The Future of Startup Debt Funding

by Varun Gupta
09 March 2021
An Ecosystem Matures

With a record number of venture capitalist funds shifting their focus to rapidly digitizing Emerging Asia, early-stage investments have been on a historic high for startups in the region. During the last 5 years (2015 – 2020), more than USD 50 Bn worth of cumulative equity capital has been invested in startups across all major digital economy sub-segments – Transportation; Marketplace; Food tech; Fintech; Edtech etc. in South East Asia alone. Coupled with almost USD 150 Bn invested in early-stage Indian startups during the same period, this represents a quantum leap for the startup ecosystem across the entire Emerging Asia region.

Lack of Follow On Funding Options

The availability of capital is a vital component for building and scaling any successful business in general, and startups in particular. Most early-stage startups in the region that can successfully close initial rounds of equity financing, often struggle to raise follow-on equity capital in the subsequent rounds. This is primarily due to a lack of larger Series B & C investors in the region who prefer to invest as part of consortia including different types of investors such as corporates/strategics, family offices, as well as private equity firms. Further traditional financial institutions like banks are not able to provide funding as they have requirements around profitability of operations and other restrictive loan covenants like material adverse clauses etc. In a few cases, where capital is still available, it may not be time efficient to effectively address the requirements of a business.

Covid Accelerates Focus on Sustainability

The global outbreak of COVID-19 has fundamentally altered the dynamics for early-stage businesses. While on one hand, they must quickly respond to rapidly changing end user behavior, on the other, they need to sharpen their focus on sustainable unit economics as the investors turn cautious and demand a route to profitability. Valuations for most start-ups have taken a hit with founders facing the very real possibility of down-rounds to sustain operations unless a bridge capital is raised to tide over the next 12 to 24 months. To mitigate these issues, raising debt has emerged as a leading solution for start-ups to finance working capital gaps and assets.

Why Debt Matters

Debt capital is a strong option for venture backed startups who want to add capital and minimize equity dilution. Venture loans can generally be arranged much more quickly than equity financings, saving valuable management time or meeting unforeseen needs. Further, a debt financing round does not establish a valuation for the company, which can be helpful ahead of a new round of equity financing, before a potential sale, or any other instances where management and existing investors would otherwise need to negotiate a price. Finally, venture lending firms do not generally require board seats or observation rights, removing questions of board dynamics. Debt is a finite obligation. In many cases, you can use debt in the same way, or as a substitute for, equity, without the long-term dilution of equity. However, it is important to understand what debt entails.

Debt v/s Equity?

This has been a perennial question for startups that have progressed past the early-stage growth pains and are ready for expansion. Here is a brief comparison on both routes:

  • Term: Equity capital is designed to meet longer term requirements and has a much larger gestation period. On the other hand, debt capital is deployed to fix short term issues like working capital gap, extension of cash runaway etc.
  • Structure: Unlike equity investments, venture debt can take many forms ranging from term loans with monthly repayments to receivables financing credit lines to short-term working capital loans with bullet payments.
  • Stage of Business: The equity route is meant for different stages of the startup’s journey. In the initial years, the funds are provided to help companies grow in terms of productivity, business development, meet customer demands and start earning a profit. Thereafter funds are meant for widening the market base, getting new customers, and covering higher demands, thereby registering a higher profit margin. Meanwhile, debt funds have no specified stages and can be raised at any point of the business, depending on the monetary needs.
  • Cost of Capital: In the longer run, on a fully diluted basis, the cost of equity capital is significantly higher than cost of debt capital. However, in the near term, servicing debt obligations can severely impact net cash flows for the business.

Choice of capital raising route must be a well-considered decision for any early-stage business as it may have critical implications in the future. A prudent way to go about shall be an optimal mix of both equity and debt capital based on requirements – type, tenor and stage of business.

Data Economy to drive Debt Underwriting

Emerging Asia is the world’s fastest growing internet economy with millions of new users adopting digital applications every year, thus contributing to an explosion in the availability of data points around their behavior. These data points provide a holy grail to all digital service providers to analyze and create new/enhanced user products. Availability of information around these new data points help in evaluation of current and future cash flow generation capacity of these firms. Along with cash flows, these data points also help venture lending firms to understand business moats, unit economics and various business drivers such as CAC, receivables, collections etc. in a more sustainable and transparent manner.

Billion Dollar Opportunity

PitchBook calculates that since 2014, US venture lending has totaled approximately USD 8 -10 Bn per year, and accounts for 10-15 percent of the total venture capital invested. However, during 2019, venture lending quantum aggregated to almost USD 26 Bn, representing 19 percent of total USD 137 Bn of venture capital. As the Emerging Asia ecosystem matures, we expect the startup debt financing to follow a similar route to become a mainstream funding option on the street. Assuming even a conservative estimate of 1percent of total venture capital investment, this should convert into a billion-dollar opportunity over the next couple of years for the entire startup debt financing industry in the region. The ecosystem is growing with startups as they need more capital, and debt is bound to emerge as an integral part of that equation.