Taking a cue from the venture capitalists

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The venture debt industry is formulaic. There are three general rules for startups looking to enter the club:

Raise a Series A round or more

  1. Take debt only at the time of or just before or after a fundraising
  2. About 15%-30% of the VC round will be given in debt
  3. Meaning, if a company just raised $5 million in a Series A round, it can get a venture-debt cheque of about $1 million. These rules help venture debt funds take the risks banks don’t want to take.

Banks have kept their distance from startups because startups don’t measure up to banks’ first criteria of lending—being profitable for three years (something The Ken wrote about here). Moreover, bank loans have other large riders like collateral, which startups find onerous. So venture debt firms fill the gap.

They lend at higher interest rates than banks at about 14-15%. Nilesh Kothari, co-founder and managing partner of Trifecta Capital, says his firm looks at over 60 parameters to give a loan. Including unit economics, business model and market opportunity. But if there was a thumb rule to assessing risk in a company, it would be to ride on the coattails of a VC investment.

They do this to mitigate risk. If there is equity capital going in, then venture debt firms have the comfort of knowing that for the next two to three years, the startup will have enough to service its debts.

Banking on VC investment for venture debt funds makes sense because the fund is evaluating the short-term repayment capabilities of startups. “Good equity bets do not always make good debt bets. As an equity investor, you have a seven-year view of things. But we lend for three years. If things get rocky in between, we are adversely impacted,” says Murali.

But what this also means is that sometimes the “umbrella for a rainy day” can become burdensome. Because in effect, you carry around a heavy umbrella for a long period of time for a month or two of rain.

The trappings of debt

When nothing less than 100% year-on-year growth will do, metrics like cash flows and revenue are not a priority. This kind of growth lays a premium on “hustle”—startup speaks for doing whatever it takes to capture the market; keep getting users hooked to its product. Financial discipline takes a back seat. Which is why taking debt is not an easy decision to make.

“It is easy to keep investing and growing. Debt brings discipline. But from burning money to taking and repaying debt is a change in mindset and is a reflection of maturity among startups,” says Ankur Bansal, co-founder of venture debt firm BlackSoil. Just as venture debt firms are hesitant about risk, startups are wary when it comes to taking on debt.

Venture debt helps increase the pool of available capital for a startup, and it gives an additional month or two of breathing room. And for the venture debt firms, an investment from a VC is comfortable enough to ensure their monthly repayments come through. But the rub here is the timing of the debt payout—the money is disbursed at the beginning of fundraising.

Funds running out

“Since you use the debt after your equity funding runs out, you have been paying interest payments on the loan for the first 12 months for the extra two months of runway. The math doesn’t make sense,” says Ashok Hariharan, co-founder of IDfy, an online fraud detection platform that provides background verification services.

Debt, he adds, makes sense only when you are able to raise it when you’ve exhausted about half your funding. (IDfy is among the few startups that have been able to raise a debt round a year after its Series A to elongate its runway.)

The reality is that some companies, especially B2B (business-to-business) companies, are better suited than others to take on debt. “Companies that sell software as a service are subscription-based businesses and have predictable revenues, which makes repayments predictable. It is the B2C [business-to-consumer] model where revenue visibility is unclear, making it tough to forecast expenses,” says Bansal.