Venture debt: The loan rangers

OneVentures is looking to extend the boundaries of both itself and the Australia venture ecosystem with its latest vehicle: the firm is launching the country’s first venture debt fund.

To co-founder Michelle Deaker, the opportunity to introduce a new tool to an increasingly sophisticated entrepreneur and VC community presented an obvious attraction. However, in speaking to LPs, she prefers to base her arguments on the perfect match of market and timing.

“We’re a first-world country in terms of our regulatory environment and legal structures, so it’s a very good market to be investing into from that point of view,” says Deaker. “But on the other side, we’re almost like an emerging economy in terms of the product offering. While there are a lot of venture debt firms in the US and Europe, we will be the first institutional-grade fund here.”

The OneVentures initiative also marks the latest step in the slow evolution of venture debt in Asia, as Australia joins China, India, and Southeast Asia as markets with local providers of specialized financing solutions for VC-backed companies. A common theme among these firms is the belief that their target markets have reached a stage of maturity at which local entrepreneurs can begin to appreciate more flexible options beyond simple equity funding rounds.

However, the theoretical appeal of the asset class is not always reflected in on-the-ground performance, as each jurisdiction presents unique challenges for lenders. Investors need to think local when providing venture debt to Asia’s start-ups.

The pioneer

One of the pioneers of venture debt in Asia is Silicon Valley Bank (SVB), the US-based lender that has arguably spread its DNA even to markets where it is no longer active. One example is InnoVen Capital, launched as SVB India Finance in 2008 and sold to Singapore’s Temasek Holdings and United Overseas Bank (UOB) in 2015. Now operational in Southeast Asia and China as well, it is seen as instrumental in growing awareness of venture debt, first in India and then in the wider region.

“I think the first issue was trying to convince the VCs why it made sense,” says Ajay Hattangdi, who co-founded InnoVen and left last year to launch his own India-focused venture debt firm, Alteria Capital. “The sell was a lot easier to founders because they get the equity dilution issue, but it was harder to get VCs to understand why venture debt made sense for their companies. The initial years were really hard because there was just us in the market talking about venture debt.”

SVB and other western venture debt providers such as EastWest Bank, which entered China in 2012, and Partners for Growth (PFG), which lends in several markets including Australia, saw the opportunity in Asia as well worth the initial investment. The rationale was that once stakeholders in the innovation ecosystem recognized the advantages of the asset class – in allowing companies to raise capital without diluting the equity stakes of existing shareholders – being an early mover would start to pay off.

The vigorous venture debt market in the US provided all the justification these lenders needed. According to a recent study, debt has accounted for 15% of total venture investments in the US since 2009, reaching more than $8 billion per year in 2015 and 2016. More than half of the companies that took venture loans did so for the first time following their Series A or B rounds. Average proceeds of venture loans peaked after Series C, dropping off as subsequent equity rounds continued to grow. 

The findings suggest that forming a relationship at the early stage of a start-up’s development is key to driving future business – something that has formed the basis for lending strategies across Asia. Though the stage at which venture debt providers approach prospective borrowers varies slightly from market to market, the Series A to C rounds tend to be seen as a sweet spot for establishing connections with local entrepreneurs that are experiencing rapid growth.

Despite the optimism regarding venture debt, however, the asset class is still at a nascent stage in most markets. In Australia, for example, PFG has done one or two deals per year in most of the decade since it began investing in the market from its global fund. Only in the last three years has the pace accelerated, with the firm completing three to four deals in each year.

PFG attributes the recent growth in opportunities to the maturation of the start-up and VC ecosystem, along with the commodities bust that has made investors more willing to commit risk capital to Australian start-ups. The launch of OneVentures’ venture debt fund is expected to generate more interest among local LPs and create a buzz in the entrepreneur community. However, loans will also probably remain modest at first due to the size of local start-ups.

“A lot of VCs like to back companies that are global from day one, but a lot of companies here start out focused on the domestic market,” says Karthi Sepulohniam, a director at PFG in Australia. “So they tend to be smaller on average than the companies we back in the US, which means our deal sizes in Australia are smaller as well.”

China challenges

In China, by contrast, the booming technology sector has created a deep pool of opportunities for venture debt providers such as SVB and EastWest Bank. Nevertheless, the lenders face both resistance from local players and strong competition from domestic financial institutions.

One challenge for the adoption of venture debt is China’s rapid growth. Local companies have seen valuations double in the space of 6-12 months, leaving Chinese investors substantially less enticed by interest-based returns versus equity exposure. Start-ups are affected by this trend as well, since it mitigates one of the main arguments in favor of venture debt.

