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Venture Debt: A Preferred Alternative For Startups

By - KSANDK on September 13, 2022

Venture Debt For Startups

According to research, worldwide venture debt capital increased five times in the previous eight years, reaching an all-time high of USD 58 billion in 2021 [1]. The venture debt market in India is only a little over a decade old. With investors looking to lower risks by making loan investments in companies rather than equity, venture debt funds have gained appeal in India. Venture Intelligence reports that Indian venture debt funds raised USD 85 million in FY 2020–21, a significant increase from USD 62 million in FY 2019–20. Startups are increasingly adopting the route of venture debt funding. 

What Is Venture Debt?

A loan issued by banks and non-bank lenders for nascent, high-growth businesses with venture capital backing is known as venture debt. The vast majority of venture-backed businesses eventually raise venture debt. It is a strategic instrument to support equity funding and when properly implemented, has many valuable applications for modern organisations. The main one is that companies may achieve high growth rates without diluting equity by leveraging debt as growth capital [2].  

Some of the other benefits of opting for venture debt are: 

  • Extending further rounds of equity funding, as the startup has a good amount of capital. 
  • It can fund the working capital needs of quickly expanding businesses that demand significant operating capital expenditure. 
  • Businesses may establish a reliable credit score early on by using a balanced capital mix of loan and equity financing. 

What Is The Difference Between Venture Debt And Equity Funding?

While venture debt and equity fund entrepreneurs, the methods may vary according to the business model. The following are some of the ways that venture loans and equity differ: 

  1. In exchange for capital, venture capitalists sometimes want a sizeable portion of the company's stock. On the other hand, issuers of venture debt often avoid owning any equity in the business. 
  2. In the case of venture debt, the debt cost is fixed and only subject to the agreed-upon interest rates between the company and the entity issuing the debt. The value of equity, on which venture capitalists frequently rely, fluctuates over time and can do so substantially depending on the success of the company's shares. 
  3. Like a bank loan, venture debt requires repayment of the principal amount and the interest that the lender would have initially assessed on the borrower (i.e., the startup). Unlike typical loans, venture capital does not require repayment of borrowed funds. Instead, the investors purchase a sizeable portion of the business, which they may later sell when the startup's overall worth rises. 
  4. The average payment for venture debt is lower than that of venture capital, despite its returns being less risky than those of venture capitalists [3]. 

Non-Convertible Debentures

A ‘non-convertible debenture’ serves as the underlying instrument for venture finance, which holds coupons that the borrower issues to the lender. In addition to such instrument-bearing coupons, the lender purchases the borrower's equity warrants. The holder of a warrant has the right, but not the duty, to purchase shares of the company's stock at a certain price and within a predetermined window of time [4]. 

In general, NCDs are fixed-income instruments often issued as a public offering by highly rated firms to build up long-term capital gains. They cannot be changed into stocks or equity. NCDs have a set maturity date, and depending on the fixed term selected, the interest can be paid either monthly, quarterly, or yearly together with the principal. 

Additionally, NCDs provide the owner with several other advantages such as high liquidity through the stock market listings, source tax exemptions, and security because businesses can issue them with a solid credit rating under the RBI's NCD issuing guidelines. These must typically be issued in India with a minimum maturity of 90 days. 

NCDs are governed by the Companies Act, 2013 and the rules thereunder, the Foreign Exchange Management (Debt Instruments) Regulations, 2019 (DI Regulations), Securities And Exchange Board Of India (Issue And Listing Of Non-convertible Securities) Regulations, 2021, the Securities and Exchange Board of India (Issue and Listing of Debt Securities) Regulations, 2008 (the SEBI Debt Securities Listing Regulations) and the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (if the NCDs are listed/proposed to be listed) and other requirements issued by the Reserve Bank of India (RBI) from time to time. 

The Bottom Line: Is It Worth It?

In the startup sector, venture debt is becoming more popular, and for good reason. It is a choice worth considering for a company due to its non-dilutive nature and quick ease. It has the power to extend a firm's runway and provide cash, which is essential for a startup to keep evolving and expanding. Even though it has drawbacks, every firm should consider it and include it in their growth plan. A startup running out of money will fail quickly, but venture financing can prevent this.

It is a smart idea to include the loan as a part of the growth strategy, and being able to explain its purpose to a particular firm in detail can aid during investor meetings. Due to the negative image that certain investors have left behind, other investors may become a bit dubious when they find venture debt on a company's books. These investors don't want a significant percentage of their money to repay a loan. This may be avoided by avoiding taking on more debt than a startup can manage and adequately defining its usage. 

If you want to read more about how to navigate the start-up industry, you can check out our other posts on investor control rights, a quick overview of how to register your company, the purpose and components of a founder's agreement, the basics of seed funding in India, or a breakdown of term-sheet clauses on our blog.


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