Venture Capital

Venture Debt Financing in India

Institutional investors have begun to invest in India as a result of its rapidly growing economy and democratically run government that has embraced reforms. Although venture debt financing is a well-known concept, it has only recently become an attractive option for start-up companies in India, where a rise in this type of financing is currently being seen.

Entrepreneurs might benefit from venture debt by reducing the dilution of selling equity to raise funds. The founders are still able to exercise control over the company because venture debt is used as operations capital and bridge funding. In order to continue attracting money at greater valuations in a market with an excess supply of equity capital, investors employ venture loans to accelerate organic and inorganic growth. Additionally, venture debt functions as a buffer for the current capital base in a year like 2023, when equity rounds were hard to come by, venture debts prolong the runway and push the company closer to profitability.

What is Venture Debt?

Venture debt is financial funding used by start-ups and early-stage businesses. This kind of debt financing is frequently utilised as a supplement to equity financing. Early-stage businesses that need to raise funds but do not yet have a track record of generating revenue will use venture debt funding. Venture debt, in contrast to more conventional types of debt financing, is often given by specialised lenders who are prepared to assume more risk in exchange for the chance of greater rewards.

Venture debt is widely used as an alternative to equity financing tools like convertible debt or preferred stock. Using debt financing, as opposed to equity instruments, prohibits further dilution of the ownership interest of an existing investment in a company, including its employees.

India’s Venture Debt financing market

The trend of investing in India has grown over the past ten years, and the private IT investment sector has experienced phenomenal growth and capital inflow. Capital inflows into start-ups are now more closely correlated with performance on the global public markets as a result of the sizeable amount of money received by Indian entrepreneurs over the past four to five years from early to very late-stage international investment corporations. The good news is that domestic investment in venture debt and locally-based debt has increased significantly in India.

The most common transactions in the market for venture debt financing in India are revolving credit facilities, revenue-linked loans with a cash sweep, accounts receivables factoring, equipment financing, and contract financing. The returns on these loans, which are frequently short-term, could range from 10% to 18%, depending on the business and borrower.

Due to their quick underwriting processes and distinctive ability to structure transactions, family offices and hedge funds become good lending sources for venture loans to emerging market venture companies.

Increase in Indian Venture Debt

The Indian financial services sector has built solid foundations for venture debt financing in the country. Due to the requirement that “bankable enterprises” need financial accounts, an established operating history, and tangible collateral, traditional lending methods are usually exceedingly challenging.

A lender can arrange a private loan with the company using venture debt. The “Equity Kicker” is a strategy used by investors to create deals with low risk of loss and the opportunity to convert some debt into equity in the future.

This year, approximately $1 billion in venture debt funding is anticipated to flow to Indian businesses, especially those in their development and late-stage ones. The stock markets’ drying up is one of the key reasons for the increased demand, and transaction or deal flow is also frenzied. Start-ups aren’t able to attract as much financing as they once could, and even when they do, their valuations fall short of ideal levels. This particularly impacts start-ups in their growth stage and late stages.

Another thing to keep in mind is that larger firms frequently take advantage of the absence of equity investment as a tactical opening to buy out smaller competitors. Venture debt is a fantastic substitute for taking equity and reducing your holding.

Benefits of this alternate funding strategy for start-ups

Increasing their venture debt has two major benefits for high-growth companies:

Reducing the Average Cost of Capital by Using Venture Debt: The first benefit is that venture debt can reduce the average cost of capital by providing minimally dilutive financing to rapidly scaling businesses. This is especially true when receiving venture financing concurrently with an equity round, as stock is the most expensive type of growth capital due to its highly diluted nature.

Flexibility is provided by venture debt: In addition to not requiring board representation, venture debt also includes a cash reserve that can be utilised in the event that the company encounters difficulties. For instance, senior-secured loans usually require the financing of a specific underlying asset and/or require personal guarantees and/or are pledged as security, which is a substantial difference from this.

The following are some more key benefits: 

• Equity costs more than debt financing.
• Debt enables businesses to remain under management.
• Due to the additional due diligence required for equity transactions, debt can be made available more quickly.
• Lower after-tax capital costs result from tax deductions for debt charges.

More investors are turning their attention to venture debt

1. According to various venture debt players, many limited partners (LP), including family businesses, domestic investors, and high net-worth individuals (HNIs^[1]), have moved their attention to the venture debt market.
2. Due to its strategic benefit, many venture debt investors and limited partners (LPs), who traditionally have only participated in the venture capital market, want to participate in this expanding sector.
3. Over the past three years, the domestic pool of capital has shown a lot of interest, investing heavily in the venture loan market. It used to be quite specialised earlier. Family offices are becoming more interested in this asset size, and some entrepreneurs with liquidity are as well. Corporate treasuries and other similar organisations have recently begun looking into venture debt as an alternative to high-rated debt instruments for investing in debt.
4. The development potential of Indian start-ups is widely acknowledged by those who contribute financing, and venture debt has grown to be a favoured vehicle of investment, especially for those who are a little more risk cautious and seek a combination of high-income and capital protection. Venture debt accounts for a sizable portion of private credit opportunities in India, and private credit, in general, is on the rise and finding favour with both domestic and international investors.
5. Due to the current market conditions, founders are now more inclined to use venture debt as an alternate source of funding. Entrepreneurs with a keen eye for business have understood that when valuation multiples are compressed, equity funding can be prohibitively expensive. They look for venture debt to optimise their capital structure and reduce their cost of capital. As a result, the ecosystem has witnessed a huge rise in the need for venture debt, which founders use to supplement their cash reserves with debt in order to improve their runways. 

The method for obtaining a venture debt

In India, raising venture capital funding takes much longer than raising venture loans. The timeframe, which typically lasts 4 to 8 weeks, is significantly impacted by how long the due diligence process takes.

There are typically six steps involved in the venture capital investment process in India:

• Finding prospects for venture debt is the first step in the origination process.
• Initial Examination: This typically takes place during a phone conversation between the lender and the founder, CEO, or CFO of the business. During the conversation, the lender will learn more about your company, your specific requirements, your plans for growth, and any questions you may have about the available financing choices.
• Term sheets serve the non-binding aim of giving you, the company, a rough idea of the terms to anticipate after completing the due diligence process.
• Due Diligence: The venture loan lender will start the whole due diligence process after the talks are over, and the term sheet has been signed.
• legal documentation and then funding

Conclusion

Despite its expansion, venture debt still makes up a tiny portion of the market. The venture finance market in India needs to be more developed. Venture debt can assist established businesses with solid fundamentals in raising more funds while utilising their venture capital. Obtaining venture financing is frequently more advantageous than going through an equity investment round. Additionally, it can be beneficial in helping businesses attain profitability rather than only focusing on expansion.

Read our Article: Types of Venture Capital Funding in India for Start-Ups