This article is written by Gursimran Kaur Bakshi, from the National University of Study and Research in Law, Ranchi. The author of this article has explained what venture debt funding is and how to get one for a startup.
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In most cases, debts are bad. But some debts are good too. These good debts are used in financing the early years of a startup. A venture debt, also known as venture lending, is a type of debt financing, obtained by early-stage companies including startups to raise working capital or financing for short-term use. Unlike any other kind of debt funding, raising capital by venture debt does not require collateral.
These days startups are gorging on venture debt financing. According to the data provided by Venture Intelligence (an Indian unicorn), venture debt investment has sharply increased in the first half of the year 2021, despite the overall lockdown on the economy during the COVID-19 pandemic. More than $170 million worth of venture debt deals has been entered into, as compared to $55 million in the half of 2020 and $64 million in another half of the 2020 year.
Let’s first understand the concept of venture debt and how it can be obtained in a startup.
What is venture debt
There are usually two known methods through which a startup can raise capital, namely, through equity funding and debt financing. A third method could be the hybrid of both equity and debt funding.
Different ways of raising capital
Equity capital is the main source of raising capital in a startup and it is raised through venture funding which is a part of private equity. It is raised by the startup through investors who see great potential in the growth of the company in consideration of common or preferred shares in the company.
In addition to equity capital, investors also help in debt financing which is an additional source of working capital for the startup. Thus, venture debt is usually raised alongside equity capital by a startup. Both are raised in the earlier stage of the startup.
Unlike equity capital, debt financing works similarly to that of obtaining loans. Thus, the investor expects the amount to be repaid in the future with interest. The difference between the two is that equity capital remains the core method of funding in a startup whereas raising venture debt funds is used to get the working capital.
The hybrid method of funding is considered more suitable in order to raise funds. However, in the current scenario, debt funding has been more preferred during the COVID-19 pandemic, where investors have become reluctant in raising equity capital.
What is debt financing?
Debt financing refers to the method of raising finance to run the business and cover the operational cost at the early stage of a startup. To understand the different stages of a startup, please refer here. It is as early as the stage where the idea of a startup is born. The financing can be short-term or long-term depending on the requirements and needs. A short-term debt financing can be used to cover the day-to-day operations of the startup whereas long-term financing can be used to purchase assets like machinery and equipment.
But in both cases, the investors are at risk. The risk is more in equity capital because the investors may not get anything in return if the company goes into liquidation. However, the investors still prefer to raise equity capital since they get the chance to be involved in the management of the company and hence, they can maintain their influence.
The capital to raise venture debt is thus offered at the early and growth stage of the startup by venture capitalists and through other venture debt funds. The investors are allowed to be repaid for this kind of funding because the amount is usually not high and they are allowed to charge pre-determined interest over it.
Further, it is difficult for the startups to give stakes to raise venture debts because they usually do not have substantive assets to avail of any other kind of financing.
Who gives venture debt financing
Venture debt funding can be given by venture capitalists and through specific venture debt funds. In India, venture debt funding is 15 years old and is well-established. However, debt financing still remains not much known perhaps, because of the strong influence caused by equity capital financing.
Venture debt funding, as stated above, can either be made through institutional channels such as venture capitalist firms or that can also be made through individual lenders. In the former case, there is still a paucity of institutional funding. But at least, there is a growing number of venture debt funds to lend the money.
No collateral is required in debt financing
As mentioned above, this kind of debt funding does not require collateral which is a form of security requirement. The financing ranges from one to four years depending on the initial requirement of the company. In cases where collateral security is present, if the debt is not discharged, the security attached to it will be taken away by the debt lender.
Since no collateral is required, the lenders are dependent on warrants that they receive on the company’s common equity. These warrants are given as a part of the compensation mechanism to mitigate the high default risk. The warrants are later converted into common shares at a per-share price of the last equity financing round. This has been explained in the latter part of the article.
Venture debt funding versus venture capital funding
You might be thinking since debt funding is much easier to get than venture capital funding, why do startups not focus on getting the same? The answer to this is that debt funding cannot be a replacement to venture capital funding. Venture capital is more generally used by startups who are with or without financial backing.
