The coronavirus outbreak and resulting restrictions have brought business activity to a grinding halt globally. Against that backdrop, traditional financial institutions, peer-to-peer lenders, and venture debt firms are getting requests from cash-strapped firms in need of a lifeline to keep operations up and running.
For startups, venture debt, in particular, sounds like a quick fix.
The financing is extended to startups that may not have tangible assets and operating profits that are requirements for traditional financial institutions, but possess technology with high growth trajectories, explained Vinod Murali, managing partner of India-focused venture debt firm Alteria Capital. “The underwriting of credit is built on a deep understanding of the VC ecosystem,” he said.
Venture debt also does not dilute a shareholder base the way an equity fundraising does, and it can also be disbursed quickly.
But its interest rates are also higher than that of traditional lenders. And, venture debt firms such as Alteria Capital and InnoVen Capital collect warrants each time they do a financing round in a startup.
“Venture debt firms take a different approach to lending to startups. We understand the higher perceived risks involved and evaluate a separate set of factors to get comfortable,” said Chin Chao, Southeast Asia CEO at InnoVen Capital. “We look at the quality of the team, the business model and the company’s competitive advantage. We then look at the existing cash runway, the quality of the equity base and the financial projections.”
This would mean that not all startups would meet venture debt providers’ requirements. Nevertheless, demand is picking up, Murali said, particularly from more mature Indian companies in the market for growth capital.
“There is going to be a strong need for growth capital post-June, especially for companies beyond Series B, which are recovering fast or are in sectors having some tailwinds. This could be an opportunity for founders to augment their equity raises with slugs of venture debt and preserve dilution,” said Murali.
Murali and Chao were speakers at DealStreetAsia’s webinar “Is venture debt a lifeline in a pandemic-afflicted world?” on 16 April. Also on the panel was Chris Wilson, a partner at law firm Simmonds Stewart. Below are the panellists’ responses to questions submitted by attendees during the webinar.
What would be the key differentiation between lending done by banks, NBFCs, and venture debt firms?
Murali: Banks and NBFCs prefer to lend to companies with operating profits as well as tangible assets on the ground in the form of plant/machinery, etc. Startups are built around technology typically with high growth trajectories and rarely have profits or hard assets, so these are not typically a target market for banks or NBFCs. Venture debt funds focus only on this target market and the underwriting of credit is built on a deep understanding of the VC ecosystem.
Chao: Traditional financial institutions such as banks have historically only lent to smaller enterprises based on a track record of historical profitability, typically for a minimum of three years, and against hard assets.
They often also require personal guarantees from all directors. Given that venture-backed startups are typically loss-making and only have intellectual property as their main asset, traditional financial institutions such as banks rarely lend to venture-backed startups. And even if a traditional financial institution is willing to consider lending to a startup, directors from venture capital firms who sit on the board of the startup will definitely not be willing to provide a personal guarantee on its behalf.
Venture debt firms take a different approach to lending to startups. We understand the higher perceived risks involved and evaluate a separate set of factors to get comfortable. We look at a company from both a venture capital lens and from the lens of a lender. We look at the quality of the team, the business model and the company’s competitive advantage. We then look at the existing cash runway, the quality of the equity base and the financial projections.
What are the risks involved? If a company in the portfolio fails, you will not be to step in to take a call on its operations. Is that a cause for concern?
Murali: Venture debt deals do have an equity kicker, typically in the form of warrants or partly paid shares. If a company goes through stress, there are several rights available to a lender to try and protect their position but the preference is always to work in concert with the founders and other investors to find a constructive path out of the problem. Needless to say, debt is a primary obligation ahead of other trade creditors and equity as an asset class comes behind debt in a liquidation scenario.
Chao: The primary risk involved is that the company is unable to pay back the loan. This is no different than what traditional financial institutions such as banks face when they lend.
Is an ideal case for an investor a part-equity, part-debt transaction?
