I have heard extreme views about venture debt, depending on who I have spoken to in the past few years. From those who have said, “I don’t think this investment class should exist”, to those who have said, “Venture debt was a godsend for my startup”. Like most things in life, the truth lies somewhere in between these two extremes.

What is venture debt?

Venture debt is a type of financing that is available to VC funded startups. It is non-dilutive to a large extent and hence preferred by entrepreneurs wanting to save equity. It is relatively new in India, with just a few years of operational history here. A venture debt fund takes comfort in knowing / deriving the probability of the next VC round. The reason they depend on this probability is that this has a higher probability of occurrence than the startup’s being profitable and repaying them through their own internal accruals.

A venture debt fund is in some ways similar to a VC fund in the sense that it raises its corpus from private investment vehicles, sovereign funds, banks, HNIs and family offices and promises them a higher return than the typical debt instruments. The fund also has a horizon, at the end of which the returns are delivered to the investors of the fund. Venture debt funds have a global loss ratio of 2%, as opposed to VC funds which supposedly have a loss ratio of 30% or more.

How is the venture debt investment structured typically?

It will be like a typical debt instrument, where the startup takes on debt at a pre-determined interest rate. The interest rate is typically higher (somewhere around ~14-15%) than what a bank would provide because of the higher risk that is undertaken. Typical repayment period is 24-36 months, not coincidentally, the time between 1 or 2 rounds of equity financing in a startup’s growth journey. It will also have warrants as part of the contract, that convert into equity for the venture debt firm, although the dilution is usually much lesser than a comparable equity round. The conversion into common share could be at the last round’s per-share price or at a discount to the future financing round.

What is the need for such an investment class?

Startups are usually loss making and also have a negative cash flow, as they are either working towards product-market fit (PMF), or they are over-investing into growth and capacity building after obtaining PMF. Also, startups are usually asset-light, thus providing no opportunity for taking any heavy assets as collateral. While banks are still busy lending to scamsters, they do not have any procedures and guidelines on how to lend to such startups. If, by any chance, the startup is profitable, then banks are sending term sheets which include clauses asking for protection in the form of personal assets of the entrepreneurs. Further, it takes a lot of paperwork and a long due diligence to get this debt.

What kinds of startups do the venture debt funds invest in?

They almost always invest in venture funded startups, and that too, at the earliest after the equity financing round is closed. The venture debt firm usually does not undertake rigorous financial and legal due diligence, because they rely on the VC fund’s inputs. If a firm has recently cleared a tough due diligence process of a VC fund, typically done by a Big 4 audit firm, then by implication, they take a small leap of faith.

This also means that if the startup is bootstrapped, the chances of a venture debt fund being interested are low.

When should an entrepreneur consider taking a venture debt investment?

Based on numerous conversations with entrepreneurs and friends at venture debt funds, here are a few common scenarios where venture debt may make sense for the startup.

• Heavy capex with long useful life – If it is a manufacturing startup with need for large and expensive machinery or if it the funds are needed for buying any other assets, both of which have an intrinsic high value and presumably a long useful life. Given this, it might be better to raise venture debt to invest in this capex and save the equity round’s cash for other operationally intensive needs. Imagine a Raw Pressery wanting to invest in machinery or an Oyo wanting to buy properties to run their own hotels (both publicly available news items)
• Delay the next equity round to achieve milestones – If the startup is close to being EBITDA positive and needs a few more months of runway to achieve that milestone, it might be worth raising venture debt, and then doing a larger equity financing round in a few months time with better metrics on hand. That will give a better negotiating position with the VC funds in future
• A bridge to the next round – If a startup is growing at a rapid pace, but the VC funding environment has turned harsh for that sector or geography, or any other extraneous policy change or market condition change that is not favourable for a VC fund raise has occurred, then a quick venture debt round may keep the startup afloat while it pares costs and prepares to ride out the storm. This usually happens less frequently and may be based on the trust and relationship between the founders, VC fund and the venture debt fund

What are the factors to keep in mind when accepting venture debt?

• Since the startup will presumably still be loss-making during the tenure of the venture debt investment, the funds raised through the equity round (VC) will be used to make the repayment instalments for the debt. In simplistic terms, this is the equivalent of repaying one commitment, with funds from another source. But most founders typically value equity as the most important currency available to them, in which case they may want to preserve that equity from dilution
• In the case of a liquidation event, debt comes higher than preference stock held by the VCs, thus making some VCs uncomfortable. Essentially, they may not be happy with the decision to use their money, to bring in another class of investor, who has better rights during liquidation. However, this is not as black and white, and the two have a very unique relationship
• While debt definitely brings financial discipline to the startup, unfortunately, the timely servicing of this debt and full repayment does not have any positive impact on the credit score of the startup. This is a dampener, but it happens because credit bureaus only track the repayment of debt to banks

Which are the active venture debt funds currently?

Silicon Valley Bank (SVB) India Finance used to be the only active fund for a long time. But in 2015, the India arm was acquired by Temasek of Singapore and then renamed InnoVen Capital. Since then, there are new funds such as Alteria Capital, Trifecta etc., which are all led by very experienced professionals who are all accessible.

How will venture debt funds evolve in the future?

As more venture debt firms are emerging, they are also trying to distinguish their offerings. Some are adding portfolio managers that can help a startup connect with their portfolio of investments. Some are adding specialists who can help startups in HR, Finance and other functions. The idea is to provide more value added services to the startup.

Thanks to my founder friends, and Vinod Murali (Alteria) and Ankit Agarwal (InnoVen) for time spent in discussing these concepts.