In the case of debt funding, as already mentioned, the money is raised along with equity capital by venture capitalists. This means, to be able to get debt funding, venture capital must already be raised. Venture capitalists are eager to raise equity on the basis of the potential growth of the startup and it follows the high growth, high-risk strategy. Whereas that is not the case with the debt funding which sort of has a restricted purpose, that is to raise working capital or buy equipment.
In raising venture capital, there is a giveaway on equity and investors earn more profits through this and the management is diluted by giving equity shares. Whereas, that is not the case in venture debt. Venture capital funding allows additional/add-on benefits, such as access to networking and facilitating partnership opportunities, however, that is definitely not the case involved with venture debt financing as it does not involve any add-on benefits.
How to get venture debt for a startup
There is no set way of getting venture debt financing for the startup. However, there are certain common steps that should be followed by startups who are looking forward to this kind of financing.
How to secure venture debt funding
To get venture debt financing, first, try to secure venture capital from an institution or individual. If you are able to secure venture capital, the same place can also give you venture debt. To get debt financing, it is important to have a solid business plan.
What to include in a solid business plan
To get going, you need to have a business plan that must include sections on business description, about the product and the market analysis on it, potential competitions in the market and their analysis, sales and marketing strategy, ownership and management plan, operating plan, financial plan, and the executive summary.
The section on the business description should be at the starting of the plan. It must include information on your idea and how it evolved into a business, what is the pain point of the market you are targeting, and how likely will you be able to achieve that. You should not extensively mention everything in an overview since that will be a part of the executive summary.
However, you can mention an overview of the industry, what are the current trends of the market, where is your product going to stand in line with the current market trends, major competitions, and estimated sales. Since this would be the first section, it is advisable that you give everything with a positive approach that should have the capacity to set you apart from other competitors.
Product and market analysis
In the second section, the product should be described thoroughly along with how it would potentially respond in the market/industry you are targeting. This should demonstrate your in-depth understanding of the market where you are going to sell your product so you must be sure of your primary goals along with the estimates on the market response.
This part of the section is important for funding purposes because it entails a thorough analysis of your potential competitions and helps you portray a standard image of yourself before the investor. Since you may receive both direct and indirect competition in the market, you should write about every possible way in which you can face the same. It will decide your leverage over the other competitors in the market. Make sure to analyse the weakness and strengths of your product and of that of your competitors because this will be an indicator to persuade your potential funding sources.
Sales and marketing strategy
This part of the section should mention the sales and marketing strategy that you plan to apply to your product, the pricing tabs, and how you would be advertising/promoting your product. You must have thought of a unique way to sell your product (unique selling proposition), write that down here. Include all the benefits that your product is associated with that will persuade the customers to buy it.
Ownership and management plan
In any startup, the management team plays a vital role in attracting investors for various types of funding. That is why this Section is pertinent for any investor to be investing in your startup. Mention your internal and external management team, their resources, and the human resources available in general. Since investors’ decision depends on how well your management team is, make sure you mention their skills and how it will impact the working of the startup.
Thus, this section should explain your ownership structure (legal structure of your business), internal and external management team structure, and human resources. There are various suggestions available on what this section can include. One of the suggestions is to have an advisory board as a management resource. This is to be adopted in startups whose primary goal is to attract funding.
An advisory board helps you in giving critical sides of your idea on which your startup is based. See, at the initial stage, you need different viewpoints on your startup to get an idea of where do you stand in the market and what is the gap between where you are and where you want to be. That is why an advisory board is necessary to give you that expertise that is missing in the startup. It will only enhance your business plan and help you attract better investors.
You can choose how to set up an advisory board and include the number of members that should be there. An advisory board may play a pertinent role in increasing the confidence of the investor in you.
Operational cost and financing plan
This portion is the most important for any kind of funding. This part can be divided into two, namely the operating costs plan and the financing plan. The operating cost mentions how your business will run, information about your employees, your assets (if any), how your product’s manufacturing takes place, how many employees would you be needing if the sales are increased, etc. It must deal with every aspect of the day-to-day operation of your business that will help the investor understand your business better.
