Startups are meant to disrupt the obvious and constantly challenge the prevalent ways of an industry. In the initial stages, most start-ups require capital to build the foundation of such disruption through technology and through new innovations. Capital is a key lever for a start-up for growth, hiring talent and investing in the future. Given the recent macro conditions of rising rates and price corrections in public/private markets, venture capital has started to be scarce.
Venture capital slowing down is leading to rise of another venture debt as an efficient tool for startups to access capital. With valuations coming down, equity is a precious commodity for any founder.
Moreover, after multiple equity funding rounds, it is common to see the share of the founders getting diluted and going as low as single digits. On the other hand, venture debt can help them procure funds faster, alongside holding on to their equity stake.
As per reports, venture debt in India had doubled in 2021 compared to the numbers in 2019. Founders are increasingly focusing on venture debt as their fundraising strategy instead of going for equity funding rounds. The fact that venture debt funds can deploy capital much faster than an equity round which could take up to 6 months, is also driving the demand.
It’s not that the investors are complaining either. The rise in venture debt deals suggests that they are more than gearing up for this.
How does venture debt work?
Venture debt is a form of alternative investment. It is provided to venture capital backed startups with strong unit economics and an ability to demonstrate growth.
In a matured economy like the US, venture debt accounts for anywhere between 10% to 20% of the annual venture equity funding. In India, it is pegged to be anywhere between 2% to 5%, indicating that there is plenty of scope for growth of this alternative asset class.
As more and more startups get venture equity funding, the market gets the signal that these companies command greater liquidity and have the capability to borrow debt and repay it. Thus, the growth of equity financing in India has been proportionately helping build the debt funding market too.
Why should you invest in venture debt funds?
Typical venture debt funds have a seven-year lifecycle. The draw and recycling period is until year five, and the fund returns capital on the principal amount loaned during the last two years. For a High Net Worth Individual it is a great opportunity to support a business in which he / she might believe, make good returns and see the capital being returned back in a 12-24 month period. A major benefit of debt financing for investors is that there is higher interest income which is distributed on a quarterly / monthly basis. Normal venture debt funds generate 13% to 15% ROI with 3-4 years of repayment period. The supply of capital and the demand for this asset class has seen exceptional growth in the last two years. Many factors contributed to the growth. First, investors saw a sudden reduction in fixed-income returns from early 2020 and felt a need for safe, predictable fixed-income products which would give good returns. Second, pandemic tailwinds allowed for better depth and access to most digital businesses. It allowed venture debt providers to demonstrate that this asset class can yield greater returns at lower risks.
Conclusion
Venture debt investments are set to grow at a rapid pace in the coming times. Companies. That need more capital to fuel their growth will need debt to keep them going whereas firms that are doing well, look at debt as a source of their war chest. With the startup winter descending on the industry, debt funding rounds are going to emerge as the go-to options for all ventures funded companies in coming times.
(The author is Mr. Mr. Vineet Agrawal, Co-Founder Jiraaf and the views expressed in this article are his own)
