Venture debt is increasingly becoming a fairly common component of funding rounds in India. The thesis for venture debt in mature markets is largely centred on intellectual property-driven tech companies, mostly having patents, which can be easily monetized. But this is rarely the case in India. The domestic venture debt model has been adapted to reflect the realities of the Indian market where value is created through strong execution and technology is more an enabler rather than the core differentiator.

One question which crops up consistently is: does a start-up opt for venture debt because it could not raise equity? This is an intuitive question, especially in a lukewarm equity environment, as is the case today, but the answer is actually the other way around. Venture debt is a magnet where equity interest works as iron filings. The fundamental premise of venture debt is NOT to take equity risk as that is a sure-shot path to adverse portfolio outcomes.

Companies which are eligible for venture debt are typically those which have raised institutional equity and are seen to have a strong ability to sustain equity interest. This is a function of the management team, market opportunity, brand or quite simply time available which provides sufficient runway to learn from mistakes and create a stronger business.

This is a product which is intended to help good companies get even better and is not meant for scenarios which are extremely high-risk with high returns and better suited for equity capital. In a bearish equity environment, venture debt actually serves as a beacon to identify better performing companies but still relies on the bedrock of equity capital.

So why do VCs like venture debt? The answer is again linked to the power law where there is an expectation of the top decile or quartile of VC-backed companies delivering sufficient returns for the entire fund. These companies can have accelerated outcomes or their probabilities of success and the scale of the outcome could sometimes be improved with additional, non-dilutive capital in the form of venture debt.

VCs chase the probability of growth as that is the most important variable dictating fund outcomes. Founders need to think about probability of survival as well as probability of growth, given that their venture is typically their sole focus compared to VCs having multiple shots at goal. Venture debt improves the probability of survival in the short term as it provides a buffer of capital for founders to use as appropriate. Hence, there is a high alignment of interest logically for venture debt with the founders as survival comes before growth.

Growth triggers can range from an aggressive above-the-line (ATL) marketing campaign to an acquisition opportunity or even a global expansion strategy—all of which require additional capital but provide acceleration of 12-24 months which can be critical to building strong leadership positions, teams or even attracting the appropriate capital sources. Another advantage through venture debt is the ability of companies to build a track record when they are young which enables them to access conventional pools of debt capital later in their lifecycle. Disciplined data reporting and accurate cost allocations are collateral benefits as well.

Venture debt is not intended for all start-ups. In situations which have binary risk or if the runway is too short (a bridge situation), having a nervous lender may distract the founder from core responsibilities and sink the company faster. It is imperative to find the right fit as excessive leverage can serve as a death knell for a start-up.

Start-ups need the appropriate regulatory and policy environment for debt. This should be a priority area for the government as it feeds the entrepreneurship ecosystem as a core business model and not as an ancillary vertical.

While the Reserve Bank of India has focused on MSMEs, rural and agri-business growth, the government needs to relook at financing schemes for start-ups with debt playing an integral role. The recent policy guidelines announced by the prime minister included an enhanced credit guarantee scheme, but the existing scheme (CGTMSE) through agencies like SIDBI or state-run banks are aimed at very young companies as the amounts are ~ Rs1 crore and the process is not easy for young teams which do not have resources within their finance verticals.

The ideal route is for the government to provide a credit backstop to reliable partners in the private sector as well and allow for higher levels of credit offtake in this segment, especially in the technology sector where companies are asset light and do not have any collateral to offer to banks or conventional lenders.

Overall, founders need access to multi-variate sources of capital at different lifecycle stages and they need every ability to preserve dilution of ownership. Entrepreneurs are clearly the value creators and capital is one of the resources they require to build lasting institutions so venture debt is an integral component of a founder’s toolkit to ensure that businesses have faster and smarter growth.

Vinod Murali is managing director at InnoVen Capital India.

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