Largely due to demonetisation, banks are flushed with liquidity. Natural outcome of this – falling interest rates. This means that fixed deposit rates that banks offer shall be lowered.
Implications for start ups
Startups typically raise chunky amounts during their fund raise and plan is to deploy that over a period of 12-24 months. This means that, there could be considerable time between capital being raised and money being deployed. This idle money should be placed in liquid funds or Fixed deposits so that it earns interest. And these can be meaningful returns. For a seed plus round of US$ 1 Mn that a young startup may have raised, the interest income over a one year period can be as high as ₹20-40 lakhs. This could well be a month of burn.
Before I proceed, let me explain the above modes of parking of capital:
1. Fixed deposits (FD) – these are to be placed with larger banks only because smaller banks do have their issues and theoretically riskier than larger banks like SBI, ICICI, HDFC and the likes.
2. Liquid funds (LF) – these are funds that primarily invest in money market instruments with low maturity period. Its a type of mutual fund that is aimed at bridging the liquidity gap between needs of large corporations and even government for their short term needs.
FD has a lower risk return profile vis a vis LF. It means – FDs are less riskier and have lower returns relative to LF. It’s about relative risk between the two. In absolute sense, FDs also have risk in case the bank that one has opted for, collapses. But credit to RBI and india’s banking system, such instances have been very rare. Nevertheless I would always opt for larger banks and not fall for smaller banks who offer slightly higher rates of interest.
Between both the above options, I have always recommended that startups should consider investing their surplus liquidity with FDs and less with LF.
Selling point of an LF is that it could deliver greater returns that range from 1-3% by and large and that they could end up being tax free. Also, if there is a sudden need for money, breaking of the FD attracts pre payment penalty which isn’t the case with LFs.
For start ups – their interest income from FDs will be tax neutral because they can offset it with losses of their burn anyways. So technically interest on FD becomes tax free and you can claim refund of the TDS. And if you file a lower deduction certificate with Income tax department, you could even get the benefit of a near zero tax deduction on the FD. Varun and his team from Constellation (@urConstellation) have helped a few of our portfolio companies obtain this certificate and can assist in this process. In fact, we have been taking this certificate for Blume each year. This is the right time to start thinking about this certificate for lower deduction of tax for Financial Year 2017-18.
Coming back to FD versus LF argument…
There is a school of thought that LFs aren’t too risky. Fair point. LFs are a money market instrument and have market risk and on paper it’s possible in some stray scenario that their value falls due to some money market developments and we loose money as we try to redeem the funds around the same time. This doesn’t happen most of the time but given the above tax neutrality of FD, why take additional risk is the only point in question. Besides, for urgent needs of capital, bank FDs can be structured in such a way that one doesn’t loose much of penal charges. Again team at Constellation has been doing this for quite a few of our portfolio companies. Mitul’s team should be able to help in case needed.
And finally, if you would like to invest into LFs only, make sure you do it with advise of expert who understands the risks and can help with a decision of choosing the fund accordingly. Do reach out to Shriya at Constellation and she may be able to assist for this.
Spending 10 minutes on liquidity management by one of the founders personally on a daily basis will go a long way in giving a startup the financial stability that could be well be a difference between a good start up and a great startup.
Liquidity management is much more than just the decision of FD versus LF. It includes managing burn, receivables, payables, taxes, salaries etc. Will try and extend this in the next write up.