Venture debt vs venture capital: As VCs turn cautious, debt can help startups fill working capital gaps

September 1, 2020 12:23 PM

As equity investors become cautious about investments, the share and importance of venture debt are poised to rise.

investment tips, investment tips for risk-averse investors, COVID crisis, fixed deposits, FD, FD laddering, Sovereign Gold BondsVenture debt can be raised without fears of a drop in valuation and equity dilution for founders.
  • By Ankur Bansal

In the past founders were forced to pursue unsustainable customer acquisition and revenue targets to bump up valuation rather than build a holistic business with a keen eye on unit economics and profitability. While by late 2018 investors had started to shift their focus to sustainable start-up models, COVID-19 has accelerated the need for sustainability to become the primary investment criteria. In a truly Darwinian turn of events, high cash-burn and growth-focused start-ups have turned to lay-offs and extensive cost-cutting exercises in a bid to survive.

How Covid almost overnight changed environment for startups

The first impact has been on the demand side. B2C start-ups have seen revenue falls to near 0 per cent levels and even post lockdown the revenue is at best 50 per cent level. Discretionary consumer-focused industries such as clothing, jewellery, and tourism are struggling for survival with no visibility on revival. On the other hand B2B start-ups with unglamorous yet bottom-line focused models have emerged stronger. Start-ups in sectors which were deemed “difficult-to-scale” such as manufacturing auxiliaries, logistics, SaaS, agriculture, and pharma have seen revenues return to nearly 70-80 per cent of pre-Covid levels. The exceptions to the consumer product downturn are sectors such as e-pharmacy, ed-tech, used vehicles, and food products that are non-discretionary and focused on mass markets.

The second impact has been on the supply chain. A large part of both blue-collar and white-collar workers are either refusing to or are unable to return to workplaces. Transport and logistics management has become tantamount as there are many layers of uncertainty in the supply chain. Here start-ups that had digitised delivery, supply change management, employee management, and remote working tools have been able to quickly adapt and continue operations. Technology has become a significant differentiator with digital-first start-ups emerging as winners. Venture investors have consciously added tech-first companies to their portfolio and will see the benefit of these tailwinds in the near term at least.

While FY20 was a milestone year for the Indian VC industry with $10 billion in capital deployed (the highest ever) and around 55 per cent higher than FY19. India witnessed a 30 per cent increase in deal volume over FY19 as well. Venture debt accounts for 4-5 per cent of the VC industry volume. However, by quarter March 2020, VC investments had already fallen by 20-40 per cent and have slowed further in the June quarter as investors are on a wait-and-watch mode. As equity investors become cautious about investments, the share and importance of venture debt are poised to rise.

Why Venture debt during Covid

Covid-19 further tipped the scale in favour of investors as founders are forced to raise capital with large equity dilution to survive. Valuations for the majority of start-ups have taken a hit with founders facing the very real possibility of down-rounds to sustain operations unless a buffer capital is raised to tide over the next 12 to 24 months. Much needed correction for many overvalued start-ups is possibly on the way. To mitigate these issues, raising debt has emerged as a leading solution for start-ups to finance working capital gaps and assets. Here venture debt helps in multiple ways:

Debt with minimal credit history, customized repayment– For start-ups to raise debt from traditional financial institutions is challenging as they have a limited financial and credit history and lack of assets that can be hypothecated as security. Covid has made this problem worse. Venture debt lenders are usually the first lenders to start-ups as they understand a start-up’s unique business model, cash-flow structure and provide repayment structures to ensure that startups can repay in tune with their business progress and cycles.

Also read: Ola, Uber drivers work in ‘toxic, isolated’ environment with health issues, dwindling earnings: Survey

Capital without dilution, loss of control – Venture debt can be raised without fears of a drop in valuation and equity dilution for founders. Venture capital investors also want founders to raise debt as it brings fiscal discipline into the business and protects previously made investments by extending the runway.

Debt in times of Covid – Start-ups are dealing with COVID with different strategies which are specific to their models and sectors. Some are seeing temporary revenue drops until they can pivot their supply chains to the new normal. Equity raises from new investors and traditional debt can take a long time to hit their bank accounts. With start-ups needing capital as soon as possible venture debt becomes a go-to solution.

Raising venture debt during Covid

Raising debt can have nuances a founder needs to keep in mind. The traditional ideas about raising equity for VCs or loans from banks do not hold:

Cash flow visibility and capital needs– Unlike equity investments, venture debt can take many forms ranging from term loans with monthly repayments to receivables financing credit lines to short term working capital loans with bullet payments. Knowing the cash flow of the business for the next nine-12 months is an important first step. Venture debt can be used to augment current business models but cannot be used to finance businesses which are still in pivot mode.

Stress-test your business models – Be sure that a venture debt firm will grill the founders on their current and future cash flows. They will drill down to understand business moats, unit economics and various business drivers such as CAC, receivables, collections. Founders should have a plan in place for EBITDA break-even in at least nine to 12 months. For example, currently, start-ups with high-quality enterprise customers have lesser variability in their revenues and can raise debt more easily.

Performance during Covid – How the business was faring before March holds little relevance now. The steps taken by the startup during these times to augment runway and strengthen the business model will play a critical role in deciding if the company is eligible for venture debt. Only those that are on the path to recovery and can manage despite the uncertainties surrounding the pandemic and frequent lockdowns will be able to attract follow on debt as well as equity

VC firms bring sector expertise, growth/sales knowledge, and are finally the first line of backers for start-ups. Venture debt augments this and supports both the founder and the investors through their journey. Venture debt is also generally limited to 20 per cent of the equity fundraise till date. Hence, it is important to ensure equity backers are very much still behind the business else getting venture debt backing may become challenging. Leveraging debt to was trick that established businesses have used for a long time. For start-ups, this can be a useful tool to reduce the burden on equity and make the most of the company’s finances.

Ankur Bansal is the Co-Founder and Director of BlackSoil. Views expressed are the author’s own.

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