“Entrepreneurs here seem to be less sensitive to dilution than we would see in the American or European markets,” says Dave Jones, president of SPD Silicon Valley Bank (SSVB), SVB’s joint venture with Shanghai Pudong Development Bank, and SVB Asia. “My feeling is that it has a lot to do with valuation – companies here enjoy very high valuations, and entrepreneurs are willing to accept greater dilution because of that.”

Despite this skepticism, SSVB and EastWest have both been active in China, supporting local successes such as Zhaogang, an online B2B trading platform for the steel industry. The company, which first worked with SSVB in 2015, filed for a Hong Kong IPO in June. New business, however, must be won at the expense of growing number of local lenders, most notably regional banks that have been encouraged by the government to back innovative start-ups. 

EastWest and SSVB both possess a renminbi banking license – which EastWest gained from the acquisition of a local financial institution. They agree that there would be no hope of competing in this market on a wide scale otherwise, due to the difficulty of lending in US dollars, which requires borrowers to work through offshore structures and presents considerable difficulties in providing assets to secure against loans. Lenders that lack such a license would likely be restricted to niche opportunities. 

Even in India, where the pioneer InnoVen has been joined by Alteria, Trifecta Capital, and Intellegrow Finance, venture lenders must adapt the product to suit the strengths of local start-ups. One of the biggest accommodations regards the type of companies backed by India’s VC investors, which influences a lender’s target customer base. In contrast to the US, investments often involve businesses outside the technology sector that lack unique intellectual property (IP) as a value driver. Lenders therefore struggle to identify securable assets.

“Obviously technology will play a role in these companies, but these are not technology bets – often either you’re solving a large supply-side issue, or you’re helping organize the demand side,” says Trifecta founder Rahul Khanna. “I think those are the big challenges that one sees in India, and where the venture market has started to look for solutions.”

One approach that InnoVen devised was to look for drivers of enterprise value other than IP that it could consider as collateral. In the case of branded clothing maker Universal Sportsbiz, the firm realized that its brand ambassadors, which included Indian cricket captain Virat Kolhi and Bollywood actress Kriti Sanon, constituted an exclusive advantage for the company that its competitors would be unable to match. As a result, InnoVen felt assured that the company would be able to repay the loan.

Nascent opportunities

Southeast Asia is seen as presenting a similar opportunity and risk profile to India, and venture debt strategies are believed to have significant potential. But gestation of the asset class still requires sufficient market demand from a suitable class of companies. This started happening around 2015 when DBS Bank noted the regional emergence of a new crop of companies in the Series A and B range that were already revenue generating and looking to grow without excessive equity dilution.

DBS’ venture debt program has gone on to back a number of regional VC darlings, including Singaporean home automation developer Zimplistic, Indian online tea specialist Teabox, and Thailand-based retailer aCommerce. The latter has described the bank’s approach as operationally engaged. The DBS launch helped spark an eruption in local venture debt, with InnoVen, OCBC, Enterprise Singapore, and UOB all setting up programs in the city-state during 2015. 

“Southeast Asia’s market is growing, but there’s still a long road ahead,” says Chin Chao, CEO of Singapore and Southeast Asia at InnoVen. “I think we’re just getting to a point now where companies are becoming more comfortable with taking venture debt. It’s behind the adoption rate that we’ve seen in India, but we are slowly getting there.”

Singapore has benefited from its reputation as the regional business hub and a preference among investors to sign contracts in the country’s more stable legal environment, but infrastructure shortcomings and cultural barriers have slowed the spread of the venture debt funding model regionally. Market participants see signs that this momentum could be changing, however.

In one significant move, Malaysia Debt Ventures (MDV), an IT financing arm of the government, set up an Islamic financing program this year that has been described as a hallmark of the industry’s maturation.  “Apart from supporting VC by permitting leverage of the funds and bridging to subsequent rounds, it also creates a domestic venture debt financier which is a feature of developed VC markets,” Ansori Zubir, CEO of MDV said at the time of the launch. 

Meanwhile, Koh Foo Hau, director of the Institute of Innovation & Entrepreneurship at Singapore Management University, reports that a number of fund managers in the region have begun pitching to raise venture debt vehicles. Their main targets are family offices and high net worth individuals that want exposure to the start-up boom without going all-in on the risk end of the VC spectrum. 