Murali: It depends on the situation. If investors want to improve their ownership in a company or if businesses are very binary in outcomes, there may not be a place for venture debt. In general, it helps founders preserve dilution and brings a trusted, consistent partner as part of the syndicate for other investors and hence is theoretically a good option but in reality, it needs to be evaluated on a case-by-case basis.
How often do you expect warrant coverage? And has that changed in the current environment? Would you trade economic terms such as headline rate for warrants, if offered?
Chao: We expect warrant coverage on every loan that we provide. This remains the same in the current environment. Otherwise, we would have to charge interest rates that are much higher than what we do today. As all deals are individually negotiated with the borrower, it is often the case that in exchange for a lower headline rate, we increase the warrant coverage and vice versa. However, all deals must meet certain minimum requirements in terms of headline rate and warrant coverage.
Can you talk about a case where you would need to enforce your security? What sort of collateral do you typically take to secure your instruments? How does this change in uncertain markets?
Chao: In Southeast Asia, we are typically the only lender to the companies which we fund. We have always taken a lien over all of the company’s assets but do not require personal guarantees or shareholder pledges. This has not changed given the current environment.
Given that venture debt is sometimes predicated on a further fundraise, how do you see your portfolio companies or new transactions coping, given the current environment?
Chao: I believe that the vast majority of companies will struggle in this difficult fundraising environment but the companies that survive will come out of this much stronger than before.
In Southeast Asian frontier markets like Cambodia, Vietnam, Laos and Myanmar, to what extent do venture debt firms feel obliged to go beyond just providing debt to startups?
Chao: We are as active or passive as the company’s founders want us to be. And although we do not publicise our value-add to the companies to whom we lend, given our network in Southeast Asia, India and China and the network of our shareholders, we can facilitate investor connections as well as make business introductions in any of these geographic markets.
Do you see an opportunity among mid-stage startups in India for debt funding post COVID-19?
Murali: There is going to be a strong need for growth capital post-June, especially for companies beyond Series B which are recovering fast or are in sectors, which have some tailwinds. This could be an opportunity for founders to augment their equity raises with slugs of venture debt and preserve dilution.
Given the weakening economy in India, do you think debt instruments will take off, particularly since companies may not be able to service the interest and principal repayments in the near term?
Murali: Overall, the short to medium term revival of the Indian economy is going to depend largely on improvement in consumption as well as the availability of credit for companies across sectors and scale. While banks are equipped to lend to profitable, asset-heavy borrowers, unfortunately, startups do not meet these requirements.
Venture debt relies on the ability of startups to raise further rounds of capital which continues to be the thesis. While the current situation does impose constraints, there is considerable dry powder across venture equity funds so companies, which are able to attract equity, will continue to be prospects for venture debt within some boundary conditions. They will also have sufficient liquidity to meet their obligations as the debt is coupled with equity raises.
How are force majeure clauses impacting transactions, both new as well as previously concluded ones? How can they impact repayments?
Wilson: In my experience, it is pretty rare to have force majeure clauses in venture debt (or other debt) agreements. They are more commonly included in things like service agreements where acts of God may prevent a party from providing agreed services. It is rare for force majeure to cover payment obligations (and is not normally the intent of such clauses). With debt, it will be pretty rare that a company can rely on a legal exemption for repayment under its loan documents.
Even if a force majeure were included, they will often carve out broad economic downturns that relate to economies as a whole. A force majeure is also typically time-limited to around 30 days, so in many cases, they will not be an effective medium-term even if available. In practice, it will almost always be best to just contact the debt provider as early as possible to begin commercial discussions around repayments.
How exactly is due diligence, particularly at the more critical stages of a transaction, conducted in such an environment?
Wilson: Not much change overall, a lot of due diligence is already undertaken electronically with relevant commercial and legal documents in Google drives or other data rooms for review, due diligence calls undertaken via Zoom, etc. Some adjustments will be required where a site visit or face-to-face meetings would have taken place, but the majority of these processes can be handled remotely. In other words, we have not seen the virus have too much effect on due diligence processes (relatively speaking).