India venture debt: Innovation capital

Temasek Holdings has become the latest investor to enter an embryonic but potentially large new market within India venture capital after agreeing to buy SVB India Finance - a unit of NASDAQ-listed lender Silicon Valley Bank - for INR2.8 billion ($45 million). The Singapore investment fund will provide loans of up to INR150 million on six-months to three-year terms to some of India's fastest growing companies.

SVB India has been in operation since 2008 and its investment portfolio is impressive. Clients include the likes of Snapdeal, iYogi, BlueStone, Capillary, FirstCry, Freecharge and Perfint. SVB India gets its pick of the most-promising start-ups because for the last seven years it has enjoyed a virtual monopoly over India's desolate venture debt space. But things are changing.

As the country's venture capital market has matured, demand for venture debt has grown. More players are coming in to fill the demand-supply gap. SVB India has been joined by IntelleGrow, a unit of early stage investor IntelleCap, and Trifecta Capital Partners, a venture debt new debt provider set up by Rahul Khanna, formerly managing director at Canaan Partners. They are nurturing the green shoots of venture debt, but what is its full potential?

"There is definitely increasing interest among high-growth, early-stage start-ups in need of a different kind of financing instrument," explains David Richards, co-founder of Unitus Seed Fund. "The problem is that there have been very few options for debt, so historically the capital has not been there."

Debt demands

While venture debt may be new phenomenon in India, it is a well-established product among start-ups in developed economies.

The most obvious example is SVB India's parent, Silicon Valley Bank, which was one of the first movers in the space when it set up in the US in 1983. Silicon Valley Bank is now one of a number of commercial banks in the US offering venture debt along with the likes of Square 1 Bank and Bridge Bank. There are also a host of pure-plays such as Lighthouse Capital Partners, TriplePoint Capital, and Pinnacle Ventures, which provide financing solutions out of traditional venture capital-style fund structures.

Most venture debt providers broadly operate in a similar way, offering debt on top of a larger round of equity funding. For example, if a start-up raises a Series A round of $5 million, the venture debt provider would contribute an additional layer of $1-2 million.

The investment is normally made alongside venture capital funds with which the bank or fund has a previous relationship. This is done on the assumption that the start-up will raises further rounds from the same VC investors, and it helps make the lender comfortable enough to provide debt with an average three-year amortization. In the case of Silicon Valley Bank debt is normally be collateralized by the company's assets, including things like intellectual property.

The main reason this venture has not taken hold in India, or indeed in Asia as a whole, is down to the relative immaturity of the venture capital market. Most Indian entrepreneurs only really caught onto to the idea of equity funding in the last decade. At same time many promoters are unaware of what alternatives are available.

"In the past there has been a lack of knowledge about what venture debt is about," explains Prashant Mehta, partner at early-stage investor Lightbox. "Many start-ups see equity as the best alternative for all activities, whether it is appropriate or not."

The problem is that while equity is typically ideal for long-term costs - such as developing a technology platform or hiring talent - many start-ups still use this kind of capital to cover short-term expenses that would be served by debt. The reason for this is that many entrepreneurs have found traditional lines of credit closed off to them.

Unitus' Richards points out that one of the main challenges of the small and medium-sized enterprise (SME) lending ecosystem has been the habit of India's financial institutions to ignore riskier, high-growth start-ups in favor of mature SMEs that have been around for a while and are turning a profit.

Modes of entry

When SVB India entered the market in 2008 it did so by setting itself up as a non-banking finance company (NBFC) and has so far made over 60 investments, adopting the investment model that had already been established in the US: It typically invests in start-ups that have raised their first institutional round and are already generating a turnover of around $100 million.

IntelleGrow, which was set up around four years later in 2012, also formed an NBFC but adopted a slightly different strategy by targeting earlier-stage businesses. Sanjib Jha, CEO of IntelliGrow, explains that his firm targets companies at the pre-Series A stage - when turnover is still below $10 million - and invests $500,000 to $1.5 million per company. The firm has made 56 investments over the last two years, primarily working with young, first-generation entrepreneurs in their late 20s to mid-40s.

"This age group is well educated, I think they understand finance very well and they fully understand the utility of capital," Jha says. "Once you understand the dynamic of the uses of capital you understand that your balance sheet needs to be leveraged."

Another recent entrant into the market is Capital Float, also an NBFC, which was set up in 2013 and last year received a $1 million round of funding from SAIF India. While the firm classifies itself under the more generic heading of SME lender, it nevertheless counts high-growth start-ups such as e-commerce platform Zovi.com among its clients.

Not all venture debt lenders have taken the NBFC route. Khanna's Trifecta is looking to invest out of a fund structure and is in the process of raising INR3 billion ($50 million) for its maiden vehicle. Khanna points out that while NBFCs can provide more structured, higher yield, forms of debt than banks, their investments don't necessarily fall into the category of traditional venture debt, i.e. providing debt alongside a significant round of equity from a third party.

"What we are doing with our first fund is modeling a product based on some of the best practices we have seen deployed the world over," says Khanna. "In lots of ways it is a three-way deal - the company, the equity provider, and us. For us to make our target returns [a 17% gross IRR] we need the appropriate level of equity support to help us manage the risk of backing a high-growth, asset light start-up."

Like IntelleGrow, Trifecta is targeting businesses at an earlier stage than SVB. It will back start-ups that are in the market for their first institutional round of equity funding, committing INR50-150 million per loan at a 16-18% interest rate.

Lightbox's Mehta says that more widely availability debt capital could help solve a lot of issues facing Indian start-ups that require a lot of working capital in order to scale up fast and fulfill orders, but don't necessarily want to suffer the expense of giving up more equity. In the early stages in particular, India-based investors offering rupee-denominated debt might be a perfect solution.

Going global

However, there is now also demand for debt from international sources, with many start-ups looking to use a combination of local and offshore financing solutions. This is because India's capital controls may make it difficult for a start-up that receives venture debt funding in rupee to deploy it outside of the country.

"It differs from firm to firm but if your company is thinking about operations outside of India you may want to look at venture debt sources outside of India that allow you more flexibility to deploy capital in other markets," says Mehta "What might happen is that you start off focusing on your home market for the first couple of years before you are ready for a global market. So if you need capital early on, domestic providers are a great option."

It is tricky to predict the exact speed at which venture debt is likely to gain traction in India as there is little precedent for it in any other emerging market. However, the consensus view is that there is plenty of demand in the start-up community. The question is how long it will take to develop the ecosystem.

IntelleGrow's Jha believes some indication can be drawn from the way microfinance has evolved. In 2004, the ecosystem in India was very small and people wondered whether it would even be $200 million market, but today it is worth around $10 billion.

"Early-stage lending and venture debt is now at the stage microfinance was at in 2004," says Jha. "Temasek's acquisition of SVB India comes at a time when the market is heating up, and more players like us are arriving. It is a learning curve, and it might take another three years, but it will be up to the incumbents to prove that there is a market."

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• Topics
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