Venture debt in India, while still nascent, has grown exponentially over the last couple of years. It is expected that the Indian startup ecosystem will subsume venture debt aggregating USD ~850 Mn in 2021 alone. For context, this is about 4% of the total venture capital expected to be deployed in 2021 in the country.

As startups progressively look at venture debt, especially revenue-based financing, as a non-dilutive, easy-access form of capital, we have penned down below our thoughts on what founders must consider before opting for venture debt. 

What is Venture Debt:

Venture debt is a form of investment structured as an obligatory payback liability, where startups can repay the principal over time for an agreed-upon return multiple. In India, institutional venture debt deals are supplemented by equity rounds (typically Series B onwards)

The table below should help distinguish venture debt from its cousin:

While venture debt is often touted as being superior to equity in case of a liquidation scenario, considering VCs have a liquidation preference (first right to recover capital) this does not make it a distinguishing feature vs venture debt.

When should a founder opt for venture debt? Here are some key indicators in our view:

1) Revenue: 

• The business has reasonably predictable/ recurring revenue. 
• Ideally, the company should be confident to grow its MRR by a minimum of 2x over the next 6-12 months 

2) Unit economics/ Model in place:

• The company has achieved PMF (Product Market Fit) and has turned contribution positive
• Conversely, if the company is figuring out a business model shift or pivot, then venture debt will tend to value dilutive

3) Repayment capacity:

• The company’s growth should quickly look to cover the debt payments. If profit growth is larger than the debt payments, the loan gives a net positive cash position (and even better value appreciation). 
• Venture debt has an extremely positive effect when loan payments are less than revenue growth multiplied by contribution margin. Example of a positive cash position: A company with debt payments at 5% of revenue and 50% contribution margins. The company only needs to grow revenue ~11% to make the debt payments and have the same cash flow for operations. All revenue growth above 11% is both positive cash flow and, of course, value appreciation without dilution.

• Note: The above example does not consider an increase in fixed costs. Companies should also factor an increase in these costs while working out minimum growth in revenue to be achieved.
• As a thumb rule, the company’s debt should be less than 33% of annual revenue. Note this rule may not apply to fast-growing companies with a ready pipeline.

4) Purpose of debt:

• Founders are confident that the company is growing but equity is too expensive, or it will take too long to raise
• Additionally, venture debt works well towards financing working capital in some businesses
• Founders should ideally resist debt in case the company has limited cash reserves and use the debt as a means for extending the runway. 
• While venture debt is opted for by founders in the hope of raising a subsequent round and can work out sometimes – this really should be the last resort for companies in our view.

Once the company decides to pursue venture debt, the founder needs to be aware of the terms of the loan. While venture debt loans typically don’t have a standard structure, considering most venture debt loans are linked to revenue, we have elaborated on key terms of an RBF loan document below:

1. Coupon/ royalty rate: Represents the percentage of revenue earned by the company to be repaid to the lender every month/ quarter. Typically ranges between 4%-7% of revenue. Some loans are structured to provide for a moratorium (no repayments) at the start of the loan. A good way to provide for this in a financial model is to forecast lower gross margin by the coupon rate and then look at cash flows.
2. Hurdle Rate/ Repayment Cap: Hurdle rate represents the minimum IRR (typically 18%- 25%) the lender seeks to make on the loan, while repayment cap represents the limit until which monthly/ quarterly payments continue until a set amount has been paid back, usually 1.25x – 2x for loans for short tenures. Founders must also ascertain the actual IRR the lender is likely to make basis reasonable future cash flows while negotiating the terms. Note the repayment cap does not equate to actual IRR as the repayments are monthly/ quarterly which usually results in a higher IRR for the lender if the loan is paid off over a short period
3. Security/ Collateral: Usually venture debt lenders, provide senior secured debt with first charge on all assets of the company. At other times, founders may be asked to pledge their shares as collateral.
4. Warrants: Some venture debt deals provide the option of warrants for the lender. Warrants are a right to buy equity in the future at a price established today. If the startup does well, the warrant can be worth a lot of money to the lender (Warrants tend to increase lender IRR by 4%-8%). However, warrants dilute the founders’ ownership, so do the math on how much any warrant will cost, assuming projections are met. In our view, founders must avoid warrants or have minimal warrants in debt deals.
5. Payback Tenors: Represents the repayment term for the loan. Most RBFs are short term in nature with tenors ranging from 1-3 years, while others with a larger gestation period may demand a higher hurdle

Conclusion Summary:

In our view, incremental capital afforded by a venture loan allows startups to achieve more progress ahead of the next valuation event, or to increase the certainty of reaching such milestones while minimizing the dilution that would occur by securing additional capital at an earlier round. Founders must however adequately stress-test their forecasts and have a sufficient cushion before opting for venture debt. Further, with the explosion of venture debt funds in the country, startups must run this as a regular process and try to get multiple term sheets as they would during a regular VC raise.

We hope the above helps founders and startups to arrive at the right call while deciding on venture debt. You may also read the thoughts of our portfolio founder – Siddhant at VDOCipher on his take towards the RBF facility extended by Malpani Ventures last year. 

We look forward to your critique and suggestions. Please do reach out to Dhruv or Siddharth with your thoughts.