How the debt financing becoming preferred instrument for startups

Venture debt offers a compelling alternative for startups based on the current market conditions. It is not only cheaper than equity but also avoids dilution of control. The demand for venture debt has grown in recent years as investors seek to deploy more capital faster

Startups are now combating the challenges of raising new funds through venture capitalists amidst deteriorating macroeconomic conditions, tightening liquidity and other geopolitical tensions.

The number of global venture deals is expected to fall by 19 per cent in the second quarter of 2022 as funding becomes more challenging to find and technology stocks plummet. The projected number of deals is 6,904, down 22 per cent from the previous quarter. Indian start-ups will suffer the most, expecting the total funding to fall by 31 per cent from the prior quarter. With the indication of a funding winter, founders are exploring alternative debt funding options such as venture debt.

As central banks worldwide continue to raise interest rates, listed companies have plummeted in valuations. Since venture firms essentially look at public markets for guidance on capital allocation, the relative valuation across Start-ups has also dropped.

Early and late-stage startups, who raised money at premium valuations, need to now raise a down round (lower than the previous one) or at the same valuation. With liquidity drying up in the venture space on account of quantitative tightening, the pool of deployable capital has significantly shrunk.

Furthermore, Venture Capital investors such as Sequoia and Y Combinator indicated that they would focus on raising funds rather than deploying over the next six months has had the alarm bells ringing.

With a smaller corpus, the competition to secure it will be more challenging for the startups. Amidst this uncertainty, venture debt has emerged as a preferred instrument for startup funding.

Venture debt offers a compelling alternative for startups based on the current market conditions. It is not only cheaper than equity but also avoids dilution of control. The demand for venture debt has grown in recent years as investors seek to deploy more capital faster.

Many factors have contributed to this growth. Investors saw a sudden reduction in fixed-income returns and felt a need for safe, predictable fixed-income products that would give good returns.

Pandemic tailwinds allowed for better depth and access to most digital businesses. Venture debt providers demonstrated that this asset class could yield greater returns at lower risks. Acquisitions have been a significant driver of the growth of venture debt in recent years.

Startups can choose from a variety of options when it comes to debt funding. The amount of funding, the stage of funding, and why the funding is needed determine the best instrument to choose. Various options available to a business include bank loan, unsecured business loan, business loans, bonds, lease debt financing, and structured debt financing.

Venture debt funding allows for a quick infusion of funds into the company, especially for companies looking for working capital infusion. One needs to match the requirements to the instrument that best serves them.

GetFive Corporate Advisors LLP, a boutique investment consulting firm based out of Ahmedabad, consulted a agro end-to-end warehouse service provider company named Go Green for structure debt financing. Go Green, an end to end warehousing company for agro-based products was looking for working capital infusion. They called upon Shrikant Goyal of GetFive, who leads the equity and debt financing pillar, for help.

Shrikant, post due diligence, realised the seasonality of Go-Green's business, and a little deeper insights into the business led him to believe that structured finance is the need of the hour. Tailoring the requirement to make it a win-win situation for both the lender and benefactor, Shrikant convinced Axis Bank to extend the financing.

Talking to Bizz Buzz, Shrikant Goyal, Co-Founding Member and Managing Partner, GetFive, says, "Whenever there are certain specific requirement of the borrower which does not fall into standard (vanilla) product of most of the banks & FIs are comfortable to take credit call on, the lender then needs to structure product accordingly to the need to the borrower. Most of the leading NBFCs take majority share in terms of structure finance. However, certain leading private banks offer structure finance as a facility."

When equity becomes more expensive, venture debt allows companies to access capital. If equity slows down, good companies that need to raise capital may rethink their strategy and raise debt instead. Debt deployments will grow leaps and bounds this year as companies that are not doing well would need more growth capital, while well-performing firms would need to replenish their war chest to maintain the growth momentum. Also, more and more growth-stage founders will make debt a part of their funding rounds to balance out dilution.

"The GetFive team took our requirements as their own and helped build the structure from scratch. They actually tailored the debt financing structure to suit our needs. Given the seasonality of our business, this is of great benefit for us as it will help us extend our runway efficiently while allowing us to maximize growth", said Maulik Shah, Managing Director, Go Green Warehouses.