Startups tap venture debt to build sustainable biz
The venture debt model originated in Silicon Valley in the 1970s and has since become an established form of alternative capital that is available to venture capital-backed companies globally.
Venture debt is in demand and startups around the world, especially in the region, have started considering this option to raise finances in order to facilitate business and protect equity.
Venture debt is a loan to companies that have raised money from venture capital investors. Traditionally, banks only loan money to companies that have collateral; venture debt is different in that lenders will offer debt financing to promising companies that are not cash flow positive, without existing collateral, provided that these emerging companies have raised money from VCs and show strong growth potential, explains Jon Levy, managing director of Y Combinator, which provides seed funding for startups.
The venture debt model originated in Silicon Valley in the 1970s and has since become an established form of alternative capital that is available to venture capital-backed companies globally. Many well-known technology companies have taken venture debt at some point in their growth journeys including Google, Facebook, Uber, Airbnb and Dropbox, says a report by PWC titled Venture debt: The new growth mantra for startups in Southeast Asia.
“Primarily, founders [and other shareholders] in high growth, cash-hungry startups want to prevent undue and avoidable dilution at the early stages of capital raising when the valuations are usually low. The founders risk losing out on richer valuations at the later stage exit options when the company grows to its full potential and has the ability to attract millions more. The appeal of debt is therefore understandable. It is, however, difficult to access financing from traditional banks given various constraints,” says the report.
Saurabh Gupta, co-founder and board member of Vistas Media Acquisition Company, says that venture debt is increasingly becoming a popular funding mechanism within the startup ecosystem in emerging markets such as Mena and Asia. Startups with clear operating plans and strategies, who can demonstrate the efficient deployment of funds with reliable revenue streams backed by strong management teams, can maximise their growth trajectory with the use of venture debt without diluting their equity in the early stages.
“This is something local banks cannot compete with as traditional lending comes with a lot of constraints compared to VCs. This, however, acts as a new business opportunity for local banks in the Mena region to evaluate rolling out, like what DBS bank in Singapore has done jointly with Temasek, launching a $600 million growth-stage debt financing programme in July. With the growth of tech startups in the Mena region in the last five to six years and now with SPACs providing an exit mechanism, the demand and investment appetite for venture debt is increasing rapidly within the region.”
Gupta says that a large number of VCs are now offering venture debt to high-growth startups with predictable revenue growth and controlled burn rate.
“Venture debt investors further rely on the company’s ability to raise equity capital at a later stage and pay off fully or partially the venture debt investors. If the startup can offer strong collaterals [intangible assets] within the business itself such as patents or IPs, that’s an additional bonus. They also get a potential upside in the form of warrants or deep discounts upon conversion to equity with a pre-determined valuation cap when certain valuation milestones are met. A win-win for both the investors and startups,” he added.
The trend is certainly emerging in the region. For instance, YAS Investment and Liquidity Capital jointly launched a $100 million venture debt fund to support Mena tech startups, PFG structures pioneered venture debt transaction for Dubai-based Trukker and buy-now-pay-later platform Tabby raised $50 million in debt financing from a San Francisco-based firm. Startups such as Trella, Trukker and Tamara are some of the regional startups that have raised a significant amount of money in debt over the last six months.
Dubai-based Walid Mansour, a venture capital professional, said: “Venture debt is a much-needed product in the Mena region as it has proved to be an established product in Western markets. The concept helps startups to scale, which has revenue potential and growth as debt is a cheaper and efficient option than expensive equity. The region certainly needs effective more venture debt instruments”
Swethal Kumar, CEO of Startupscale360 and co-founder of The Crossroads, said: “While raising funds from venture capital is important for startups at an early stage, they need to be careful about not diluting large equity too quickly at the early stage. Venture debt sometimes helps to extend a startup’s runway and reach certain milestones without diluting equity. It’s like a safety net to act as a buffer against certain risks. As we know that the debt is cheaper than equity, it helps to increase the valuation of the company. But getting debt from commercial banks for startups is sometimes difficult and even if you tap the debt, the compliance of the bank is generally horrendous.”
On the other hand, Kumar says that venture debt funds typically provide more flexible capital with fewer covenants. “During a pandemic, when venture capitalists were not sure of investing in new deals or bailing out their affected existing investments, the capital-hungry startups were turning to venture debt globally.”
However, Biancka Gracias, partner at Iclo, cautions: “I am very sceptical how effective venture debt can be for startups in the region because of the nature of the startups and the fact that they hold more intangible than tangible assets classes. The expense and structure of venture debt also remain unexplored. As a legal mind, it should not be considered by startups because this will draw startups down a rabbit hole of senior debt which may not look kindly on their balance sheets for future prospective investors.”
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