

2010-11(P)
19.002
upto Nov. 2010
FDI inflow s into India
Note: (P) All figures are provisional
37.84 37.76 (Source: www.dipp.nic.in)
40.00 34.84
35.00
30.00
22.83
25.00
19.00
US $ Bn.

20.00
15.00
10.00
5.00
0.00
2006-07 2007-08 2008-09 2009-10 (P) 2010-11(P) upto
Nov . 2010

Years
 3

2.2 Debt Financing

} Debt financing involves raising a loan / debt which is to be repaid back, normally with interest (which is the return a lender
gets for lending the money to the borrower) over a pre-defined period of time.
} Raising finance in the form of debt could have some apprehension, since it involves relinquishing some cash profits even if
the business is not making sufficient profits.
} Debt financing proves to be a good option if the borrower is able to generate sufficient cash flows for paying back the debt
with interest.
} This also provides an assured return upfront to the foreign investors by way of fixed rate of interest.
Debt financing from outside India is highly regulated by the External Commercial Borrowing (ECB) guidelines issued by Reserve
Bank of India (RBI). While India is an attractive destination for investing, the same cannot be said for borrowing funds in the market.
The cost of borrowing is typically high in India compared to the international market. This has resulted in Indian companies opting to
use the ECB route frequently. The ECB inflows into India are tabulated as under:

Under Automatic
Years Total ECB inflow Under Approval Route
Route

2006-07 25.35 17.92 7.43

2007-08 30.96 20.02 10.94

2008-09 18.36 9.46 8.91

2009-10 21.67 13.92 7.75

2010-11 (upto
12.58 7.68 4.89
Nov 2010)
Source: www.rbi.org.in

ECB Inflow in India

35 30.96
ECB Inflow (US $ Bn.)

30 25.35
25 21.67
18.36 Total ECB inflow (US $ Billion)
20
12.58 Under Automatic Route
15
10 Under Approv al Route
5
0
2006-07 2007-08 2008-09 2009-10 2010-11 (upto
Nov 2010)

Years
2.3 Internal Accruals / Generated Funds
Internal accruals are internally generated funds which arise on account of cash profits earned by the business, release of
funds from working capital assets, sale / disposal of fixed assets etc. Before a business decides on the use of internal funds
for new requirements, it needs to do a cost and benefit analysis of the same, as at times, diverting internal funds to new end
uses could starve the existing operations of funds which could impact operations.

Fund raising also depends upon the stage of the economy, as in a recessionary phase, fund raising would generally be diffi-
cult from the equity market. Investors typically shy from risk and would opt for a safe instrument like debt. These aspects were
clearly demonstrated in the market place during the recessionary period in Year 2009. Further, overseas investors, also need
to keep track of the evolving exchange control regulations and the tax laws in India. Implications thereon can drastically
change the economics of borrowing or investing in the Indian markets.
 4

3.0 EXCHANGE CONTROL REGULATIONS

Foreign investment into India in whatever form is regulated under

the Exchange Control regulations and is administered by the RBI.
3.1 Equity Investments

Equity investment into India can be made under the following two routes:
} Automatic route
} Approval route

When the investment falls under the automatic route, no specific

approval is required. However, in cases, where the investment falls
under the approval route, specific prior approval of the Foreign Investment Promotion Board (‘FIPB’) needs to be obtained.
Under the exchange control regulations, equity financing can be obtained through FDI route, Portfolio Investment Scheme
(PIS) and Foreign Venture Capital Investor (FVCI) route. The FDI guidelines issued by the RBI would be applicable in the
case of funding by way of equity from outside India.

Under the FDI policy, investments in most sectors are generally permitted under the automatic route. However, the pricing of
shares (at the time of issue) has to be in accordance with the prescribed pricing guidelines. There are various categories of
instruments which are classified as part of equity capital under exchange control, such as
} Equity shares
} Fully and compulsorily convertible preference shares
} Fully and compulsorily convertible debentures
3.2 Debt Financing
Debt financing raised in the form of foreign currency (generally referred to as ECB) are also accessible either under the
automatic route or approval route. The various forms of debt which are classified as part of ECBs under exchange control are
} Vanilla Loan
} Non - convertible or optionally convertible debentures
} Non - convertible or optionally convertible preference shares

As ECB is regulated by the RBI, it is subject to strict restrictions. While these restrictions appear particularly stringent vis a vis
global standards, these have held our economy in good stead during the global recession, as our exposure to the sub-prime
crisis was relatively limited and controlled.

