Daybreak - Startups can't get over venture debt. But the lenders are getting pickier

Episode Date: November 13, 2024

For quite a while now, the Indian startup ecosystem has really been feeling the pinch. People in the know call it the funding winter. These are periods of tremendous financial insecurity for startups, particularly now. You see, for the last five years ago, the startup funding culture here in India was like a rollercoaster that was only going up. But now the scenario has changed considerably. After a dream run, big-ticket equity funding has slowed down and once sky high valuations are very quickly coming back to Earth. These startups still need the money, obviously. But they have realised that raising a round of funding may not be as easy as it once was. But they have found their knight in shining armour. In comes ‘venture debt’. These are essentially loans that go to VC-backed startups. A lot of the startups in the Indian ecosystem are thirsty, and venture debt is increasingly proving to be the refreshing splash they needed amid this funding drought.But there's a catch. Tune in.  Daybreak is produced from the newsroom of The Ken, India’s first subscriber-only business news platform. Subscribe for more exclusive, deeply-reported, and analytical business stories.

Hi, this is Rohan Dharma Kumar. If you've heard any of the Ken's podcasts, you've probably heard me, my interruptions, my analogies, and my contrarian takes on most topics. And you might rightly be wondering why am I interrupting this episode too. It's for a special announcement. For the last few months, I and Sita Ramon, Ganesh, my colleague and the Ken's deputy editor, have been working on an ambitious new podcast. It's called Intermission.

We want to tell the secret sauce stories of India's greatest companies. Stories of how they were born, how they fought to survive, how they build their organizations and culture, how they manage to innovate and thrive over decades, and most importantly, how they're poised today. To do that, Sita and I have been reading books, poring over reports, going through financial statements, digging up archives, and talking to dozens of people. And if that wasn't enough, we also decided to throw in video into the mix. Yes, you heard that right. Intermission has also had to find its footing in the world of multi-camera shoots in professional studios, laborious editing, and extensive post-production.

Sita and I are still reeling from the intensity of our first studio recording. Intermission launches on March 23rd. To get alert, as soon as we release our first video. episode, please follow intermission on Spotify and Apple Podcast or subscribe to the Ken's YouTube channel. You can find all of the links at the ken.com slash I am. With that, back to your episode. For quite a while now, the Indian startup ecosystem has really been feeling the pinch. People in the know call it the funding winter. Let me paint a picture for you. You see, for the last five years or so, the startup funding culture here in India was a lot like a

roller coaster that was only going up. But now that scenario has changed drastically. You see, after a dream run, these big-ticket equity funding rounds have slowly slowed down. And with it, those once sky-high valuations are very quickly

coming back to Earth. This is a period of tremendous financial insecurity for startups. They still, of course, need the money, but they've realized that raising a round of funding may not be as easy as it once was. But now, they have found their night in shining armour.

In comes venture debt. So venture debt is a form of financing given to VC-backed startups. It's more flexible than the kind of financing given by traditional financial institutions and is generally used for use cases like acquisition financing or to meet working capital needs. That was a Ken reporter, Gaurav Barger. He says that founders have been seeking out these loans a lot more of late. Take Ether Energy, for example. Six months ago, it raised about 200 crore rupees from Stride Ventures to fund its ambitions.

Or country delight, the online milk and grocery delivery startup. In late October, Alteria capital handed it the same amount, 200 crore rupees in venture debt. For the likes of Stride and Alteria, which are in the venture debt business, this has really been their moment. You see, in the United States, venture debt is already 15 to 20% of venture capital flows. Of course, India isn't at that level yet, but it is steadily getting there. In fact, it's up from 1 to 2% about a decade ago to 6 to 7% today. A lot of the startups in the Indian ecosystem are thirsty.

And venture debt is increasingly proving to be that refreshing splash of water they needed amid this funding drought. But there's a catch here and a pretty big one at that. It's sort of a chicken and egg problem. You see, it's not like the providers of venture debt just handled. out loans at random, generally it tends to write shortcut to bigger VC rounds. It sort of comes as a part of a package deal. But now that VCs aren't writing as many or as large checks as they once did, it puts these providers in a bit of a tough spot.

How do they pick the right kind of startups to fund? Should they be focusing on the latest equity rounds, which now of course are few and far between? Should they look for ebita break-even? Or should they just rethink the whole game? Welcome to Daybreak, a business podcast from the Ken. I'm your host Rahil Filippos, and I'll be joining my colleagues Nikita Sharma every day of the week

to bring you one business story that is worth understanding and worth your time. Today is Wednesday, the 13th of November. The Ken reporter Gorev Bagar spoke to Apurva Sharma. She's the managing partner at Stride Ventures. He wanted to understand how the venture debt landscape has evolved over the years. Turns out it's been tremendous. Apurva says when Stride entered the scene back in 2019, a total of around $300 million in debt was deployed. Cut to 2023 and that number rose to $1.2 billion.

