India’s fast expanding economy and democratically-run government that has accepted reforms has led to institutional investors investing in India. While venture debt funding is a well-known idea in Silicon Valley, it has only lately emerged as a practical choice for startup businesses in India and currently a rise in the Venture debt financing in India is observed. A financier will make a direct loan of funds to a startup company in need of growth capital.

Venture debt can help entrepreneurs by lowering the dilution of selling equity to raise money. The interval between equity fundraising may also be extended via venture loan. Due to the use of venture debt for operating capital and bridge funding, the founders are still able to exercise control over the business. Investors use venture loans to speed up organic and inorganic growth in a market with an excess supply of equity capital in order to continue attracting capital at higher values. Additionally, in a year like 2023, when equity rounds were difficult to come by, venture debt acts as a cushion for the current capital base, extending the runway significantly and bringing the business closer to profitability.

Venture debt financing landscape in India 

Over the past ten years, the trend of investing in India has increased, and the private IT investment area has seen extraordinary expansion and inflow of capital. Indian entrepreneurs have received a sizable amount of funding over the previous four to five years from early to very late-stage international investment companies, making capital inflows into startups more closely connected to performance on the global public markets. The good news is that there has been a significant rise in domestic capital going into locally-based debt and venture debt financing in India.

Revolving credit facilities, revenue-linked loans with a cash sweep, accounts receivables factoring, equipment and contract finance, are the most frequent transactions in the market of Venture Debt Financing in India. Depending on the industry and borrower, the returns on these loans, which are often short-term, might range from 10% to 18%.

Family offices and hedge funds are suitable lending sources for venture loans to emerging market venture companies due to their speedy underwriting and unique transaction structuring capabilities.

Growth in Venture Debt in India

Strong foundations for venture debt financing in India are created by the Indian financial services industry. Traditional means of lending are frequently quite difficult due to the demand for “bankable enterprises” to have past financial accounts, operating history, and tangible collateral. According to Stride Ventures' India Venture Debt Report 2022, the amount of debt disbursed through venture loans in India actually increased to $538 million in 2021 from $271 million in 2019. With ticket sizes ranging from $2 million to $25 million, 110 businesses raised venture loans, including Mensa Brands, Urban Business, and Licious.

A financier can create a private lending deal directly with the company using venture debt. Investors aim to build deals with little potential for loss and the ability to convert some debt into equity at a future date and this is known as “Equity Kicker”.

The overall amount of venture debt capital flowing to Indian startups this year, particularly growth and late-stage ones, is expected to exceed $1 billion. Transaction or the deal flow is frantic, too, and one of the main causes of the increased demand is the drying up of the equities markets. Startups aren't able to get as much investment as they once could, and even when they do, their valuations aren't as high as they should be. Growth-stage and late-stage startups are particularly affected by this. “Consider MobiKwik as an example. While its initial public offering was delayed, the supplier of digital payments raised Rs35 crore in venture debt from BlackSoil in August (IPO).” This was filed with the Securities and Exchange Board of India more than a year after it submitted it’s Draft Red Herring Prospectus (SEBI). In order to avoid diluting their ownership and still achieve their business goals, entrepreneurs are turning to debt funding due to rising public market valuations, unfavourable IPO markets, and investor pushback.

Another point to note is that bigger players frequently use the lack of equity investment as a tactical opening to acquire smaller rivals. An excellent alternative to taking equity and diluting your holding is venture debt.

Benefits of this alternative funding option for early-stage companies 

High-growth businesses can gain two key benefits from increasing their venture debt:

• Using Venture Debt to Lower Average Cost of Capital- The first advantage is that by providing minimally dilutive finance to quickly scaling enterprises, venture debt can lower the average cost of capital. Since stock is the most expensive form of growth capital due to its highly diluted nature, this is particularly true when obtaining venture financing concurrently with an equity round.
• Venture Debt Offers Flexibility- In addition to not requiring board representation, venture financing also comes with a cash reserve that can be used if there are any setbacks for the business. This differs significantly from senior-secured loans, for instance, that frequently call for the financing of a certain underlying asset. and/or needs personal guarantees, and/or is pledged as security.

Among the additional major advantages are:

• Equity is more expensive than debt financing.
• Debt makes it possible to keep control of enterprises.
• Tax deductions for debt costs lead to lower after-tax capital costs.
• Debt can be made available more quickly than equity because equity investments require greater due diligence.

