Businesses don’t take on debt lightly, even if the amount is a fraction of what they were paying at the beginning.
Many start-ups in India are small, but there are several examples of companies that have borrowed billions of dollars to finance the construction of new businesses, said Amit Kulkarni, a partner in the business development and innovation practice at McKinsey & Company India.
This is because many Indian entrepreneurs have been able to borrow money in advance of starting their businesses, he said.
Kulkarnis research suggests that companies borrow money for at least 10 years in order to get started.
The reason is that debt-free start-up businesses typically make more money.
“If you start out with $10,000, you can’t get started for $5,000,” he said, referring to the debt-based approach.
“It’s more cost-effective to borrow in advance.”
Borrowing money for the first time in India is a tricky business.
The process can take from six months to three years and is fraught with risks, said Gopal Gokhale, co-founder of the India’s largest e-commerce platform, Flipkart.
But once you start borrowing, you need to be prepared for delays in getting your business up and running.
In India, the business environment is not conducive to start- ups.
Many are not prepared for debt and many of them have not invested in their businesses in the past.
India’s banking sector is also very different from that of the US and Europe.
One of the key reasons for this is the lack of financial oversight and regulation.
A loan is a loan and there is no formal regulation for it, said Rishi Gupta, an assistant professor at Columbia Business School and the author of “Business Finance and the Indian Economy.”
The lack of regulation is also one reason that the loans can take years to repay, Gupta said.
“India is a very different place from the US or Europe,” he added.
Banks in India often do not lend to start ups, and many companies do not have a strong financial cushion to absorb the risk of default.
Businesses that fail to pay back their loans will have to repay them, said Vijay Prasad, a professor at the University of Oxford’s business school.
When it comes to defaulting, “If you are a startup, you have to take the loss and make it right,” he told CNBC.
“And if you don’t make it straight, you lose your credibility.”
Some companies are already facing this.
On Monday, Flipksart, a mobile wallet service, said it had defaulted on nearly 100 million loans.
There are a few ways for a company to avoid default, said Gupta.
For starters, a company should have adequate capital.
In fact, a startup should have a cushion of cash that can withstand a loss.
Then, a lender should offer a guarantee to cover the company’s losses.
And if a company fails, the lender should pay back the entire loan within three months, Gupta added.
A company should also be able to withstand a decline in its value, Gupta explained.
Companies should be able take the full cost of the loan.
If a business defaults, a borrower can either pay the full loan back within three years or take a defaulting business to the court.
These are the basics, Gupta told CNBC, but what’s missing from the equation is the actual money to make a business viable.
Investors, including those in the start- up space, are also concerned about the financial outlook.
“When we look at the current environment in India, companies have been reluctant to borrow,” said Srikanth Ram, managing partner at KPMG India.
“That’s why it is a concern to us.”
As of March, India had a total of over $50 billion in outstanding debt.
To be sure, this is far from being the biggest debt in the world.
According to Bloomberg, the U.S. is the world’s third-largest debt holder at $52.3 trillion, with China and Japan the second and third.
So, while it is possible that a few small companies will start to default, the bigger picture is that the debt burden is a threat to the future of India’s economy, Gupta cautioned.
Even a small business, however, could become an asset for the country if it has to repay debt, Gupta stressed.
With more than a trillion dollars in outstanding debts, a failure to repay will be a blow to India’s financial health, he added, adding that this is especially true for start-Ups, which are more likely to be the victims of a default.
In fact, the government has already announced a series of measures to address the debt crisis, including lowering interest rates and raising interest-free loans