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How should startup founders approach venture debt?

Updated: Jun 29, 2022

Access to adequate and timely funding can often be the difference between survival & progression to the next milestone or failure for a startup. When financing a growing business, start-up founders rely on equity capital right from ideation stage to IPO. Another form of non-traditional funding that has gained traction in recent years and acts as a complement to equity capital is venture debt. Indian start-ups raised about $600 million of venture debt in 2021[1].

At MPC, we can help start-ups founders raise venture debt in a more informed manner. Here are points to ponder for startup founders when considering venture debt as a potential source of funding.

1. What is venture debt?

Venture debt is provided by dedicated venture debt funds (AIFs or NBFC) as a complement to equity financing. If structured appropriately it can function as an attractive way to finance a business at lower cost and with less dilution than equity financing. Most companies raise venture debt immediately following or alongside an equity round. Here are some of the features of venture debt:

  • Venture debt is a loan that needs to be repaid over time (interest and principal). It is typically structured as a term loan (a sum of money to be repaid over 1 to 3 years).

  • The structure usually comes with warrants rights on equity capital.

  • But like any loan, there are financial and non- financial covenants to be adhered by any startup.

  • Unlike equity, when raising venture debt, it does not require a valuation to be set for the business.

  • Much like traditional financial institutions (Banks/ NBFC), venture debt providers do not take board seats.

2. What are some of the use cases for venture debt?

  • Venture debt can be used as growth capital to prevent excessive dilution in an equity round.

  • Venture debt can used to extend the runway between equity rounds. This can provide a cushion in case equity funding takes longer that expected. Additionally, venture debt can also allow founders to better time the market for equity funding taking macro factors into account.

  • Where bank/NBFC financing is not feasible, venture debt can be used to fund both working capital and capital expenditure at start-ups.

  • For business which are new to credit, a small amount of venture debt at an early stage can also help build a credit record (borrowing/ timely repayments) before transitioning to traditional lenders.

Venture debt is best avoided when companies have access to financing from a bank or an NBFC. Traditional lenders not only offer financing which is cheaper but also a multitude of products (supply chain, leasing, cash credit against WC, trade finance etc.) customisable to specific requirements.

3. How is a venture debt transaction structured?

Venture Debt is typical structured in the form of Non-convertible Debentures or NCDs with a repayment schedule ranging from 12 to 36 months and a coupon of 14-16% (ballpark) per annum. In addition to coupon, venture debt providers require warrants (right but not obligation) to buy equity of the company at a certain price before expiration.

In addition to the aforesaid coupon and warrants, there are processing charges to be paid to venture debt providers by borrowers. Venture debt providers also impose financial and non-financial covenants on the borrower such as minimum cash balance, debt to equity, DSCR, continuation of founders etc.

4. How to evaluate the cost of venture debt funding?

As you have seen, there are certain explicit costs to venture debt financing. These are clearly articulated in a term sheet and are self-explanatory.

  1. Rate of interest / Coupon – paid on monthly/quarterly rests on the outstanding amount

  2. Processing fee – paid upfront before any drawdown

Where it gets tricky is when you consider the implicit costs to venture debt financing. For instance, the effective interest rate paid by a company can increase depending upon the repayment schedule, back ended fees, and other charges for prepayment, if any.

Another aspect that needs thorough evaluation is the impact of warrants. While warrants align lenders interest to company’s success, they also cause dilution. Warrants are typically exercised by venture debt firms at exit and can increase returns multi-fold to the lender.

5. What is the best way to raise venture debt?

Much like equity fund raise, start-ups should initiate discussions with multiple lenders to bring competitiveness in the process and ensure at least one successful conclusion. Therefore, engaging an advisor who knows the prevalent market terms will enable a company to get the best possible transaction structure for a venture debt raise.

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