Monday, July 4, 2016

Venture Debt in India

[The following guest post is contributed by Dhanush M, who is a student at the Jindal Global Law School]

It is an established convention that “Debt and startups don’t mix”. This could be attributed to the fact that the business models of banks and non-banking finance companies (NBFCs) who are the primary lenders in debt are built around collaterals like plant and machinery. Furthermore, lending guidelines issued by the Reserve Bank of India (RBI) are centered on asset classes. Startups, which lack a definite asset base, tend to lose out on debt as a source of capital from traditional lenders.

The constraints on traditional lenders in lending to startups have led to the growth of funds specializing in venture debt. Venture debt could grow to be a strong option for startups who seek additional capital by minimizing the dilution of equity. Venture debt is a form of debt financing for venture equity backed companies that lacks assets or cash flow for traditional debt financing, or that seek greater flexibility in the firm’s capital structure. Venture debt firms usually set their rate of interest at 15% with monthly repayments and with the debt having maturity period around two to three years.[1]

Venture debt could also be issued with warrants convertible to equity on a future date as the RBI has allowed investments with warrants subject to the conditions that the pricing of the warrants and price/ conversion formula shall be determined up front and that 25% of the consideration amount shall also be received up front. The balance consideration towards fully paid up equity shares would need to be paid within a period of 18 months from the date of issuance of warrants.[2]

Also, with regard to the pricing of warrants, the RBI mandates that the price at the time of conversion should not in any case be lower than the fair value worked out, at the time of issuance of such warrants, in accordance with the extant Foreign Exchange Management Act (FEMA) Regulations and pricing guidelines stipulated by the RBI from time to time. Thus, a start-up shall be free to receive consideration which is greater than the pre-determined price.

Lender’s perspective

Venture lenders (VLs) receive a combination of debt and equity in the start-up usually in exchange of their loans, with the debt usually being convertible into equity upon the occurrence of certain events. The loans are fully amortized over their term through equal monthly payments of interest and principal.

VLs tend to lend to a start-up once that start-up has been able to attract venture capital. VLs could seek to have an implicit, non-binding promise to be repaid venture debt from the present and future equity investments of the VCs.  VLs also recognize that they would stand to gain considerably from a follow on round of financing or a reasonably near exit.

VLs also seek to protect their money from taking the start-up’s intellectual property (IP) as a collateral. In addition to security interests, VLs could also enter into contracts with start-ups entitling them to first proceeds from the sale of IP. However, it is pertinent to note that the IP of a start-up in the technology sector could pose unique problems in terms of both security interests and liquidation value. For instance, it is highly probable that the collateral in the form of IP could massively depreciate when a start-up decides to shut down.

VLs monitor their debt by relying on covenants, material adverse change (MAC) clauses and other “subjective default clauses”, such as an existing equity investor deciding not to participate in a future round of investment, which would prematurely allow VLs to accelerate the repayment schedule due to events beyond the company’s control.

However, even if a start-up were to violate a covenant, VLs tend to not call a loan prematurely, because that would risk adversely affecting their relationship with the venture capitalists (VCs). Furthermore, the liberal approach to covenants can be attributed to the reduced need of VLs to monitor their loans as VCs’ strict monitoring of their investment in turn reduces the burden on VLs to extensively evaluate their loan.

VLs also tend not to take board seats in a start-up where they are involved, which could be beneficial to the lender to the extent that lenders who exercise control could face the prospect of equitable subordination of their claims in bankruptcy, substantially limiting the usefulness of IP as downside collateral.

Start-ups’ perspective

The principal motivation for a start-up to avail venture debt is that extends the start-ups staying power[3] until its next equity round of funding, which happens to dilute the founder`s equity stake. It is also highly probable that a start-up that continues to grow using debt is likely to receive a higher valuation, when more equity is sold in a subsequent round of funding.

Also, venture debt could be valuable source of funding to overcome down rounds - where investors purchase a stake in a company at a lower valuation than the valuation placed upon the company by earlier investors, which could be particularly relevant in 2017, where the U.S Fed is likely to start its policy of gradually increasing interest rates nullifying the unabated flow of capital in the Indian start-up ecosystem. Start-ups would be keen to avoid down rounds, where the value of shares held by the existing investors, founders and employees with stock options suffer a downgrade in such transactions.

Venture debt also helps VCs make better decisions in allocating capital. VCs can either use their capital to make follow on investments in existing portfolio companies or to fund new start-ups as greater time until the next VC investment provides VCs an opportunity to evaluate the start-up’s prospects and development in deciding whether they would fund the next equity round or bring an another VC for subsequent rounds of funding.

Furthermore, venture debt brings benefits not limited to the financial benefits by reducing the agency costs for VCs through monitoring deposit account balance and payouts of excess VC cash of the invested companies.

To conclude, the market conditions for the growth of venture debt as a source of financing in the Indian startup ecosystem is increasingly looking favorable with VCs’ reduction in the frequency and quantum of investments coupled with the fact that there is a ‘massive revaluation’ in the star-up sector, where start-ups could use venture debt to overcome concerns of liquidity and valuations.

- Dhanush M

[1] Lending Start-ups a hand beyond equity, N Ramakrishnan, available at

[2] Master Circular on Foreign Investment in India, Master Circular No. 15/2014-15

[3] The ability of a person or entity to endure for a long period of time, even through rough times or situations, available at

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