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The Art Of A Good Unicorn | Can venture debt help grow business for startups?

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Private credit is turning out to be quite the superstar in the private capital space. As a form of lending that lies outside the traditional banking system, (lenders work directly with borrowers to negotiate privately held loans) it seems to be having a good run. At least $4 billion was reportedly deployed across select transactions in the first half of 2023, according to Ernst and Young (EY), one of the big four accounting firms.

What does a startup founder get out of venture debt besides capital? (REPRESENTATIVE PHOTO) PREMIUM
What does a startup founder get out of venture debt besides capital? (REPRESENTATIVE PHOTO)

Venture debt is a subset of private credit that seems to have emerged as an attractive alternative, offering a non-dilutive source of funds that could even complement equity financing.

Traditionally, startups would rely heavily on equity financing to scale their operations. But, at the same time, there may be some value in diversifying a company’s capital structure. The USP? Provide startups with the flexibility to leverage their balance sheets without startup founders relinquishing additional equity stakes. could be especially beneficial during a company’s growth phase.

In India, where access to traditional bank loans might be challenging for early-stage ventures, this could be a lifeline.

Chetan Prakash Sancheti, partner, Private Credit at Anicut Capital, said, “Startups are generally started by first-generation entrepreneurs. Banks may operate in an extremely regulated manner in terms of their offerings… A bank may require hard collateral for funding, say, a 10,15 or 20 crore rupee opportunity, which a startup promoter may not be able to offer, limiting their growth. A venture debt person comes in and offers them a 5 or 10 crore rupee facility; whatever is available… they take that risk… and yes, it’s slightly expensive, but given the opportunity that the promoter is seeing in the growth phase, they will pick it up from a venture debt person”.

The investment thesis of venture debt is different from venture equity, according to Sonal Rangnekar, partner, Desai & Diwanji. “One can’t treat this as a term loan or a working capital facility that one would take from a financial institution. It’s a predictable interest income that, sometimes, comes with an equity kicker… where the venture debt company would have the opportunity to earn superior returns.”

“Most startups are not asset-heavy. So, the collateral that most venture debt funds would be looking at is hypothecation, brand equity or IPR. It depends on each company’s strengths as evaluated by the lenders. From a founder’s perspective, venture debt is a great viable option, as there is the comfort of no equity dilution and maintaining control, and a founder doesn’t have to hastily agree to a lower valuation,” Rangnekar added.

When negotiating with private credit, there is a lot of scope and flexibility to restructure the payment terms, she said. “Venture debt would be more favourable towards the business cash flow and changing the terms accordingly. These are very quick processes, compared to any bank, because the fund structure is pretty flat. It’s less bureaucratic hassles, so it’s quick money in that sense from a founder’s perspective.”

So, venture debt could allow founders to optimise their capital structure by combining equity and debt financing. That seems to be a judicious mix, which could ensure that founders retain a higher percentage of ownership while accessing the necessary funds for expansion. And it could even extend the runway for startups, serving as an additional financial cushion. That might mean that founders would be provided with a bit more breathing room to achieve the milestones they set for themselves.

Is venture debt dumb money?

Put another way: What does a startup founder get out of venture debt besides capital?

“Private credit not only brings its own expertise in the structuring of the transaction in terms of repayment, it also brings its own ecosystem,” Sancheti said.

“Once a company has taken venture debt, they would have to repay it over a period of 3-5 years. With equity, once the money is coming in, the exit could either be the next funding series or an IPO. But, in debt, generally, it has to come from cash flows. In three years, the company could grow with the help of private debt… A conversation we keep having with promoters is agreeing upfront in terms of flows, but also supporting them in terms of bringing one more player into the CapTable (which shows the equity ownership capitalisation for a company)”, Sancheti added.

While this could be an alluring option, maybe startup founders still don’t have the requisite knowledge or information about the nuanced world of venture debt. Could this be due to an equity-first mindset deeply ingrained in startup culture? What is it that startup founders need to understand before getting into bed with venture debt?

“Some of the companies we interact with consider private credit in sync with NBFCs or banks. It takes a lot of time for us to tell them that the money they are looking for is not like a banking or NBFC requirement, where there is some asset-backed collateral. With private credit, it’s a slightly higher risk. For some, the private credit space may not be right. Some founders want equity to be substituted by debt and some founders may need to be educated that, at times, equity is needed, rather than debt,” Sancheti said.

“Let’s say a negative net worth company wants to raise capital after one year to bridge the year’s working capital. Since it’s a negative net worth company, a founder has to realise they are already burning cash and putting debt as a repayment-based liability creates bigger issues. So, one needs to think about when to pick up debt. However, if cash flows are good and there’s a transition taking place from a low cash flow to a high cash flow, certain bets could be taken,” Sancheti added.

Cause to be wary of venture debt

However, startup founders need to realise that venture debt is not everyone’s cup of tea, Rangnekar said.

“The founder has to evaluate when to avail of this kind of financing because there will be a higher rate of interest. Before going for venture debt, the founder needs to ensure that the company is strong enough, has a steady flow of income, the current asset pool is strong and has a great equity capital pool. The venture debt lender would be looking at these aspects. We’ve seen cautionary tales in the market, like BYJU’s and PharmEasy, where the promoters found themselves in trying times when renegotiating and restructuring the debt,” Rangnekar added.

“If a company is facing a lot of losses, it may not be an appetising offer for any debt fund to consider. Maybe the company would have to succumb to a lower valuation and get some equity funding there. Some companies may not be able to service the high-interest debt which most funds offer,” Rangnekar elaborated.

India may be on a path to witnessing a shift towards more customised venture debt solutions that closely align with the needs of unique business models of startups. That may mean that venture debt funding may grow more in traction as a viable alternative. There’s already a growing trend. According to Inc42, during H1 2023, debt funding was said to account for close to 5% of the $5.4 billion raised by Indian startups, as compared to 1.48% during H2 2022. Yet, if it’s going to be a bigger deal, the risks and rewards of venture debt must be kept in mind by startup founders.

“Ultimately, the founder or promoter has to keep growing and be the winner. Venture debt is just an enabler for them,” Sancheti said.

Shrija Agrawal is a business journalist who has covered startups and private capital markets before it was considered cool in India.

The views expressed are personal

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