In the startup world, several big names such as Yatra.com, RedDoorz, Myntra, Practo and Snapdeal — all are backed by leading names in the equity investments space — have secured venture debt financing at some stage in their career. This round is often just a tiny fraction of what these companies raise in a typical equity funding, which don’t normally exceed US$5 million.

Many of us would have often wondered why these massively-funded companies should take venture debt financing, and why they cannot go for another round of equity funding instead?

To answer this question, we need to understand venture debt financing, and its fundamental difference from equity investment.

What is venture debt financing?

As we know, funding has always been a key constraint for most early-stage startups. While startup can survive the pre-revenue period bootstrapping or pooling money from friends and family, they would need money at a later stage for growth, expansion, hiring etc.

Also Read: Debt funding complements venture capital: Experts

However, getting VC funding is a long and tedious process; it could take months, even years, before a startup gets its initial funding. Be it angel funding, seed funding or institutional funding, equity investment is risky for both startups and investors, and it could dilute your equity. You may even lose the control of the company that you built with your blood, sweat and ears. Eventually, you would end up owning just under 5 per cent of the equity in your venture, while the rest is owned by your VCs.

These concerns have led to demand for alternative forms of financing that provide startups with the capital they need, but at a cost that makes sense. Venture debt is one such tool.

Venture debt is a form of debt financing for venture equity-backed companies that lack the assets or cash flow for traditional debt financing, or that want greater flexibility. It is a form of specialty debt financing provided to companies that are not serviced by traditional lenders such as banks. The financing is usually structured as a combination of a loan and limited equity investment rights (warrants). Companies in the technology, consumer or healthcare domains — that typically do not possess any hard assets or collateral that can be used to get a traditional term or working capital loan — opt for venture debt funding.

Venture debt funding means you dilute less, and alternatively take a little bit more money. If properly used, venture debt financing can reduce dilution, extend a company’s track or accelerate its growth at a limited cost to the business. If misused or under unfavourable conditions, debt can reduce a company’s flexibility or become an obstacle to future equity poses.

Types of venture debt financing

There are two types of venture debt available in the market:

1) Equipment financing and 2) Growth capital.

Equity financing is a great tool for hardware companies. They can use this tool specifically for the purchase of equipment and here the equipment acts as your collateral. The availability of equipment financing is linked to the actual purchase of equipment and, therefore, if less equipment is purchased than originally planned, less financing can be used.

Growth Capital, which is more common, is a great tool for companies looking for loans for corporate purpose. Long-term growth capital loans are secured by a lien on a company’s assets, which may or may not include a lien on intellectual property.

Why it makes sense for startups

Venture debt is the next logical layer of risk capital which provides entrepreneurs an extension of their cash flow runway between equity rounds, enabling them to make their companies more valuable with a relatively inexpensive form of capital (compared to equity). This is a form of flexible capital which works in tandem with entrepreneurs and investors to help improve the ability of the company to increase enterprise value.

From a startup’s perspective, debt funding helps companies to have more cash in the bank without diluting much. It is a lower cost of capital. Secondly, when you have more money in the bank, your negotiating power is higher and increases your runway and confidence to drive your engine faster.

How and why venture it makes sense for VCs

Debt fund makes a lot of sense from a VC investor’s perspectives, too. It is in their (VCs) interest for their portfolio company to have the lowest cost of capital. Debt money is less expensive than equity. They also benefit from the fact that these companies get additional runway, and when the company goes out to raise additional (capital) later, everybody benefits from the vacation lift. So generally, it is a win-win type of a scenario.

Also Read: Meet the VC: Rahul Khanna of Trifecta Capital says India still suffers from a trust deficit

Venture debt is a also real option with real assets where one can collateralise. Traditional businesses always go after debt funding as they want to own 100 per cent of their company, whereas new businesses go after VC money, diluting huge equity. But VCs are always worried about the company’s capital structure, revenue growth, etc. because they believe in great returns, whereas debt funding enables companies to borrow money diluting less equity or without diluting at all.

Venture debt connects old economy to the new one

For domestic investors that have legacy businesses, large institutions and brands (banks, insurance companies, development finance organisation, etc.) — who are not able to understand the new economy and don’t have the risk appetite to invest in venture capital — this is a good platform to invest their money. They have deep pockets but are not able to fully appreciate the risk profile of venture capital. Given that venture debt is seen as a lower risk and more predictable type of return models, these large guys are investing into these funds.

Other advantages

Venture loans can be arranged much faster than capital lending, saving valuable management time or meeting unforeseen needs (for example, an acquisition). A venture debt financing does not establish a valuation for the company, which may be useful before a new round of capital financing, before a potential sale, or avoid an internal round, where management and existing investors would have to negotiate a price. Finally, venture lending companies generally do not require board seats or rights of observation, eliminating issues of board dynamics.

Who are the leading debt venture providers?

Although debt funding as a product tends to lag venture capital by 10-15 years in all markets, it is fast becoming an option for startups to get additional funding and cash flow runway without diluting much equity. There are at least three active venture debt providers in Asia — Trifecta Capital, InnoVen Capital, and Intellegrow.

India-based Trifecta has already invested in around 20 companies including Urban Clap, Big Basket, rivigo, StalkBuyLove, while InnoVen — owned by Temasek — has provided debt funding to nearly 90 companies, including FirstCry, Practo, Myntra, FreeCharge, Capillary, Zoomcar, Yatra, Snapdeal, GreenDust, Oyo, and Voonik.

Intellegrow has backed half a dozen companies, mostly in the social enterprise segment, including Banka Bioloo, Milk Mantra, ORB Energy, and Think Labs.

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