Differences between Venture Debt and Traditional Equity financing 

The use of venture debt as a means of extending a company's capital runway has grown in favour. It provides urgently required capital for rapidly expanding businesses seeking to scale and expand. Often, these businesses are on track to turn a profit, but they require funding to keep operations afloat and to make resource investments that will propel them forward. Both venture debt and equity financing provide cash to firms, but they differ in a few key aspects when comparing debt vs. equity funding.

Allocating equity money has a high opportunity cost and is the priciest form of financing for a corporation. So, entrepreneurs must concentrate on maintaining an ideal balance of capital between debt and equity. Equity money must be the main external source of funding at the early stages of the company's development, while it is still figuring out its product-market fit and has not yet established its revenue model.

Debt can complement equity capital by substituting it for predictable use cases when the company enters the expansion stage and needs additional funding to expand up (For example, working capital financing).

Debt capital is more effective than equity capital in all foreseeable use scenarios (For example, working capital financing).

The process of raising venture debt 

The Venture Capital funding process in India takes substantially longer than raising venture loans. The duration of the due diligence procedure has a significant impact on the timeframe, which normally lasts 4 to 8 weeks.

The Venture Capital funding process in India typically consists of six steps:

• Origination- The process of origination includes finding prospects for venture debt.
• Initial Examination- This normally happens during a phone call between the lender and the company's founder, CEO, or CFO. The lender will learn more about your business, your particular needs, your goals for expansion, and any inquiries you may have regarding the financing options throughout the conversation.
• Term Sheets- The purpose of a term sheet, which is a non-binding document, is to provide you, the company, a general sense of the terms to expect after the whole due diligence process is finished.
• Due Diligence- Following the conclusion of talks and the execution of the term sheet, the venture loan lender will begin the complete due diligence procedure.
• Legal documentation
• Funding

Conclusion

For well-established firms with solid fundamentals, venture debt can help them raise more money while still using up their venture capital. Despite its growth, venture debt remains a small slice of the overall market. "India’s venture debt market is highly under-penetrated. In many circumstances, taking out venture debt is probably preferable to going through an equity investment round. For example, it can assist businesses in extending the runway on their present investment and achieving significant milestones without the need for a cumbersome bridge round. It can be used as a "safety blanket" or insurance policy to act as a buffer against specific risks or as a means of financing opportunities, such as acquisitions or significant capital investments. In addition, it can be extremely helpful in assisting companies to achieve profitability as opposed to merely concentrating on expansion.

FAQ’s

1. What is venture debt financing? 

It is a minimally dilutive form of debt financing employed by high-growth businesses. A venture debt loan's precise structure can vary, although it is commonly set up as a term loan with interest payments and warrants.

Since venture debt can be utilised as a supplement to or an alternative to equity funding, it is available to both venture capital-backed and non-venture capital enterprises. The ultimate objective of venture financing is to give companies the expansion money they require to achieve their business objectives while also enabling founders to preserve control and reduce stock dilution.

1. Why is venture debt financing becoming popular in India? 

One, founders are better informed and the ecosystem is more developed. The level of education among founders has greatly grown, and they now have a greater understanding of the subtleties of debt and how it can aid in the accomplishment of their business goals and strategies. In addition to extending a startup's runway in the face of uncertain funding, venture debt can also be used to cover working capital demands, supply chain requirements, or to finance mergers and acquisitions.

Second, the market has grown in size. Because venture debt is a derivative asset class that often tracks venture capital funding, the market for venture debt has grown along with the venture capital sector. That follows naturally.

Finally, as more funds migrate to venture capital, the amount of venture debt has increased. “Over the last three years, we’ve seen a lot of interest from domestic investors. Earlier, it used to be very niche. Now we’re seeing family offices and even founders with liquidity pump money into venture debt”.

1. What are the benefits of venture debt financing for startups?

• Using Venture Debt to Lower Average Cost of Capital- The first advantage is that by providing minimally dilutive finance to quickly scaling enterprises, venture debt can lower the average cost of capital. Since stock is the most expensive form of growth capital due to its highly diluted nature, this is particularly true when obtaining venture financing concurrently with an equity round.
• Venture Debt Offers Flexibility- In addition to not requiring board representation, venture financing also comes with a cash reserve that can be used if there are any setbacks for the business. This differs significantly from senior-secured loans, for instance, which frequently calls for the financing of a certain underlying asset. and/or needs personal guarantees, and/or is pledged as security.

Among the additional major advantages are:

• Equity is more expensive than debt financing.
• Debt makes it possible to keep control of enterprises.
• Tax deductions for debt costs lead to lower after-tax capital costs.
• Debt can be made available more quickly than equity because equity investments require greater due diligence.