Venture Debt - the what, why and when not! With Ishpreet Singh, Stride Ventures

  
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There is a saying that debt is often cheaper than equity.

Our topic for today is venture debt, which has become mainstream in the Indian start-up ecosystem of late. In 2019-20, the total amounts raised by venture debt funds was about $62 million which jumped to about $85 million in 2020-21.

As the pool of growth stage start-ups increase, it is fast becoming an attractive non-dilutive alternative to equity financing. Not just that. In many cases, it is a great additive to equity financing as a bridge round. Say you are at a Series B stage company and you know you have to raise the next round in the coming year, but if you were to go out to the market today and raise capital you will get a lesser valuation than what you would if you improve your numbers over the next 10-12 months and then raise. To get that extra 10-12 months runway, Venture Debt can be an alternative to bridge rounds.

Our guest on the podcast today is Ishpreet Singh Gandhi, the Managing Partner and Co-founder of Stride Ventures, one of India's leading venture debt funds. You could listen to the episode on the browser above or on Spotify/ Apple Podcast/ Google Podcast by clicking the play button below:

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Here are parts of the transcript (edited slightly for better readability):

Ravish: A good point to start off with might be to understand what venture debt is. Traditionally, we've looked upon debt as a bad thing. Now, venture debt comes in at the stage where a lot of companies do not have the traditional cash flows or even assets (which has been the traditional way for underwriting term loans by banks). You've worked with multinationals as well as start-ups. I know that Lendingkart and Rivigo were some of the first start-ups that you lent to while you were at IDFC. Two questions – what is venture debt and at what stage of a start-up’s life cycle should one explore raising venture debt?

Ishpreet: So venture debt becomes available in eligibility once you've raised your first institutional capital. So moment you raise a venture capital round with an equity infusion of around $4-5 million, you become eligible for venture debt for a very early stage company. And it can go to later stages as well because you remain backed by some of the institutional investors by then.

In terms of standard offering, a traditional venture debt product is typically coming on top of venture capital round. So the moment you have a venture capital infusion, you can club your financing with venture debt. Say hypothetically you're a company that is planning to raise ₹50 crores, and you believe that ₹40 crores are getting committed from the VC. The remaining ₹10 crores, you say, okay I do not want to dilute for this capital and that 10 crores can be replaced with the venture debt option, which ends up getting repaid over a period of next 2 to 3 years.

And while doing that you pay a certain interest rate plus you give a certain portion of warrants in the company, which can be 10-15% of the debt amount. And that typically ensures that you do not dilute your stake in the company for those ₹10 crore rupees.

It's been a very widely used tool in the US and the mature economies. It came in existence in the 70s-80s in the US when Venture Capital started coming in and today constitutes a very large portion of the US equity market. Its size ranges anywhere from 13-15% of the Venture Capital market in the US. And some of the other economies like Europe, it will be 8-10%. It's gaining steam in India – it will be around 3-4% of the Indian Venture Capital market today. We think it can be a billion-dollar market in the next one and half years because it is closely correlated with the Venture Capital market and we have seen that grow exponentially over the years.

Our whole purpose remains - how it can be used by founders. Because a lot of founders realize while raising rounds that they end up diluting a lot, which could have been replaced by debt.

The other point, which you have to understand is that this debt can be replaced by equity because this has to be repaid. It's a loan ultimately. A founder must understand that this should be done at a time when you can afford to repay. So it can backfire if you have not timed it well or have not done it in an educated manner. And that's where it's very important for the founders to realise the importance in terms of creating non-dilutive structures which can be repaid.

Another benefit is that the turnaround time is faster than the typical equity venture capital fundraise.

Ravish: What are some of the other pros and cons to taking venture debt? When receivables aren’t coming in or if you’re using it just as a way to prevent dilution and not using the money - then effectively you might just end up paying interest on undeployed capital! When is the right time to take it? And also at what point should you not take debt?

It's a very valid question. When you raising the capital round, you have to be very sure of how much capital you're looking for. And I'm sure generally founders are aware of that. So of the 40- 50 crores of capital being required upfront, it's very important for a founder to understand and forecast the revenues and losses. And then back-calculate that this is the type kind of runway I want for my company for the next couple of years. to check if they should take venture debt.

When I started Stride in 2019 and went to the Venture Cap ecosystem and founders, there were mixed reviews. People are clear of the fact if they’d be pre-revenue or very minimal in revenues - so revenues are not very clear. That's where the traditional venture debt of long-term loan comes in. And, and more importantly, this is an instrument that works beautifully where you're sure that this is a fix-six year story.

That's why I said it's very critical for the founder to time it, well, they should be on top of their business.

Ravish: How do incoming venture capital investors (ex: a Series B investor coming in) look at companies or start-ups that have already some amount of debt on their balance (say debt taken while/ after raising Series A)?

Ishpreet: So venture capital investors have started realizing the importance. We work very closely with all the top funds in the country. Our portfolio has a lot of companies funded by Sequoia, Accel, Elevation, Chiratae, and others. The whole purpose is that they also don't want to dilute in good companies and they would want debt funds to contribute, to grow their portfolio companies.

Ravish: But this is for existing investors, what about incoming ones?

Ishpreet: In both the cases we have seen it is complimentary. And that's where your first aspect of the question comes in handy - asking what the use case is and how do they intend to repay debt-  do they repay when they raise equity capital or do they immediately repay or do they keep on holding onto it. We have, I think in our portfolio, already seen more than 15 companies raising or about to complete the follow on equity rounds. In fact, they were talking about augmentation of further debt!

Because the genuine capital requirements cases can be replaced by debt.

Most would not want to raise large equity rounds if that capital requirement can be complemented with debt. Especially where the marketing spends are high and that additional capital can generate the delta revenue for you.

Ravish: Is that the same as Accounts Receivable financing?

Ishpreet: No. AR financing is more of receivable financing for corporates. That is typically like capital provided for you for a marketing spend. So it's more prevalent in the B2C companies where you say, okay, I have to increase my Google spends and my marketing spends by 10% - on that I can generate 20% more winnings, but I do not have that source of capital to do it from equity investor. In AR financing the repayment happens as a share of revenue every month. In Venture Debt the repayment also happens monthly but it is secured lending done on the assets of the company. AR financing is unsecured and it is done as a share of the revenue. There the return for the lender can be as high as 25-26% because they are taking a larger risk because if a company is unable to pay you back, you practically can’t do anything.