Venture capital debt is a form of debt financing, typically a senior secured non-convertible loan, offered to new age venture capital backed companies. It serves as a strategic tool to complement equity financing and, if incorporated effectively, presents various effective use cases for new age businesses, including:
- Protect equity dilution – By using debt as growth capital, companies can achieve high levels of growth without having to dilute equity.
- Extension of the track between laps – Debt is often used to lengthen the track between rounds. For entrepreneurs, this means greater capacity to raise capital in the future.
- Inadequate financing of working capital – It can be used to finance the working capital needs of rapidly growing businesses that require large investments in working capital.
- Financing of capital investments – When bank financing is unsustainable, risky debt can be an important tool for financing capital spending and business acquisitions.
- Create a credit report – By deploying a healthy capital mix of debt and equity financing, businesses can establish a stable credit history at an early stage.
How is corporate debt structured?
- The underlying instrument of risky debt is a ânon-convertible debentureâ (NCD).
- CRS are coupon-bearing instruments issued by the borrower to the lender.
- In addition to this coupon-bearing instrument, the lender also subscribes to warrants for shares of the borrower.
- The warrants are a security which gives its holder the right (but not the obligation) to subscribe to the capital of the company at a certain price within a specified period.
How is venture capital debt different from equity financing?
- Equity is the most expensive source of finance for a business, and the opportunity cost of allocating equity is high. Entrepreneurs therefore need to focus on maintaining an optimal mix of capital between debt and equity. In the beginning, when the company is working on the adequacy of its product market and has not yet established its revenue model, equity should be the main external source of capital.
- When the business enters the expansion phase and must need additional capital to grow, debt can supplement equity by replacing it for predictable use cases (for example, financing working capital) .
- In all foreseeable use cases, replacing equity with debt is more efficient (for example, financing working capital).
Main differences between equity financing and debt financing:
What parameters do subprime debt funds consider before investing?
A fund analyzes certain key parameters related to the company and the industry to make investment decisions:
- The strength of the founders and key leaders: The qualities that the funds look for in founders will include domain expertise, vision and the ability to build strong teams, among others.
- Existing investors support the business: Lenders are comforted by the quality of the investors and their willingness to support the business in the future.
- Established revenue model and healthy margins: High growth companies with an established revenue model and high margins can strategically allocate debt to support their current operations and scale. Most importantly, the business must have a clear path to profitability.
- Market opportunity: The company must have a large addressable market, a strong fit with the product market, a well-designed go-to-market strategy to use debt capital prudently in order to grow.
In addition to business metrics, the fund also examines equally important operational parameters:
- The company’s liquidity position. Efficient liquidity management and a strong liquidity position mean financial prudence.
- Scalability of the relationship. The funds establish a full working relationship and become anchored in the business as it grows.
- Company-defined protocols to ensure data integrity. Without data integrity, information would be a diminished source at best. The relationship must be built on a solid foundation of trust.
- Corporate governance framework. The company must balance the interests of management, employees, investors and various other stakeholders in a transparent and objective manner. High standards of governance indicate how the affairs of the company are controlled and operated.
How can investors invest in venture capital debt?
Risk debt funds are structured as Alternative Investment Funds (AIFs) in India. AIFs are private 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 traditional asset classes such as public stocks 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 observed for investing in AIF units. Investors can subscribe to the units of an AIF either directly or through distributors appointed by the fund.
Debt-at-risk AIFs generally have a commitment period of four to five years during which the committed capital is recycled. During the commitment period, investors receive quarterly payments that are linked to the NCD coupon-bearing instruments. CRS are financial instruments issued by companies to raise long-term capital through public or private issuance. Unlike convertible instruments, CRSs cannot be converted into shares at any time.
In India, risky debt remains underpenetrated and represents 3-4% of the Indian venture capital ecosystem. This is growing rapidly as the venture capital debt ecosystem matures in the country.
Risks of subprime debt lending that investors should be aware of
Subprime loans are often viewed as higher returns for higher risk. In effect, investors derive the risk associated with venture capital debt from the risk inherent in venture capital. However, the investment thesis and the risk profile are fundamentally different.
- Subprime loans come with considerable security to protect against downside risks. Debt is senior secured debt with a charge on the assets of the company. In addition, borrowers are fast growing, institutionally backed companies with a strong focus on corporate governance and transparency.
- The returns in the case of venture capital debt are a combination of fixed interest income and rising stocks through warrants. This interest income is high yielding and is an attractive alternative to the difficult low yield situation that investors are currently facing. More importantly, these returns are regular and predictable in nature.
- In addition to fixed income securities, investors can also participate in the upside of shares of portfolio companies in the event that those companies gain in valuation. Venture capital debt allows investors to participate in a structured way in the venture capital ecosystem.
Who should invest in venture capital debt?
Investors can allocate a portion of investable capital to different alternative products depending on their risk appetite and return objectives. High net worth individuals (HNIs) in India are increasingly eager to explore venture capital investing. In recent times, corporate treasuries and other such institutions have started to explore subprime debt as an alternative form of leveraged investment outside of highly rated debt instruments.
However, many of these investors lack the sourcing and selection prowess that venture capital (VC) investors have and therefore face the challenge of hunting for the right deals. Additionally, venture capital funds have an average hold 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 capital debt to serve as an ideal gateway for venture capital investors. The inherently low risk profile and predictability of subprime loan returns allow investors to gain exposure to growth-stage startups while taking less risk. Investors can participate in the rise of stocks through warrants in any company. With limited drawbacks and potentially high payoffs, investors can test the waters of venture capital investing by partnering with venture capital funds.