It might sound like an obvious statement that entrepreneurs don’t want to give up equity in their business. But the challenge remains — how do they raise the necessary capital early on in order to grow and scale up operations?
It is very difficult for these young companies to secure a loan from a commercial bank. As a result, many entrepreneurs have little choice but to go for venture capital, in the process “giving up” some equity to the new investors. This is where venture debt can play a crucial role in the financing ecosystem for early stage companies, providing transition capital to businesses.
Venture debt has been a common financing vehicle for tech startups in the US for a number of years but for a variety of reasons it has been less prevalent in Asia. However, this trend is changing.
Venture debt is a form of senior debt financing that can be used for anything from working capital and equipment financing through to project financing and M&As. The most common structure used for venture debt is a loan with warrants attached as it gives the venture debt provider the right, but not the obligation, to buy shares in the company at a certain price before its expiration. The venture debt provider can thus benefit from any potential future equity upside, enhancing its overall return.
Venture debt seeks to fill in a gap which has not been fulfilled by the traditional commercial bank loan market
In terms of funding requirements, it is not easy for startups to tap into loans provided by the traditional banks. They do not have enough fixed assets to pledge as collateral for a bank loan.
Sometime the only major asset available to pledge is the company’s intellectual property. Furthermore, they often lack a track record in terms of cash flow generation and in many instances, they are not profitable yet.
Finally, the commercial banks may not have the expertise to evaluate the creditworthiness of early stage tech companies.
Why choose Venture debt?
- Venture debt is significantly less dilutive for the existing shareholders than venture capital. The dilution coming from venture debt happens only when the attached warrants are exercised. The proceeds from venture debt can be used to grow the company and achieve a higher valuation in subsequent rounds of equity raising.
- There is less interference from venture debt providers. Generally no board seat is required in return for venture debt.
- It provides an extension of the company’s cash runway. The startup can delay its next equity raising, especially if its valuation has fallen, and the management has more time to focus on tackling problems…