Loan or own? Chinese strategics offer debt to start-ups

A fierce battle is being contested in China's childcare space. At least five online start-ups offering a combination of baby products and social networking have received funding in the last eight months, with three raising $100 million or more.

Of these deals, BabyTree - which is backed by Matrix China Partners, SIG China and China Broadband Capital (CBC) - stood out. Not only was its $300 million round the largest ever seen in the space, but it was also mostly in debt form. Jumei International, a US-listed Chinese online beauty products retailer, provided a $120 million convertible loan and a $130 million revolving credit facility.

While debt-dominated rounds are commonplace in the US, they are rare in China's venture market, particularly for as yet unprofitable start-ups borrowing hundreds of millions of dollars.

"Part of the reasons is that debt financing isn't suitable for private companies," says Hurst Lin, co-founding partner at DCM China. "Usually we see companies using such debt instruments after public listings because they have sizable market capitalization, sufficient cash flows and shares can be pledged as collateral. Private firms don't have this kind of liquidity."

Nevertheless, with the BabyTree deal proving it is possible and some Chinese entrepreneurs reluctant to dilute their holdings by selling equity, demand for debt-based funding could rise. It raises numerous questions - good and bad - for start-ups and their early VC backers.

Equity-driven

In China, relatively small convertible note financings tend to be found prior to a Series A or seed round, largely because it means the issue of a start-up's valuation can be deferred until the first institutional round. "Early-stage debt financing tends to be a function of bridge loans," says Ron Cao, co-founder of Lightspeed China Partners. "If a start-up raises equity and the valuation isn't as high as the CEO wants, the company may consider using debt to bridge between the institutional rounds."

In return for coming in early, convertible bond investors often receive a discount of 10-30% to the Series A round price. Meanwhile, the bonds automatically qualify for a Series A round as debt-to-equity funding within a certain timeframe. Another advantage of the debt is that in the event of a liquidation, creditors would be reimbursed ahead of any outstanding equity holders.

"I have started to see some funds also invest in a post-Series A company using a combination of equity and debt," notes Thomas Chou, partner and co-head of the China PE practice at Morrison & Foerster (MoFo). "There may be different rationales for doing so, but they will have seniority over all preferred equity in a liquidation, and potentially security or guarantees over the debt. For example, founder shares are often pledged."

I have started to see some funds also invest in a post-Series A company using a combination of equity and debt - Thomas Chou

Convertible loans are a preferred mechanism for strategic players because, much like angel investors, they may not have the ability or desire to set the valuation of an equity funding round. They therefore participate through debt and expect to convert into equity in the next institutional round.

As one venture debt specialist suggests, Jumei's investment in BabyTree doesn't make sense as a straight loan because the interest rate isn't very high. Rather, the company is seeking a higher return post-conversion when BabyTree goes public or is acquired. In this sense, it is a pre-IPO round at cheaper price.

This is a viable approach because the two companies complement each other operationally. BabyTree has more than 10 million daily active users in a niche market - young mothers - and this appeals to Jumei, which has ambitions to become the dominant female online platform in China. It can offer BabyTree access to a robust e-commerce infrastructure with a cross-border element.

The combination of the size of the round - BabyTree's previous investment came in January when after-schooling tutoring services provider TAL Education acquired a minority stake for RMB 150 million ($25 million) - and the synergies with Jumei could offer rich rewards. The company said in a statement that the $300 million would enable its e-commerce business "to rapidly grow to become number one in the baby and maternity sector."

According to Analysis International, parents in China spent more than RMB1 trillion ($163 billion) on childcare products in 2011. The total is expected to reach RMB2 trillion this year.

Risk factors

However, plenty of other industry participants are also eyeing the opportunity. In March, online retailer Vipshop led a $100 million Series C round for Lamabang, a social networking platform focused on mothers. It previously received funding from Matrix, Greenwoods Investment and Morningside Technologies. US-listed Vipshop is in direct competition with Jumei following its acquisition last year of domestics and fashion products site Lefeng.com.

This presents an element of risk that not all companies appreciate. "Every entrepreneur at this stage is optimistic and they tell investors, ‘We don't have to pay your money back as a loan because our equity is going to be worth so much later,'" the venture debt specialist observes. But in reality these loans appear on start-ups' balance sheets. If an IPO or other exit fails to materialize, they could be left with a mountain of debt that can't be serviced and VC investors could get burnt.

Should BabyTree ran into trouble and Jumei enforced a default, the creditor would ask for the equity to be converted at much higher discount. In that case, the existing VC investors - Matrix, SIG and CBC - would see their shareholdings significantly diluted.

"In some of these loans, there is no incremental payment. However, if a repayment is due and it's not paid, an investor can call for the loan to be accelerated and repaid in full," MoFo's Chou says. "In China PE and VC transactions investors usually‎ have the right to approve any significant debt financing. So the VCs will typically need to approve the company agreeing to be bound to such financing."

More Chinese technology companies are raising ever-larger private rounds at ever-higher valuations. If the phenomenon continues, the market is likely to follow in the footsteps of the US with equity and debt combinations becoming increasingly popular. This not only applies to later-stage deals worth hundreds millions of dollars, but also to earlier transactions as venture debt gains traction in the market.

"Given valuations have been getting higher in general, especially in the later stages, it makes sense for companies to have debt or convertible bonds or some sort of equity-debt combination in funding rounds. It means investors have more downside protection," says Lightspeed's Cao. "I think there is a trend here."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Venture
• Greater China
• Technology
• Consumer
• Expansion
• Venture
• Structured finance
• China
• Growth capital
• TMT
• Consumer
• Lightspeed Venture Partners
• DCM-Doll Capital Management