Introduction of venture debt is not expected to be transformative, however, especially as new funding channels for start-ups such as crowdfunding and cryptographic token sales continue to carve up market share. Even in Singapore, where venture debt availability expanded rapidly in an environment marked by only a handful of formal VC firms as competitors, the effect has been muted.   

“It has made a positive impact as an additional source of funding, but I don’t think it’s propelled the ecosystem to another level,” Hau says, noting that even in the massive US market, venture debt has never been the primary funding instrument for entrepreneurs. “Nobody expects venture debt to be a rock star from either an investor or lender perspective. It just plays a complementary role, and rightly so.”

Series B crunch

Nevertheless, optimism persists across the region, largely on the basis that many jurisdictions, including those in Southeast Asia, suffer from shortfall in Series B funding. This has opened the door for strategic players and new concepts such as token sales.  The prevailing view is that as more options come to the table for revenue-generating companies, it will become less likely that all the growth capital will funnel into any particular funding mechanism. 

One firm subscribing to this philosophy is Ion Pacific, a Hong Kong-based merchant bank that focuses on incorporating venture debt components into hybrid, tailor-made funding schemes that include creative use of equity commitments and conditions such as deal time frames as short as one year. The idea is that by modifying the parameters of the classic venture debt play, the firm can leverage its strengths in an increasingly competitive market and, in effect, expand the viability of the asset class. 

“We’d rather take a much deeper dive into a company because we’re technologists at the core, and getting comfortable with the technology gives us the ability not to think about traditional venture debt metrics,” says Michael Joseph, co-CEO and managing director at Ion. “That’s especially important in Southeast Asia because the ecosystem is still nascent and the metrics under which companies operate wouldn’t be an obvious play for most of the traditional venture debt players coming into the market.” 

 

SIDEBAR: The founder’s view

At first glance, venture debt seems a no-brainer for entrepreneurs. They get access to capital without sacrificing equity in a flexible range of funding schemes that can be mobilized quickly to offset the operational costs that tend to pop up in the early days of company creation. 

At the same time, with no talking points as thorny as valuation, negotiations are more straightforward. The process is typically described as more of a legal formality than business due diligence, especially given that venture debt players often piggyback on equity rounds where the company has already been validated. 

Loan terms such as interest rates and fee structures are usually squared between parties fairly quickly, with the most sensitive point being the quantum of the transaction. Even here, an industry standard of around 10-15% of the equity round seems to have surfaced as a universally agreeable amount. 

The main risk factor is signing on the dotted line when the company is either too small or young. This can jeopardize the start-up's ability to raise subsequent rounds because equity investors would be subjugated to the debt instrument. Still, there are many ways to make it work, especially if revenue streams are sufficiently robust to pay back lenders quickly or the loan is precisely strategized to promote the needed growth. 

“It’s double-edged sword because if you’re a company with debt and no way to pay it, and every time you raise equity, it’s just to pay the debt, that’s going to be a huge problem,” says Vishal Gondal, CEO of Goqii, an Indian fitness app maker that received venture debt this year from Trifecta Capital after closing a Series A round. “But if you’re using venture debt for working capital, that’s a different requirement, and no investor would have a problem with it.”

Zoomcar, an Indian rental car provider, received almost $1.5 million in venture debt from SVB India Finance (now InnoVen Capital) in 2015 when it was raising a Series A in a more capital-intensive mode in terms of building out vehicle supply capacity. The loan propelled the company through a more than fivefold growth spurt that year and helped set up a business diversification that now includes an online marketplace and two-wheeled transport. 

Earlier this month, Zoomcar agreed another venture debt deal, this time for $3.6 million with Trifecta. It extended a Series B led by Mahindra & Mahindra that included an approximately $35 million equity component. The deal says much about how venture debt is becoming a more competitive space in India, where start-ups are beginning to shop around a new class of lenders and compare the merits of potential partners. 

“Most of the guys at Trifecta have backgrounds in venture capital, so they’re really equity investors at heart, and they have a strong portfolio,” says Greg Moran, Zoomcar’s co-founder and CEO. “They understand deal structure a little bit better, are inherently pretty proactive with introductions to key stakeholders, and often can be a little bit more helpful when it comes to brainstorming. When you’re an entrepreneur, you want people you trust who are independent, so you can bounce things off of them.”

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• Topics
• Greater China
• South Asia
• Southeast Asia
• Australasia
• Financing
• Technology
• China
• India
• Australia
• Structured finance
• Venture
• SVB
• OneVentures
• Innoven Capital