The restrictions could be with reference to:

} recognized lenders,
} eligible borrowers,
} amount and maturity,
} end uses. Example, such borrowing cannot be used for on-lending investment in capital market, real estate sector,
working capital, etc.
External C Approval Route
To overcome restrictions such as end uses, minimum maturity period, etc the Indian company could also consider other
funding routes through a Letter of Credit (LOC) or guarantee. It becomes very crucial to be updated about the current
exchange control implications every time a funding requirement arises in India since the exchange control regulations keep
evolving and changing depending on the economic scenario and development needs.
 5

4.0 TAX REGULATIONS

4.1 Equity Investments: Taxability of dividends
The regular income from the equity financing i.e. equity shares or preference shares could be in
the form of dividend.
} Investors
− Dividend declared by an Indian Company is exempt in the hands of the investors/
shareholders as per the Indian tax laws provided Dividend Distribution Tax (DDT) is paid.
− Capital Gain on sale of shares of the Indian company at the time of exit is
primarily taxable in India. However, the same may be exempt depending on
the factors such as period of holding, tax jurisdiction of the investor/ shareholder, etc.

} Investee:
− The Indian company would be liable to pay a Dividend Distribution Tax @15% at the time of declaration, distribution or
payment of dividend (whichever is earlier).
− Dividends are not tax deductible in the hands of the Indian company, which means dividend paid is not allowed as an
expense while computing the taxable income of the Indian company.
4.2 Debt: Taxability of Interest Income
Income from the debt is generally in the form of interest in the hands of the lender.
} Lender
− As per the Indian tax laws, the interest income is taxable in the hands of lender as per the normal rates prescribed.
− The tax law in India permits a tax payer to be governed either by the Indian domestic tax law or by the Double Tax
Avoidance Agreement (DTAA), whichever is more beneficial to the tax payer. The beneficial rate is to be applied for
withholding tax purposes.
− As per the Indian domestic tax law, in cases where the loan is taken in foreign currency, the tax rate for interest is
20%. However, if the loan is in Indian currency, the applicable tax rate is 40%.
− The tax rate on interest received by the lenders who are tax residents of jurisdictions like The Netherlands,
Switzerland, Cyprus would be 10% and from jurisdictions such as UK, USA, Singapore, etc tax rate would be 15%
under the respective DTAAs.

} Borrower
− The Indian company would be required to withhold requisite taxes while making the interest payments.
− The interest expense is normally tax deductible in the hands of Indian company except in certain specific situations viz
for earning tax free income or for acquiring assets for extension of existing business.
 6

5.0 OPTION EVALUATION: EQUITY VS DEBT (SOME ASPECTS)

Particulars Equity Funding Debt Funding

Repayment of debt as per the terms agreed
Repayment No committed repayment obligation.
upon.
Lenders will not have any claim beyond their
Future profits of the Company Only Equity shareholders to have claim.
interest dues and repayment of principal.
Dividends declared are tax free in the hands of The interest paid on debt is taxable in the
Return on investment
the shareholders. hands of the recipient.
Interest – Tax deductible. Indian Company
Payment of return on investment by Dividend – Non tax deductible.
would be liable to withhold taxes on such
Indian Company Indian Company would be liable to pay DDT
interest payments.
Exit possible only by way of liquidation, buyback
as permitted under the regulations, sale of
Exit Exit by way of repayment.
shares to the third party or existing
shareholders.

Funding by equity in India has benefits such as easy entry, no restriction on end uses, etc. under exchange control
regulations. These benefits are not available with funding by way of debt. However, at the same time, equity financing has
constraints under the tax provisions like no tax deductibility, etc vis a vis debt financing. Funding is driven by various
commercial, exchange control and tax regulations. One has to select the funding option depending on the objectives and
various other commercial factors.
 7

6.0 CERTAIN OPTIONS: INSTRUMENTS WHICH BALANCE EXCHANGE CONTROL AND TAX REGIME
We have discussed in depth the more traditional options available in the alternate funding market. As the market for fund
raising evolves, it is imperative to develop creative solutions to ensure an optimal solution. As is evident, exchange control
regulations and tax provisions are enacted to achieve different objectives of the government. The key challenge thus, is to
decide on the funding option that is not only permitted as per the exchange control regulations but is also tax efficient. There
exist instances of conflicting provisions within the regulations. One such example is of the exchange control regulations
containing the restriction of debt equity ratio whereas there are no such rules in the tax laws in India. In order to achieve
maximum tax benefit, tax planning regarding the funding alternatives may be possible by way of having any proportion of debt
and equity. However, under exchange control regulations, as there is a provision of minimum debt equity ratio, it will restrict
such planning. The synchronization between these two regulations also becomes vital and crucial since both these regulations
keep changing constantly.

