presents

Insights at the Convergence of Tech, Business, and the Economy

THE ECONOMICS BEHIND

A STARTUP’S OPTIMAL
CAPITAL STRUCTURE
[Startup Debt series - Part I]

RICHARD PINTO Principal

A company's capital structure is a mix of debt and equity financing it uses
to fund its operations and assets.

Finding the right equity vs debt mix depends on -

company's age industry risk tolerance

In early stages, startups often rely heavily on equity due to limited access to
debt financing options.
Debt is used for various purposes like expansion, acquisitions, and bridging
temporary funding gaps.

Equity is typically directed towards riskier business activities and helps

support innovative business models that are not yet market-proven.

Debt

Debt

Equity Equity Equity

Inception Growth Maturity

As startups mature, they often struggle to integrate debt into their capital
structures, despite its benefits for growth and sustainability.
Why Debt Takes a Backseat for Startups

Equity's Allure Profitability Paradox

Venture capital's surge in Startups prioritise

popularity provides startups easy growth over profits
access to equity funding
No profits = High risk for debt providers
(Debt becomes unavailable)

Collateral Catch-22 Cash Flow Conundrum

Startups lack physical Startups' income can be

assets like buildings (Think unpredictable (Ups and
ideas, not factories) downs are the norm)
No collateral = Less secure loans Unstable cash flow = Risky lending (Debt
(Traditional lenders hesitate) providers hold back)
Balancing Debt and Equity

An optimal capital structure involves balancing debt and equity, crucial

for financial health and growth.

WACC (Weighted Average Cost of Capital) is the blended cost of all funding
sources, reflecting both equity and debt costs.

Equity Risk
Premium

X
Cost of
Beta Cost of Equity
Equity

+
Weighted
Average Cost of Risk Free Weighted
Capital Rate Average Cost of
Capital
Average Yield
on Debt

Cost of Cost of Debt

Debt X (after tax)

Tax Shield
WACC is a crucial indicator of market cap, reflecting investor return
expectations and risk assessment for both equity and debt.

In DCF valuation, WACC discounts future cash flows, determining present

equity value, crucial for early-stage startup assessment.

As a rule of thumb:

Lower WACC means lower risk, potentially higher Market Cap

Higher WACC means higher risk, potentially lower Market Cap
 Current Economics of Debt and Equity

REVENUE-BASED
FINANCING
VENTURE DEBT

FIXED DEPOSIT-BACKED
OVERDRAFT
14% 15%
to to
8%
to
18% 20%
11%

*Interest rates in %

Low initial costs More flexible, good Shares revenue-

but requires collateral for runway extension risky but viable
and may decrease over or working capital. for early startups.
time.

Cost of Equity is complex and stage-dependent, with early-stage

startups facing higher costs due to increased risk.

Over 50% of startups report an average cost of equity exceeding 20%

(Source: EY)
 Case Study

Company A, a Seed-stage startup, secures INR 5 Cr of equity funding from VC.

The startup needs working capital (₹1 Cr) due to a long manufacturing cycle
(3 months) and receivable credit period (1 month).

Ideal Solution

Seeks an overdraft facility [OD] at 10% interest to manage working

capital burden during production and receivable cycles.

Pre-Securing OD Post-Securing OD

Cost of working capital INR 20 lakhs p.a. INR 10 lakhs p.a.

WACC 20% p.a. (all equity) 18.33% p.a.

What should be your Optimal
Capital Structure

Nature of the industry, maturity of the company, overall financial health

are just a few of the components that affect your ideal debt-to-equity
ratio.

It's a constantly evolving process - fine-tune your mix as your business

and the market change.

While aiming for a low financing cost (WACC) is good, consider these:

• Don't sacrifice growth by being too conservative with debt.

• Lower debt might limit your ability to invest in future opportunities.
• High interest rates or a shaky market might make minimising WACC
tough.

Minimising WACC is important, but do it strategically, considering your

risk tolerance, growth plans, and the current market.
About

Insights at the Convergence of Tech, Business, and the Economy

Signals by 3one4 Capital is a platform where we uncover the

critical shifts shaping the future of technology, business, and the
global economy.

Through insightful thought pieces, expert analyses, and

real-world case studies, Signals illuminates the opportunities
emerging from the convergence of tech, policy, and economic
forces at play in New India and beyond.

Our field notes will offer a wealth of perspectives to help you

navigate the opportunities of tomorrow, from startup case
studies that celebrate entrepreneurial spirit to in-depth industry
insights that inform your strategic decisions.