Further, the financing plan should mention three things, your current financing, your expected funding needs, and your projected income. Your project income will allow the investor to get an idea of your financing requirement and thus, you should mention all these details by including your income statement, the balance sheet, and the cash flow statement. These three documents are the most important.
An executive summary is the summary of the whole business plan wherein you highlight the main points of the business plan with keywords. Further, the appendix can mention other additional information on the business.
About the underwriting process
The consideration associated with venture debt is interest payment, fees, and warrant. There are venture debt lenders who are already ready to finance venture debt through an intense underwriting process. Underwriting takes place by an individual or institution who wants to assess risk associated with an investment, loan, or borrowing.
Underwriting is a process of evaluating the risks associated with a particular borrowing. Underwriters have the duty to evaluate each loan, determine the collateral security that is available (if any), and see whether the borrower will be in a position to repay or not in the event of default.
By assessing all these factors, the underwriters can establish fair borrowing rates for loans, create a market for securities, and in case the associated risk is too high, the loan may be refused. This writing process requires thorough and procedural research to arrive at a decision because the lender has to analyse various factors such as the viability of the product, the management team of the startup, and the investors who have already invested (if any).
Thus, it is similar to a vetting process that allows investors to arrive at an informed decision.
Source of debt financing
This may be categorised as private and public. Private sources may include individual lenders who are willing to be given debt financing based on a personal guarantee. Whereas, public venture debt financing can be availed through bank loans or bonds. This type of financing is called financial leverage. Other types of loans include microloans, business loans, credit cards, peer-to-peer loans (personal loans) and trade credits. Since venture debt funding is an alternative to the traditional type of funding you avail from banks, these can be granted by various debt funds established by various venture capitalist institutions/firms/individuals.
Lender’s repayment methods
The lender has to evaluate whether the startup would be in the position to raise equity rounds to repay the venture debt in the near future. This is because repayment can also be done through a warrant which allows the debt to be converted to equity at a later stage. But the equity involved here is less than that gained in a venture capital investment.
Taxes on debt interest costs
In debt financing, the repayment includes the principal amount and the interest. While the principal payment is usually not tax-deductible, the interest paid over it can be deducted under the income tax as it is considered within the category of expense. Hence, it can be claimed as a return. But this may vary according to different income tax laws of different jurisdictions.
Advantages and disadvantages of venture debt
The first perception of venture debt financing would be that it is easier to get because no collateral property is associated with it. However, that should be considered as a disadvantage. It is because if there is no collateral involved, it may not be a safer method of financing. Since this is similar to that of borrowing money through a loan, the lender may require personal guarantees. The personal guarantee can be in the form of personal assets such as your house, car, any other kind of investment that you have.
You should go for debt financing where you have a high-growth business because then you require constant capital to enhance your business. Whereas, you can also opt for debt financing for short-term purposes where you can easily repay the same within a year or so of its maturity. But the startups should be vigilant about the effect these types of financing put on their credit rating.
Venture debt financing during COVID-19
During the COVID-19 pandemic, as there has been an increase in venture debt financing, many funds have been established for the same. For instance, in India, to get this type of funding, various funds like Alteria Capital, Trifecta Capital, and Innoven Capital. These funds have provided venture debt to startups like Bigbasket, Dunzo, and Curefit to name a few. Other capital venture funds are also to be established by Ankur Capital and Unicorn India Venture to provide debt financing. Venture debt funding started 15 years ago in India and since then, it has enhanced the ecosystem of Indian startups who have been unable to gather funds at the initial stage. Even startups want to pass that valley of death stages of a startup wherein 90% of it fails. That’s where venture debt financing comes to the rescue.
Debt financing is a quicker method of getting funding for the startups but it involves various aspects that need to be given proper consideration before venturing into it. The same rule is also applicable to investors and individual lenders who are in the business of giving venture debt funding. Risk evaluation is something that both sides should equally consider before arriving at a decision. Lastly, since the venture debt financing is derived from the venture equity market, one needs to have a close follow-up of the same to understand the right time and the right method to get debt funding.
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