Venture Debt and its Future - Part 4
Venture debt is a very exciting, but also extremely risky type of financing. Companies can take on venture debt to fund their business ideas, expansions, and acquisitions. The debt is funded by the investment banks who provide the cash for these companies to pursue their dreams of profit. Venture debt enables start-up companies to explore new products or services that they would otherwise not be able to afford. A company with venture debt can then either launch their product in the market as they secure customers through sales or simply bankroll themself until they are ready to generate revenue from sales.
In the last blog, we discussed when a startup should raise venture debt, whether is it an alternative to venture capital and how venture debt is becoming as common as a Series B round of funding. In this blog, we are further going to discuss the questions related to it.
Table of Contents
Who are the typical LPs in venture debt?
The typical Limited Partner in venture debt is a private equity firm that has been investing in early-stage companies for years. They have strong networks of contacts, excellent contacts at investment banks, and the ability to make money on their investments. They are looking for the next big deal, so they will often be the ones who bring you into contact with other investors who can help fund your deal.
Limited partners in venture debt are also mid-sized companies and large corporations with a lot of cash. They typically lend money to early-stage companies that need funding to grow and develop their business.
The key characteristics of these investors include:
They have small amounts of capital available for investment.
They want to see strong financial results from the company they are investing in.
They want to know that the entrepreneur has a good track record of success in similar businesses.
They do not want to be part of a legal dispute between the company and its founders or shareholders.
There are two types of limited partners: general partners, who provide the capital and expertise to run the business; and limited partners, who take money up front and return it to the firm when they sell their stake.
General Partners
General partners typically include a mix of individuals, large corporations, and financial institutions that want part ownership in a company's growth. They are the other type of investor interested in owning a portion of a company or portfolio. They invest cash upfront and receive periodic payments for as long as they hold their investment.
Limited Partners
In venture debt, LPs include both individuals and institutional investors such as venture capital funds and hedge funds. Venture debt is sold by private equity firms to raise money for companies with high growth potential but little or no revenue.
Why should LPs invest in venture debt over venture capital?
While venture debt and venture capital are both used by entrepreneurs and investors to finance early-stage companies, they serve very different purposes. Venture debt is designed to provide working capital for companies, while venture capital is designed to provide risk-free investment returns to investors.
The main reason venture debt is a better option than venture capital for LPs is that it offers more flexibility. Venture debt comes with fewer limitations on how much you can invest, how long you can invest, and when you can exit. As you can see in the above graph, venture debt offers more IRR than venture capital.
Venture capital funds are typically limited to $1 million per fund and three years from the date of investment. Venture debt funds, on the other hand, are generally set up as revolving funds with annual or semi-annual payouts (in some cases monthly or quarterly). These terms allow LPs to invest more money over time and exit earlier than VCs would allow them to do in an LP fund.
Additionally, LPs can participate in different venture debt funds using different investments at the same time – meaning they have greater flexibility than VCs do in terms of where they decide to put their money.
Venture debt has the benefit of being more accessible than traditional VC funding because it can be obtained relatively easily through private placements and public offerings.
There are many reasons why venture debt is a good investment for private equity firms, even if they don't need the money for their investments.
1. Venture debt has a higher interest rate than venture capital. The interest rates on venture debt can be as high as 20%. This is much higher than the interest rates that venture capital companies charge.
2. Venture debt is easier to obtain than venture capital. Private equity firms can buy loans from banks or other lenders, rather than having to go through the process of raising money from investors and then negotiating with banks and other lenders. This makes it easier for them to get loans at attractive rates and allows them to quickly get the money they need without wasting time sending out requests for proposals or waiting for responses from interested parties.
What happens when companies default on their venture debt?
When a company defaults on its venture debt, it can cause financial problems for the company's investors. The company will likely have a large amount of debt that needs to be written off, and the investors may not receive any of their money back.
When a company defaults on its debts, the lenders are left holding the bag — and often that includes the investors who put money into the company's initial financing round.
Lenders typically have several options available to them when a company defaults on a loan or bond issue. One option is to ask the bankruptcy court to allow them to take charge of running the business and continue operations. Another option is to try to find another investor who will buy out their stake in the business, which would give them back their investment plus any additional money they may have made on top of their original investment.
