Heaptalk, Jakarta — Establishing a start-up company is not solely about ideas and visions, but also sufficient funding to make these two points can be well executed. In the early stage of business, the agenda to emerge the business in the market is as critical as increasing market share and improving products or services. For this reason, sufficient cash becomes the primary key to run the agenda and venture debt is an option of multiple solutions offered.
Venture debt refers to the type of loan financing provided by the venture capital (VC) to companies. The partner of Innoven Capital Southeast Asia, Paul Ong, explained during an online discussion held by UX-driven corporate and fund services company, Lanturn, that this kind of debts is essentially predicated on the amount of equity capital a company has raised as well as the quality of a company’s VC investments.
“If you look at the realm of startups, these companies typically are sacrificing profits for growth to get to a certain size. They are loss-making. Therefore, these companies typically cannot obtain loans from traditional sources and banks, if they do not fit the traditional credit criteria to do so,” said Paul. Further, he included the SME lending houses, banks, and private credit funds as traditional lenders.
Traditional lenders mainly rely on a traditional credit analysis that perceiving multiple factors startups cannot fulfill. The analysis focus on the profit and loss (P&L) statement as well as the balance of annual reports to analyze the companies’ earning before interest, taxes, depreciation, amortization (EBITDA), and profits. In contrast, startups’ business model generally cannot meet this traditional credit assessment.
Favorable opportunity
As the founder of a company continues to raise capital from outside, Paul shared the founders’ stakes will dilute over time. To avoid this possibility, venture debt is a favorable opportunity, not only for a company and a startup, but also for founders to obtain more additional capital to grow. Moreover, the cost of obtaining venture debt is considered cheaper and less dilutive than raising equity.
Paul emphasized venture debt is not a one-for-one alternative to venture capital money disbursement as there are more synergistic options to channel the fund. Venture debt works similarly to housing loans or car loans. VC companies such as Innoven Capital, provide an upfront capital with a portion of the principal and interest can be returned monthly over the 10 years of the loan.
VC companies such as Innoven Capital take different approaches to looking at an emerging company and credit in general. “We know that startups sacrifice profits for growth. We understand the way startups plan for and calculate their cash runway to operate. We’re familiar with the investors that partner with these companies. We take all of this into consideration as part of our credit analysis,” uttered Paul.
When do startups need venture debt?
The principal consideration as a lender, according to Paul, is not to lend to companies in the early stage of their life cycle. VC companies usually would like to see traction on the product and market fit first. “If we were to just call it a stage of maturity, the sweet spot would be anywhere from Series A onwards,” he said.
Besides, the need for an institutional investor on the cap table—or capitalization table is a spreadsheet or table that shows the equity capitalization for a company— in the form of venture capital or private equity is necessary to the credit analysis. Therefore, at whatever stage that sort of happens, the information gives the company a higher probability of obtaining a loan from VC providers, as compared to otherwise.
The decision on the proper time to obtain and utilization of venture debt depends on the company’s business model. Paul gave an instance from the company perspective, that it’s considered very expensively to use equity capital for the utility such as to plug a working capital gap to free up cash.
Boosting key metrics
Paul explained most proper time to obtain venture debt is when raising the debt allows the companies to execute on business growth that helps reap rewards or boost their key metrics earlier. “For example, can you spend a million dollars tomorrow or in a single month on a paid marketing campaign that you know will bring you a certain positive return on investment (ROI)?” asked Paul.
By borrowing that one million dollars from a VC provider to spend on a single marketing campaign, the startup gets to amortize the cost over 24 months or 30 months. But, you need to understand the ROI from that marketing campaign, in turn, provides the startup with great attraction. Hence the startup can raise more equity funds at a higher valuation on the back of improved revenues when going back out to the market.
Another instance might be opening another five physical outlets if the startup is a consumer player or a coffee chain, for example, with the same amount of money. The startup gets to open a certain amount of stores at the same time also amortizing the cost of opening those stores over a longer period.
“Both these examples allow you to extra cash to spend first, boost your revenues earlier, and amortize that cost over one to three years, rather than burning through that same amount of capital of your existing cash that you’ve raised and that you’ve diluted yourself for and shorten your cash which would then have just forced you to go out to market earlier to fundraise again,” said Paul to elaborate the corporate side of obtaining venture debt.
On the personal side, venture debt is an ultimately cheaper option than equity. The reason is the founder gets additional cash to improve the value of the company without diluting as much equity as the founder otherwise would have if he was to have taken the same amount from an equity investor.
Regarding how much of the proper amount, Paul recommended the right level of debt in a company is a maximum of about 20 percent of the cash balance. He added, “We would prefer, and I think eventually all venture debt lenders would prefer, to be part of an equity raise. In terms of how we gauge the size of loans, we don’t see ourselves as an alternative, but as synergistic.”
As the pioneer of the venture debt concept in Southeast Asia and backed by Temasek and UOB Group, Innoven Capital SEA has invested capital in more than US$210 million through 100 debt transactions. Innoven Capital SEA has backed more than 55 portfolio companies, including 3 unicorns, with equity raised from investors of US$5,000 million.
