Historians warn that nothing fails like success. Philosophers warn that the most dangerous lies are the lies we tell ourselves. Doctors warn that the dose makes the poison; anything powerful enough to help has the power to hurt. Synthesizing these three warnings is important for corporate India because the climate—low competition, slothful lenders, and high inflation—that encouraged and rewarded entrepreneurs for taking huge amounts of debt for their companies and personal finances no longer exists. This shift is not a passing shower, but a climate shift with fundamental implications for how Indian entrepreneurs must fund, structure and run their businesses. Borrowing equity must end.

Before looking ahead, let’s look back. The love affair of big entrepreneurs with debt that began in the 1970s was rational. The licence raj ensured that businesses did not have clients but hostages, and prices almost never went down. The lack of fiscal discipline and formal inflation targeting ensured that nominal prices always rose and the replacement cost argument with appreciating rather than depreciating assets became a viable argument. Finally, the nationalization of banks and legal system choke ensured that debt defaults had weak consequences because of slothful or unwilling lenders (amenable to “phone banking" and political influence). Consequently, many Indian entrepreneurs treated debt like equity—payable when able.

Debt and equity sit on the same side of any company’s balance sheet, but are very different species. Debt targets security, but equity loves risk. Debt collects interest at periodic and pre-agreed intervals, while equity waits for returns. Debt investors expect full principal repayment; equity investors expect to lose their principal on some investments (a few of which typically account for most profits in their portfolio). Equity investors think differently about scale (linear growth means lower risk) and transformation (lateral growth means greater risk); and once a business model is validated, scale should be funded with debt and transformation with internal accruals and equity. Unfortunately, companies have funded both scale and transformation with debt without realizing that when things don’t go according to plan—as they often do—equity investors don’t come to collect their collateral or take ownership, but debt investors do. The current troubles for many Indian banks arise from their acting like equity investors, but any returns on the principal cannot compensate debt holders for principal losses. When projects fail, equity investors can still be on the same side of the table as an entrepreneur. But debt providers have no choice but to be on the other.

The future of Indian entrepreneurship looks quite different from the past. Entrepreneurs will borrow less, with lending against shares and pyramid structures for equity holdings coming down. Entrepreneurs will run less diversified businesses and sharply distinguish between their three roles—as executive authorities on performance, as board members for quarterly oversight, and as shareholders pushing for accountability. These roles were traditionally concurrent, interlinked and guaranteed. First-generation entrepreneurs that scale up their ventures will end up owning between 5% and 25% of their companies by their last round of private financing or initial public offer (think Flipkart, Ola, Quickr, Ratnakar Bank, and many others) in line with global norms (Jack Ma owns 9% of Alibaba, Reed Hastings owns 4% of Netflix, and Jeff Bezos owns 16% of Amazon). Once the current court challenges of the Insolvency and Bankruptcy Code are settled, the immediate, automatic and strong consequences of default will ensure that a market for corporate control will emerge. We expect 200 companies to change hands. Banks and debt markets that traditionally lent to the rich will become less aristocratic and more meritocratic. This means that the underleverage of retail customers with real incomes will blunt the overleverage of large corporate India. The working capital crunch of Micro, Small and Medium Enterprises will not be solved by banks, but a new generation of lenders that will use the digital exhaust of the Goods and Services Tax and UPI, among others, to extend cash-flow-based credit. The Indian private equity industry will grow faster in the next decade than it has in the past—it already has $130 billion in assets. Initial public offer markets are already becoming more sophisticated at weighing intangible assets, rewarding sustainable cap tables, and offering a governance premium.

The current economic slowdown has many reasons, but the most important one is that the old is dying faster than the new is being born. But this surely represents overdue medicine: short-term pain for long-term gain, with India emerging stronger. Entrepreneurs cannot predict the future, but they can make themselves worthy of it. The current round of pain in corporate finance is an atonement for past mistakes around the relative roles of debt and equity, but this churn is birthing a new world of financial structures, leverage ratios, accountability and governance. This will be good for India, the country’s banks, investors and entrepreneurs because money will stop looking at entrepreneurs through the lens of their parents or bank balances, but evaluate the courage in their heart, the strength of their back, and the sweat of their brow. Welcome to a more just and meritocratic India.

Gopal Jain & Manish Sabharwal are, respectively, co-founders of Gaja Capital and Teamlease Services

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