Venture debt refers to variety of debt financing products offered to early and growth stage venture capital backed companies and has seen a larger usage by technology and healthcare sector start-ups. World over, it is provided by dedicated venture debt funds and technology banks. It may probably be too early to predict the success of this financing business as compared to other secured lending alternatives or conventional corporate banking. The underlying situation being financed at ventures is negative cash flows but equity backing the enterprise is upwards of twenty times the debt. The proposition thrives on business growth and management team’s enterprising success. This is very unlike the conventional banking where the equity backing is just about one to two times and may even not be there, and no real institutional capital involvement to ensure any kind of corporate governance. As it stands today, on any risk adjusted parameter, the overall RoE of the venture lending business and its fundamentals seem to stand out in comparison to any other alternative lending or banking business.
One of the basic requirement of any startup is to adequately capitalise the business from inception until it reaches sustained profitability. Most startups have negative cash flows for a long period of time before they realise positive net income. Venture debt is a smart and critical source of capital which complements the equity. When structured appropriately, venture debt can be an attractive financing option for founders because, it results in less equity dilution, does not requires valuation to be set for business, no board seat or management interference and the due diligence process is less exhaustive in comparison to equity round. Data shows that if optimally used, venture debt can reduce dilution of the founders and early stage investors by around 15 to 20% and can have indirect but positive influence on business policy of the start-up.
Like there is diversity of venture equity capital investors which come in at various stages of evolution of a startup, there are four primary uses of venture debt and four different stages at which it can complement the business to reach sustainability;
- Venture debt helps extend the runway to the next valuation driver, thus help founders put in sufficient time gap /performance ramp up in between the equity rounds
- It can also extend the runway to cash flows being positive and thus altogether avoid the last round of equity, this is particularly handy when things mature and founders need to take a decision to calibrate growth (equity driver) versus cash flow generation
- In critical times, venture debt can act as cushion to something that can go wrong, like a delay in large customer signing up or a major macro event which can derail the plan for one or two quarters
- Lastly, and more relevant to B2B businesses, working capital cycle becomes the last hurdle to overcome in path to sustainability and venture debt acts as a good bridge to eventual conventional bank financing
Typically, the term of venture debt is up to 3 to 4 years and the principal amount is either 30-40% of the amount raised in last equity financing round or up to 6x of MRR of the company. This business activity in India has been quite active over the past five years, but largely small amounts of $1 to 3 million as interim support between various series of equity raise. As next level, there is growing interest from European/ US based credit funds to explore larger size deals for late stage/mature companies. We haven’t yet seen any technology bank in Asia but it could just be a matter of time.
At IMAP India, we have been successful in building a good eco-system for this product with help of our partners in US and Europe, and thereby help structure it appropriately as winning formula for issuers and investors.
