Venture Debt – Meaning, Structure and How it Works? – Forbes Advisor INDIA

Venture debt is a form of debt financing, typically a non-convertible, senior secured loan, offered to venture backed new age businesses. It serves as a strategic tool to complement equity financing, and if incorporated effectively, has various effective use cases for new age businesses including:

• Protecting Equity Dilution – By using debt as growth capital, businesses can attain high levels of growth without having to dilute equity.

• Extending Runway Between Rounds – Debt is often used to extend the runway between equity rounds. For entrepreneurs, this means higher capital raising ability in the future.

• Financing Working Capital Mismatch – It can be used to finance the working capital requirements of rapidly growing businesses that require significant investment in working capital.

• Financing Capital Investments – Where bank financing is not viable, venture debt can prove to be an important tool to finance capital expenditure and business acquisitions.

• Create a Credit Track Record – By deploying a healthy capital mix of debt and equity finance, businesses can build a steady credit track record at an early stage.

How is Venture Debt Structured?

• The underlying instrument in venture debt is a “non-convertible debenture” (NCDs).
• NCDs are coupon-bearing instruments issued by the borrower to the lender.
• In addition to this coupon-bearing instrument, the lender also subscribes to equity warrants of the borrower.
• Warrants are a security that gives the holder the right (but not the obligation) to subscribe to equity of the company at a certain price within a specific period of time.

How is Venture Debt Different from Equity Funding?

• Equity is the most expensive source of financing for a business and the opportunity cost of allocating equity capital is high. Entrepreneurs, therefore, must focus on maintaining an optimum mix of capital between debt and equity. At the early stage when the business is working on its product market fit and is yet to establish its revenue model, equity capital must be the primary external source of capital.
• When the company enters the expansion stage and must require additional capital to scale up, debt can complement equity capital by replacing it for predictable use cases(For example, working capital financing).
• In all predictable use cases, replacing equity capital with debt is more efficient (For example, working capital financing).

Key differences between equity and debt financing:

What Parameters do Venture Debt Funds Look at Before Investing?

Business-related Parameters

A fund analyzes certain key parameters related to the business and the industry to arrive at investment decisions:

• The strength of the founders and key management personnel: The qualities funds seek in founders will include domain expertise, vision, and the ability to build robust teams, among others.

• Existing investors backing the company: Lenders derive comfort from the quality of investors and their willingness to support the company in the future.

• Established revenue model and healthy margins: High growth companies with an established revenue model and strong margins can strategically allocate debt to support its current operations and scale. Most importantly, the business must have a clear path to profitability.

• Market opportunity: The business must have a large addressable market, a strong product market fit, a well carved out go-to-market strategy to use debt capital prudently in order to scale.

Operational Parameters

In addition to business metrics, the fund also looks at equally important operational parameters:

• The liquidity position of the business. Efficient liquidity management and robust liquidity position signify financial prudence.

• Scalability of the relationship. Funds build a comprehensive working relationship and become well-entrenched into the business as it scales.

• Protocols set by the company to ensure data integrity. Without data integrity, information would at best be a diminished source. The relationship must be built on a strong foundation of trust.

• Corporate governance framework. The business must balance the interests of the management, employees, investors and various other stakeholders in a transparent and objective manner. High governance standards indicate how the affairs of the company are controlled and operated.

How Can Investors Invest in Venture Debt?

Venture debt funds are structured as alternative investments funds (AIFs) in India. AIFs are privately-pooled investment vehicles for investing in non-traditional asset classes such as infrastructure funds, private equity funds, venture capital funds, among others. They allow investors to diversify from conventional asset classes like public equities and debt securities.

The stock market regulator, Securities and Exchange Board of India (SEBI) has imposed a minimum limit of INR 1 crore to be met for investment into AIF units. Investors can subscribe to the units of an AIF either directly or through distributors appointed by the fund.

Venture debt AIFs generally have a commitment period of four to five years during which the committed capital is recycled. During the commitment period, the investors receive quarterly payouts which are linked to the coupon-bearing NCD instruments. NCDs are financial instruments issued by corporates to raise long term capital through a public or private issue. Unlike convertible instruments, NCDs cannot be converted into equity shares at any point of time.

In India, venture debt remains underpenetrated and accounts for 3-4% of the Indian venture capital ecosystem. This is seeing rapid growth as the venture debt ecosystem is maturing in the country.

Venture Debt Lending Risks Investors Should Know About

Venture lending is often seen as higher returns for higher risk. This is because investors derive the risk involved in venture debt from the risk inherent in venture equity. The investment thesis and the risk profile, however, are fundamentally different.

• Venture lending comes with considerable security to protect downside risk. The debt is senior secured debt with a charge on the assets of the company. Further, the borrowers are institutionally-backed and rapidly growing companies with a strong focus on corporate governance and transparency.
• Returns in the case of venture debt is a combination of fixed interest income and equity upside through warrants. This interest income is high-yielding, serving as an attractive alternative compared to the predicament of low-yields the investors are now facing. More importantly, these returns are regular and predictable in nature.
• In addition to the fixed income, investors also get to participate in the equity upside of the portfolio companies in the event where these companies gain in valuation. Venture debt serves as a gateway for investors to participate in the venture ecosystem in a structured manner.

Who Should Invest in Venture Debt?

Investors can appropriate a portion of investable capital to different alternative products based on their risk appetite and target returns. High net worth individuals (HNIs) in India are becoming increasingly keen to explore venture investing. In recent times, corporate treasuries and other such institutions have started exploring venture debt as an alternative form of debt investment apart from high-rated debt instruments.

Many of these investors, however, do not have the sourcing and screening prowess that venture capitalists (VCs) possess and hence, are faced with the challenge of hunting for the right deals. Additionally, VC funds have an average lock-in period of eight to 10 years. This can deter new investors, who may shy away from the irrevocable and binding commitment.

This has allowed venture debt to serve as the perfect gateway to venture investing for investors. The inherently low-risk profile and the predictability in returns in venture lending allows investors to take exposure in growth-stage startups while taking lower risk. The investors can participate in the equity upside through warrants in all companies. With limited downside and potentially lofty upside, investors can test the waters in venture investing by partnering with venture debt funds.