Nikhil Bandarkar K, founding partner at early stage venture debt and equity firm Panthera P Capital, says that this space saw rapid growth starting 2020. Before that, it was relatively unknown. So what changed? Well, Nichol said that founders at the time were making a very fundamental error. They were diluting way too much at the seed stage for things like working capital and financing. What he didn't realize in the moment was that equity comes at a much higher cost than debt. What he means by that is that these startups raise tons of money,

but in the process they lost hold over a lot of their own companies. Now, this is particularly true in the consumer and D2C brand space. Here, many founders hold less than 20. 10% stake in their companies at a series C or D stage. Now, that's the other upside of venture debt. The best example is the homegrown electronics brand boat. The founders still hold over half of their company, even after raising $6 million in venture debt from Inovain Capital in 2019 and 2020.

In other words, venture debt's non-dilutive nature allows founders to retain a larger stake in their own companies and get a much bigger exit if the valuation grows. success stories like that of boats have also made founders more aware of how to utilize venture debt smartly. In 2019, the then three-year-old company used its venture debt round to meet working capital needs. What ended up happening was that it scaled enough to secure a hundred million dollar fundraise from private equity firm Wardberg Pinkus just a few months later. But what's in it for the limited partners, the folks actually handing out these loans? Well, it's the predictability and stability that venture debt offers.

Generally, these limited partners comprise family offices, some overseas high net worth individuals, and even founders who made it big and are now looking for opportunities to put money back into the new economy. All of this points to something that we speak about a lot here on daybreak. The fact that we have a lot of millionaires who are looking for new ways to invest and grow their wealth. Venture debt has become one such average.

and it's very popular now. A limited partner's capital is tied up for 9 to 10 years when investing in VC funds, but with venture debt, their capital is locked in only for 5 to 6 years. Plus, venture debt funds pay their limited partners quarterly. In VC funds, the cash flow is backended as limited partners get paid out only when the fund exits via an initial public offering or a secondary transaction. But things are not as straightforward anymore, especially now that valuations. are finally coming back to saner levels.

For venture debt to grow, equity rounds need to keep happening, which is exactly what has really cast a shadow over this space. More on that in the next segment. The bottom line is, less big equity funding means fewer places to deploy money for venture debt. And the funding dry spell has been pretty bad. The first six months of 2024 saw only four deals worth over $200 million.

That's a far cry from the 17 big-tickings. deals during the same period in 2022. Now, this isn't great news for venture debt. Fewer blockbuster deals means fewer add-on lending opportunities. And with capital tight, everybody's fighting to get the best deals. The competition isn't just from debt funds either. Lenders like HDFC, IDFC and RBL have set up new economy arms and are making it easier for startups to access credit,

especially those that are at Series B stage and higher right now. So, venture debt providers are already feeling the squeeze on deals, and the perks that made debt attractive aren't what they used to be. Let me explain how it works. You see, typically, when a venture debt firm lends to a startup, it receives a percentage of the loan sum as equity warrants. That's basically the option to buy some stake and later earn returns. Today, from close to 15% of the loan sum in warrants, venture debt firms are now getting just around 8 to 10%. Choosing the right startup is also becoming very challenging. Earlier it was much easier.

You picked the high-flying startups with big valuations and VC backing. But now it's clear that they don't always make the best bets for venture debt. Just ask the debt providers who backed Arzu, Rasha Mundi or Go Mechanic, all promising on paper yet ultimately went downhill. For venture debt, the rules are just different. Bottom line is, they need to be sure that a company has to be sure that a company has, the ability to repay the loan. And for that, funds are now paying closer attention to things like free cash flow

and how debt is being used for growth. Because just looking at a startup's ability to raise equity funding is clearly not enough anymore. Which is also why the focus is now more on mature companies at the series C or later stages. So in the end, venture debt might be a clever way to bet on startups, but only if all the stars align. Daybreak is produced from the newsroom of the Ken India's first subscriber-focused business news platform. What you're listening to is just a small sample

of our subscriber-only offerings. A full subscription unlocks daily long-form feature stories, newsletters and podcast extras. Head to the ken.com and click on the red subscribe button on the top of the website. Today's episode was hosted by Rahil Filippo's, produced by me, Snigda Sharma, and edited by Rajiv Sien.