Venture debt is one of the most commonly used terms in startup circles.
For entrepreneurs and startups, venture debt is one of the most convenient forms of financing that offers capital at a reasonable cost.
For most startups, venture debt has been an integral part of their entrepreneurial journey. However, most of the loan products, your startup must reap an annual revenue of USD 200000 to USD 1 million.
Let’s begin this article by understanding in detail what venture debt is.
What is Venture Debt?
Venture debt is a type of debt financing. In simple terms, it is a non-convertible secured loan that complements equity financing and has several use cases for new-age businesses, such as:
- Protecting Equity Dilution – Using debt as growth capital fuels high-level business growth, preventing equity dilution.
- Extending Runway Between Rounds – Using debt capital helps entrepreneurs to boost capital-raising capacity in the future.
- Financing Working Capital Mismatch- Meets working capital requirements of a growing business
- Financing Capital Investments – Funds business acquisitions and capital expenditures in the absence of bank finance.
- Create a Credit Track Record – By providing a robust capital blend of debt and equity finance, companies can build an appealing credit track record at an early stage.
Breaking Down Venture Debt
Venture debt is typically provided to businesses that have already acquired venture capital equity fundraisings but lack a positive cash flow.
Businesses generally use financing from venture debt lenders to:
- Reach a specific milestone
- Purchase capital assets to pursue the milestone
Several startups need more substantial assets to be used as collateral. However, venture debt does not require any particular and concrete collateral security. In exchange, venture debt lenders are deployed with warrants on the company‘s equity.
How is Venture Debt Structured?
Here is how a venture debt is structured:
- The fundamental instrument in venture debt is a Non-convertible Debentures (NCD).
- NCDs are coupon-bearing tools.
- Lender also signs up for the equity warrants of the borrowing company.
- Warrants allow the holders to sign up for the company‘s equity at the desired price for a particular tenure.
How Does Venture Debt Work?
It is a type of debt offered by banks and financing institutions for a small or medium term. However, sanctioning the venture debt funds depends on the last equity round generated by the business.
Typically, around 30% of the capital raised as initial equity funding is sanctioned as venture debt funds. Borrowing a company’s equity capital warrants such debt funds. The interest rate for such borrowings can be a benchmark rate like the LIBOR rate.
Covenants & Liquidation Preference
Bank and non-bank lenders both include covenants and liquidation in the loan agreement. It helps to regulate the incentives and boosts the chances of repayment from the borrower.
Types of Venture Debt
- Equipment Financing: Enables businesses to finance the equipment required for operations.
- Accounts Receivables Financing: Provided against accounts receivable of the borrowing company.
- Growth Capital: Source of working capital for businesses, helping organizations accelerate growth.
How is Venture Debt Different from Equity Funding?
Here are the key differences:
| Parameters | Equity | Debt |
|---|---|---|
| Equity Dilution | Significant | Minimal |
| Payout Frequency | Irregular | Regular |
| Investment Tenure | 5-10 yrs. | 1-3 yrs. |
| Capital Recovery | Repaid by selling company stake | Repaid within the agreed period |
| Cost of Capital | Equity value fluctuates | In the form of preset coupon |
| Use Cases | Product research, business expansion and development | Funding working capital, equity dilution, capital expenditure, etc. |
What Parameters do Venture Debt Funds Look at Before Investing?
Here are the parameters:
Business-related Parameters:
- The strength of the founders and key management personnel: Like creating a robust team, domain expertise, vision, etc.
- Existing investors backing the company: Investors’ support for a business is a positive sign for lenders.
- Established revenue model and healthy margins: Helps to strategically assign debt and charts the path to profitability.
- Market opportunity: A large market, a relatable product, and a well-planned market strategy to use debt capital efficiently are imperative.
Operational Parameters
- Robust business liquidity management
- Scalability of the business relationships
- Securing data integrity protocols
- Enhanced governance standards in the corporate framework
How Can Investors Invest in Venture Debt?
Typically, venture debt funds are measured as alternative investment funds (AIFs) in India. AIFs are considered private investment vehicles used to invest in non-traditional assets like:
- Private equity funds
- Infrastructure funds
- Venture capital funds
SEBI (Securities and Exchange Board of India), the stock market regulator, has dictated a minimum limit of Rs. 1 crore for investment into AIF units. Willing investors can sign up for such AIF units directly or via distributors assigned by the fund.
Venture debt AIFs usually have a commitment tenure of 4-5 years. During this period, the capital promised is recycled. The investor gets quarterly payouts during this commitment period.
Who Should Invest in Venture Debt?
Investors can fix some of the investable capital to several alternative products, depending on the target returns and risk appetite. The High net worth individuals (HNIs) in India have shown keen interest in venture investing.
Add to it, corporate treasuries and other related institutions have begun digging deep into venture debt to understand it. They wish to use it as an alternative form of debt investment along with high-rated debt tools.
The incredibly low-risk possibility and the predictable returns have made venture debt the perfect podium for venture investing for potential investors. It has also enabled investors to fuel different growth-stage of startups at a lower risk.
With fewer downsides and a promising upside, investors can rope in the benefits of venture investing by collaborating with venture debt funds.
However, several such investors need more screening and sourcing skills to become successful venture capitalists. As a result, they need to strike the right business deal. Furthermore, VC funds usually have a lock-in tenure of 8-10 years. This can discourage new investors, who may not be comfortable with irreversible commitment.
Conclusion
Businesses seeking venture debt must ensure that a viable business plan and a guarantee for loan repayment must be in place. Going for a venture debt will be convenient for companies after closing a round of equity. This is because creditworthiness will be at its peak.
Companies can accelerate their performance and fuel incredible growth thanks to venture debt funds.