Venture debt is often secured by assets such as intellectual property or real estate. If both approaches fail, lenders might try liquidating assets such as real estate or equipment owned by the company so they can recoup some or all their losses.
How big is the venture debt market opportunity in India and how bigger can it get?
The venture debt market in India has potential. The country is one of the fastest-growing economies in the world, which means that there are more opportunities for investors to make money in the venture debt market than ever before.
Many factors affect the debt market some of which include:
1) The number of companies that need to borrow more money for growth and expansion.
2) The number of banks willing to lend money to companies.
3) The number of institutional investors looking for opportunities in Indian venture debt.
The current venture debt market size in India is about $1.3 billion and growing at a CAGR of 45 percent over the last five years. It is expected to grow at a CAGR of 25% over the next five years. The amount of venture debt in India doubled in 2021 to $538 million from $215 million in 2019. The average ticket size of venture debt is $5.85 million with 111 deals in 2021.
The venture debt market opportunity in India is huge, but it is not growing at the same pace as the US, China, and other emerging markets. The reason for this is that Indian startups are typically early-stage companies, which means they have an annual burn rate of less than $10 million per year. This makes them very vulnerable to funding delays or even defaults.
The solution to this problem is to enable more Indian startups to raise capital from international investors. This can be done by opening more channels for foreign direct investment (FDI) into the country, reducing the cost of credit for Indian entrepreneurs, and making it easier for foreign investors to get comfortable with investing in India's young economy.
Venture debt has become an important source of financing for many Indian companies, especially those in the technology sector. Venture debt accounted for nearly 30 percent of all new capital raised by Indian startups in 2015.
As India's economy continues to develop, venture funding will continue to expand as well. The Indian startup ecosystem currently supports over 100 unicorns (startups worth $1 billion or more), and many more unicorns are waiting to break out of India's borders into other markets around the world.
Venture debt has seen more uptake in the US, what are the challenges that have held it back in India?
There are three main reasons why venture debt has seen more uptake in the United States than in India.
Venture capital is a mature profession in the US. Many entrepreneurs have been around for several decades and have accumulated significant amounts of wealth.
There are more venture capitalists in the US than there are in India.
There is more experience in managing funds for early-stage investments because there is more funding available for startups through angel investors and venture capitalists.
In India, however, some fewer entrepreneurs have been around for several decades and accumulated significant amounts of wealth. This means it will take longer for early-stage investments to mature if they do not receive adequate support from government policies or regulations. Also, Indian entrepreneurs do not have access to angel investors as readily as their American counterparts do. In addition to this disadvantage, Indian entrepreneurs need to overcome cultural barriers when pitching their ideas to investors abroad because they may not know how foreign investors respond when they hear pitches from people with different backgrounds or cultures.
Three main challenges are holding venture debt back in India.
Lack of an efficient regulatory framework.
There are currently no regulations governing the use of venture debt by Indian companies and there have been no guidelines from RBI to provide clarity on how to structure such financing instruments. This makes it difficult for banks to differentiate between high-risk and low-risk companies, which can lead them to make wrong decisions about loan approval processes.
Lack of awareness about venture debt.
There is also a lack of awareness about venture debt among potential investors. Most people think of venture debt as being synonymous with high-risk investments like high-growth tech companies and startups with uncertain prospects, but this is far from reality. Venture debt is much safer than most people think if you know how to use it properly — but there are still many myths surrounding it that need busting before venture debt becomes more popular here in India.
There is no mechanism to certify companies using venture debt as they do in the US.
There isn't much of a precedent in India for venture debt. The fact that it's relatively new here is one reason why there are so many questions about how it will work. There are still very few lenders willing to lend money to new ventures here. Banks tend to prefer lending in established industries where they already have a track record of success and know how to assess risk levels. That's why they're not too keen on giving loans that could go bad if things go wrong – but if those risks can be assessed then this isn't such a big problem for them.
Conclusion
Venture Debt can be a critical lifeline for fast-growing companies experiencing capital constraints. Venture debt provides a better IRR on investment than venture equity. This kind of funding leverages the expertise and experience of the VC with the growth potential of a small business – helping to accelerate innovation and promoting long-term growth.