Why Venture Debt is Gaining Popularity The long funding winter is pushing startups to this new asset class

As equity funding dries up, venture debt is becoming a hot favorite among startups and investors alike. In fact, since last year, there has been a steady shift towards this asset class. According to Venture Intelligence, India's venture debt funds raised $85 million in the fiscal year 2020-21, up from $62 million in the fiscal year 2019-20. In 2021, more than 100 companies, including Mensa Brands, Infra.market, Licious and Zetwerk, raised venture debt. Many startups also used venture debt to acquire companies and expand to new markets.

For the uninitiated, any business has two basic avenues to raise capital, which are equity and debt. Earlier, debt was available through only banks, but today, venture debt is available to startups easily. It has also become hassle-free in terms of collaterals.

The shift is further evident in the pace at which many top venture debt firms in India have been closing their fundraising. According to news reports, Stride Ventures, which has companies such as SUGAR Cosmetics, and Homelane in its portfolio, is looking to close Fund II, with a corpus of INR 1,000 crore and with a greenshoe option of around INR 875 crore, anytime soon. Trifecta Capital, with portfolio companies such as BigBasket, Cars24 and ShareChat, Alteria Capital with Mensa brands, Infra.Market, and InnoVen Capital, with Udaan and Dailyhunt, have been raising and closing funds at a very high speed.

What has changed?

Earlier, venture debt was not a go-to choice for startups. The awareness about the benefits this asset class offers was less. "Venture debt is picking up in the startup landscape in India rapidly, as venture debt also becomes a great solution for quick capital infusion for startups at their growth stage. Those founders who are confident about their performance and see long-term value being created won't like to dilute their stake through equity funding at certain stages thus they turn to venture debt," said Mitesh Shah, partner, Physis Capital.

Further, a lot of startups today need money for working capital, which is a temporary cashout flow. "And it is not viable to use equity funding for that. For them, it is preferable to use debt equity for managing working capital and use equity money for more growth-focused uses," added Shah.

Another key point to note here is unlike NBFCs and traditional banks, which would require collators or pledges of shares for providing debt, venture debt firms cater to startups in particular and offer low interest, around 13-17 per cent as opposed to 20 per cent earlier. This makes venture debt even more popular among startups today.

Venture debt players are able to underwrite early-stage startups for venture debt because seed rounds today are the same size as what Series A used to be a decade ago. "Done along with or after an equity round, venture debt funds broadly provide high teen returns to investors. About two-thirds of the returns come from fixed income.
Investors are opting for Venture debt as an asset class because of the low volatility in returns and the equity kicker can outperform enabling the upside can be far greater," said Ankur Bansal, co-founder and director, BlackSoil.

The awareness about venture debt has also increased a lot over the years. It is primarily because of the rise of the startup ecosystem, especially after the pandemic. Many startups today have reached their growth or late stages and that is when they often opt for venture debt for acquisitions or expansion. "Venture debt proves to be a valuable supplement to equity capital to fast-track growth in a non-dilutive manner. This nature of the capital along with the quick processing and turnaround time has made it an extremely valuable source of funds for startups," said Shruti Srivastava, principal, Avaana Capital.

Investors choice

Venture debt is gaining popularity amongst investors as well. However, venture debt is not something new. It was there earlier as well, but domestic venture funds started around 2016-17. "The underserved market helped establish the venture debt sector. The relatively better returns compared to other debt products gave confidence to investors. The awareness and acceptance of startups' funding have certainly changed the investor's perspective about the asset class. The robustness of the sector and confidence of investors helped establish the space," said Anil Joshi, managing partner, Unicorn India Ventures.

By nature, the venture debt offers a scope of additional return by way of warrants in successful ventures. "Hence the blended return makes it a lucrative investment opportunity for investors and popular," he added.

From the investors' perspective, the regular recovery of capital reduces risk. "And at 14-17 per cent IRR, it also is a very profitable option. Further, the option of equity coupons with venture debt gives the investors the experience and involvement of being an equity investor but at the same time have more security on their investments. Thus, making venture debt an increasingly popular choice for investors," said Shah.

Despite a couple of bumper years, the venture debt market in India is still very nascent compared to the size globally. This opens up huge opportunities. "In India, venture debt investments account for 2 per cent of the VC investments where as in more mature markets like the USA and China they account for 20 per cent and 10 per cent of VC investments. This leads to a large headroom for growth for venture debt investing as the startup ecosystem matures," said Bansal.

The risk-reducing aspect of venture debt funding is definitely enticing even for investors. Thus, domestic investors have been at the forefront of helping the firms raise and deploy funds at a fairly fast pace in the recent past.