Early-stage startups, rearing to grow, often hit a wall when it comes to raising money for their working capital needs. Unable to grow on their own dime, most founders are dragged into selling a part of their stake to equity investors (equity financing).
But soon after the big-ticket deals have been sealed and champagne corks popped, reality sinks in: The entrepreneurs are no longer the masters of the companies they’ve created.
This is why, increasingly, founders are opting for the venture debt route in India. Mid-stage startups are now slowly gravitating towards firms such as InnoVen Capital, Trifecta Capital, and Unicorn India. They are an alternative to equity venture capital (VC) funds like Softbank, Sequoia Capital, Accel Partners, and Nexus Venture, which have ruled the startup financing sector for long.
According to data tracking firm Tracxn, 2017 saw 27 rounds of venture-debt funding, amounting to $62.7 million (Rs439 crore), as against 26 rounds ($58 million) in 2016. Companies that raised such funds include Shopclues, BigBasket, and Swiggy. Over the past two years, other prominent startups like Snapdeal, Faasos, Portea, Freecharge, Practo, and OYO, among others, have also taken this route to expand.
Unlike regular VC investments made in return for shares in a company, debt funding is a loan that does not entail equity dilution. It typically complements equity financing and is usually structured as a three-year term loan with warrants or options for the company’s stock.
The rising popularity of such funding is good news for startups that are often not considered creditworthy by banks due to a lack of collateral or profitability. They may also not want to raise funds against equity at an early stage when their shares are worth little.
Mumbai-based InnoVen Capital is one such source of funds. It has invested in over 110 Indian firms to date, disbursing loans of $75 million to startups in 2017. In the first half of 2018, it invested over Rs130 crore in follow-on round across 11 companies, including Power2SME, Chaipoint, Treebo, and Bizongo, a 350% jump from the previous year’s investments of Rs37 crore across four companies.
As a result of the wide prevalence of equity financing in India’s startup sector, several prominent founders hold very little in their ventures. For instance, before it was acquired by the US-based Walmart in May, the two founders of India’s most-funded tech venture, Flipkart, owned just around 5% each in the company.
Venture-debt funding solves this problem.
“Venture debt gives the startup a chance to raise funds without diluting equity. It provides an alternative source for all cash needs of a growing business, allowing them to achieve key milestones before raising a fresh equity funding,” said Siddharth Talwar, co-founder and partner at venture capital firm LightBox. It can also be leveraged to pick funds at higher valuation with less dilution, in the next equity round. LightBox’s portfolio company Furlenco, a furniture rental startup, has raised several venture debt funds in the past year.
In addition, venture debt is a tad cheaper—around 15%—than loans from non-banking financial companies (NBFCs) who charge anywhere between 18% and 20% as interest.
Venture debt funding has been popular in several other startup ecosystems for decades now. The concept first emerged in the US in the 1980s and gained prominence in the 2000s when companies such as Facebook and YouTube opted for it.
In the US, “the market is much wider with over $6 billion in venture debt,” said Rahul Khanna, managing partner of Trifecta Capital. The venture debt market in the US is about 15% of the overall VC market. In India, however, it has not been popular so far, accounting for just between 2% and 4%.
This is because the ecosystem is still young, experts said. Now, as the industry matures, startups are getting ripe for venture debt opportunities.
“Debt funding will play an important role in a startup’s journey. Our portfolio companies will require approximately $140-150 million in debt capital in the next few years,” said Sudhir Sethi, chairman of IDG Ventures.
While it appears to be a safer funding option, experts warn that venture debt is not a replacement for equity financing. For one, venture debt funds lend only to those startups that are well-placed to raise a follow-on equity funding.
Khanna of Trifecta Capital cautions that funds need to focus on the top few players in any category to ensure that the funding is secure.
Risks still remain, he says. “If a company is not able to raise the next round of funding, the investment can become a non-performing asset,” he said. A case in point is the funding boom between 2014 and 2015 when indiscriminate funding created unrealistic valuations. Companies such as Flipkart and Ola were downgraded by brokerages on valuation correction in 2016 and 2017.