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
http://www.thehindubusinessline.com/specials/emerging-entrepreneurs/lending-startups-a-hand-beyond-equity/article8780221.ece.

[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 http://www.investorwords.com/8413/staying_power.html#ixzz4D2acsHuo

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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