Venture Debt: The dawn of a New Era for Business

Entrepreneurship prompts us for opportunity identification, innovation, creativity, willingness to take a risk, and an entrepreneurial mindset. The financing of entrepreneurial firms has always been a key consideration in the entrepreneurial ecosystem. Like in any business, the start-ups’ options to raise finance lie in the choice between debt and equity. Out of the myriad forms of start-up finance that have emerged over the years to bridge the funding gap between the entrepreneurs/ enterprises and the investors, venture debt is one.

Most of us have been familiar with the term ‘venture capital’ which commonly refers to equity financing of a start-up post its early stage. The venture capital firms, in exchange for the funds to the start-up, acquire a certain percentage share in the entrepreneurial firm, hold a position in the company’s management and provide advisory services to the firm for potential expansion. Venture debt is a risky debt both for the investor and for the borrower and lies at the intersection of venture equity financing and traditional debt. The product has emerged as a popular mode of financing start-ups in recent years and has witnessed a lot of traction.

Why Venture Debt?

Let us presume that X and Y bump into an innovative idea for a new business. They obviously need to finance their business right from the ideation stage till the implementation and growth. Normally, their early stage is financed by self, family, and individual investors while venture funding usually comes into play in the growth stage (Fig.2).

Venture financing aims at those investments in businesses that have a high potential to grow, hence the risk involved.

Consider that the discussed business satisfies all the parameters of venture funding and has reached a stage of having developed a fit-to-market product, it can now compete for Series A venture equity funding. As discussed earlier, this kind of funding shares the ownership of the firm with the funders. After having received a certain amount of equity funding and achieved certain growth, the firm owners need more growth capital but realize that they would have to dilute their ownership further for any more equity funding!  Here’s where they consider venture debt. It’s a ‘debt’ since it promises a rate of interest to the lenders. The start-up owners bring down the cost of this debt by offering to the lenders an equity kicker i.e. an incentive wherein the lender gets ownership in the company once the firm achieves some performance goals. For the start-up, it is the provision of funds for the extended runway, increased market valuation and portfolio diversification topped up with a very big advantage of minimal equity dilution, a major concern for the start-up owners while deciding to avail external finance. 

In order to minimize their risk, the lenders offer this funding as a complement to equity funding i.e., they extend the debt to those start-ups which have certain level of equity funding. Moreover, venture debts are short term loans and even collateralized by the intellectual property of the start-up. 

The recent venture debt funding deals in India in the year 2021 so far include INR 25 Crores to DealShare, INR 35Crores to Pepperfry, the online furniture platform and INR 200 Crores to BharatPe, the fintech firm. The firms, already having funded by the venture equity, have availed the debt funding for expanding their reach in the market. Bharat Pe, for example, founded in 2018, leapt up at a breakneck pace and received funding right from its seed stage followed by Series A, Series B and Series C capital before it raised venture debt.  

Why not Bank Debt? 

Banks require that the prospective borrower meets certain pre-conditions to be able to avail of a loan. Some of them include the requirement of a stable business, certain years of operations of the business, the profitability of the business, and low risk. In the early stages of business, meeting all the stated requirements is a challenge for the start-up making bank debt a challenge. Moreover, the new businesses may not have tangible assets to collateralize for a loan from the bank.

Venture Debt in India

The product has gained phenomenal traction amongst Indian entrepreneurs in the past 5 years (Fig.2). Analysts suggest that the Indian start-ups are finding it as a good accompaniment of venture equity financing. The economy has seen the rise of multiple venture debt funds over this period. The major players in the venture debt market like Alteria Capital, Trifecta Capital, and the likes have raised huge investments in their venture debt funds because of the growing interest of the investors.

Fig. 3 exhibits the rising venture debt deals in India in the five years from 2015 till 2020. While the deal count of venture debt has doubled between 2017 and 2020, the values in this period have increased manifold. The highest rise of 2X was witnessed in the pandemic year of 2020 as compared to the year 2019. The past years had an increase in the number of deals as well as the ticket size per deal indicating the growing acceptance of venture debt amongst the borrowers. The year gone past had aggressive venture investments in Indian start-ups to the tune of approx. $10 billion despite the unprecedented economic conditions worldwide. While the year 2020 observed a drop in the value of venture funding in comparison to 2019 (Fig. 4), funding in the form of venture debt galloped in this year (Fig.3). To an extent, the uncertainty in the economy elucidates the scenario. The downturn in the economy and the resultant reduced market valuation of the start-ups discouraged the firm owners from availing equity-based funds to retain the maximum ownership of their firms    

The venture debt funding in such a scenario prevented the start-ups from down-round and from shelling out a bigger share of their ownership of the firm to the venture capitalists while still providing them extended runway.

Conclusion

The growing entrepreneurial focus in India opens the doors for multiple funding options and also for funding products like venture debt. The growing interest of the start-ups and the investors equally has led to the growth of venture debt funds in India.  Although this option comes with its own set of advantages, it piggybacks on venture capital i.e. it is normally extended to the firms that have previously raised their round of venture capital. The existing funding from a venture capital firm in a way establishes the credibility of a start-up for a venture-debt fund to invest in. To that extent, availing of venture debt as a standalone funding option can be a challenge for the new enterprises, especially in their pre-seed, seed, and early stages. Besides, the product has a life cycle of about three to four years and expects the firm to perform and earn consistent revenues to repay the debt. Whatever said, the option of venture debt still addresses some of the funding concerns of the start-ups and can work well if coupled with other funding options as a portfolio. 

As per the data from Inc42, the Indian ecosystem has 40000 active startups from 2006 till the first half of 2020 out of which approx. 9 percent of the start-ups are funded. These figures talk volumes about the scope of startup funding options in India and also about the need to bridge the funding gap between the start-ups and the investors for a flourishing entrepreneurial ecosystem. 

Key takeaways  

  • Venture debt- a feasible option for a diversified funding portfolio
  • Reduces equity dilution of a firm and helps the owner maintain ownership.
  • Despite the risk elements involved, the option has witnessed a rise in acceptance by the borrowers and investors in India 
  • With the constant evolution of the entrepreneurial ecosystem, the product finds a huge scope in India.

References 

Further readings

https://www.ycombinator.com/library/2E-venture-debt

Vikku Agarwal
Research Scholar- Jain University, Bangalore; Faculty- International School of Management Excellence