At times, the ECB funding may not really work for the Indian company in view of the various issues in terms of end use
restrictions and forex risks. At the same time, in the absence of favorable credit worthiness in India, an Indian company may
not be able to raise funds locally In order to “marry” the ostensible differences in an acceptable fashion, yet another funding
route may be opted for. In order to push down debt, the Indian company may opt for a funding instrument which is a hybrid of
equity and debt such as fully and compulsorily convertible debentures.

A fully and compulsorily convertible debenture is treated as equity for the purpose of reckoning sectoral cap. Hence, the
onerous ECB guidelines would not apply to such instruments. On the other hand the debenture is treated as loan or debt for
tax laws and is therefore an ideal instrument for pushing down the debt.
Some of the benefits of fully and compulsorily convertible debentures are:
} No end use restrictions as prescribed in ECB guidelines
} Interest paid to investors would be tax deductible in the hands of Indian company

The return to the debenture holder is in the form of interest till the conversion of debentures into equity shares. Such interest
would be taxable in the hands of the investors depending on the jurisdiction of the investors. Subsequent to conversion, the
return is in the form of dividend It should not be concluded that the hybrid option or guarantee based options are the only
solutions under all circumstances. There may well be situations or scenarios where a plain vanilla equity financing or debt
financing option is optimal. The key takeaway would be that there are options to the more traditional ones, however, it is
mportant to contextualize each of the options before taking a final decision.
 8

7.0 ACCESSING CAPITAL MARKETS : SOME KEY ASPECTS TO BE NOTED

The buoyant economic growth has translated in some key opportunities and key challenges for the Small and Medium
Enterprises (SMEs).

Opportunities Challenges
} Tremendous growth, major scaling up opportunities } Increasing competition
} Extending business beyond India. } Market dominance by bigger players
} Better access to capital } Quick scaling
} Building a world class organization } Building professional organizations
} Raising the right type and amount of funds, at
the right time

7.1 Why Access Capital Markets: Key Advantages

} Access to huge pool of sophisticated and flexible finance: This is a better mode of financing than traditional sources
like bank finance, promoters capital which has limitations like limited resources, fixed repayment obligations, higher risk
etc.
} Acquisitions in India and Abroad: Major acquisitions like Corus Steel, Jaguar and Land Rover by Tata Group, etc.
would not have been possible without access to sophisticated capital markets.
} Brand building: Enhanced image and status of the company with large customers / institutionalized customers and other
business associates. Greater public visibility, with possible benefits in marketing and attracting human resources.
7.2 Modes of Capital Access
} Private Equity funding
} Initial Public Offering (IPO) / Follow on Public Issue (FPO) / Rights Issue / Preferential placements
} Bonds
} Foreign Currency Convertible Bonds (FCCBs), Optionally Convertible Cumulative Preference Shares (OCCPSs), etc.
 9

7.3 Some Key Investor Requirements Essential for Generating Investment Interest
} Ensuring a proper corporate structure of the business for investment
− Converting the business in a corporate form i.e. as a Company
− Rationalizing the group structure and cross-holdings
− Analyzing industry specific regulations
− Determine the business / company that should be considered for infusion of capital on brand and image, growth pros-
pects, ownership and control aspects, tax benefits etc.
− Group structure to optimize the business activities and operations to expand in future.

} Sound and Well planned business model

− Identifying core competencies and defining business model
− Prepare strategic and financial plans for 3 – 5 years

} Competent Delivery Team of Professionals Managing the Business

− Build a team whom you can count on
− Create / Restructure the key positions to suit the business model
− Clearly define roles and responsibilities for all the positions
− Have a well defined HR plan for 3 – 5 years.

} Business Review Framework

− Developing an effective Management Information System (MIS) for all strategic business units.
− Developing Standard Operating Procedures (SPOs)
− Having an Enterprise Risk Management (ERM) Framework in place.

} Proper Corporate Governance Framework and controls

− Broad basing of the Board of Directors (BOD) by inducting more independent members, members from various
industries and having diversified expertise and experience.
− Using BODs meetings as a tool for strategic decision making, operational reviews, risk management reviews.
− Conducting BOD meetings at regular intervals to improve effectiveness
− Bringing more transparency and accountability in financial reporting
− Maintaining proper legal and secretarial records.
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February 2011

© RSM Astute Consulting, 2011