Debts are generally not so good in most of the cases. Some debts, however, are beneficial. These good debts are used to fund a startup's early years. A venture debt, also known as venture lending, is a type of debt financing obtained by early-stage companies such as startups in order to raise working capital or short-term financing. Unlike other types of debt, venture debt does not require collateral.
These days, startups rely heavily on venture debt financing. Despite the overall economic lockdown caused by the COVID-19 pandemic, venture debt investment increased sharply in the first half of 2021, according to data provided by Venture Intelligence (an Indian unicorn). Venture debt transactions reached more than $170 million, compared to $55 million in the first half of 2020 and $64 million in the second half of 2020.
Let us first define venture debt and how it can be obtained in a startup.
What is venture debt ?
There are typically two well-known methods for a startup to raise capital: equity funding and debt financing. A third option could be a hybrid of equity and debt financing.
Various methods of raising capital
Equity capital is the primary source of funding for a startup, and it is obtained through venture funding, which is a subset of private equity. It is funded by investors who see huge potential in the company's growth in return for common or favoured stock in the company.
Along with equity capital, investors contribute to debt financing, which serves as an additional source of working capital for the startup. As a result, venture debt is typically raised alongside equity capital by startups. Both are funded in the early stages of a startup.
Unlike equity capital, debt financing works in the same way that loans do. As a result, the investor anticipates that the amount will be repaid with interest in the future. The difference between the two is that equity capital is still the primary source of funding for a startup, whereas venture debt funds are used to obtain working capital.
The hybrid funding method is thought to be more appropriate for raising funds. However, during the COVID-19 pandemic, where investors have become hesitant to raise equity capital, debt funding has been more preferred.
What is debt financing?
Debt financing is a method of raising funds to run a business and cover operational costs during the early stages of a startup. It begins with the conception of an idea for a startup. Depending on the requirements and needs, the financing can be either short-term or long-term. Short-term debt financing can be used to fund the startup's day-to-day operations, whereas long-term financing can be used to purchase assets such as machinery and equipment.
However, the investors are at risk in both cases. The risk is higher in equity capital because investors may not receive anything if the company goes bankrupt. However, investors prefer to raise equity capital because it allows them to participate in company management and thus maintain their influence.
Venture capitalists and other venture debt funds provide capital to raise venture debt during the startup's early and growth stages. Investors may be repaid for this type of funding because the amount is usually not large, and they may charge pre-determined interest on it.
Furthermore, because startups typically lack substantial assets to qualify for other types of financing, it is difficult for them to give stakes in order to raise venture debts.
Who provides venture debt funding?
Venture capitalists and specific venture debt funds can provide venture debt funding. In India, venture debt funding has been around for 15 years and is well-established. However, because of the strong influence of equity capital financing, debt financing may still be little known.
As previously stated, venture debt funding can be obtained through institutional channels such as venture capitalist firms or through individual lenders. In the former case, institutional funding is still scarce. However, there are an increasing number of venture debt funds willing to lend the money.
How does a startup obtain venture debt?
There is no set method for obtaining venture debt financing for a startup. However, there are some common steps that startups that are interested in this type of funding should take.
How do you get venture debt funding?
To obtain venture debt financing, first seek venture capital from an institution or individual. If you can secure venture capital, the same place can also provide venture debt. A solid business plan is required to obtain debt financing.
What should a solid business plan include?
To get started, you'll need a business plan that includes sections on business description, product and market analysis, potential market competitors and their analysis, sales and marketing strategy, ownership and management plan, operating plan, financial plan, and executive summary.
Description of the company
The section on the business description should come first in the plan. It must include information about your idea and how it evolved into a business, what the pain point of the market you are targeting is, and how likely you are to succeed. Everything should not be included in an overview because it will be included in the executive summary.
However, you can provide an overview of the industry, what the current market trends are, where your product will stand in relation to the current market trends, major competitors, and estimated sales. Because this is the first section, it is recommended that you approach everything with a positive attitude that will set you apart from other competitors.
Product and market research
The product should be thoroughly described in the second section, along with how it might respond in the market/industry you are targeting. This should demonstrate your thorough understanding of the market in which you intend to sell your product, so you must be certain of your primary goals as well as market response estimates.
Competition analysis
This section is important for funding purposes because it includes a thorough analysis of your potential competitors and assists you in presenting a standard image of yourself to the investor. Because you may face both direct and indirect competition in the market, you should write about every possible scenario. It will determine your market leverage over your competitors. Make a point of analyzing the weaknesses and strengths of your product as well as those of your competitors, as this will be used to persuade potential funding sources.
Strategy for sales and marketing
This section should include the sales and marketing strategy you intend to use for your product, pricing tabs, and how you intend to advertise/promote your product. You must have come up with a unique way to sell your product (unique selling proposition), so write it down here. Include all of the advantages that your product has that will persuade customers to buy it.
Plan for ownership and management
The management team is critical in attracting investors for various types of funding in any startup. As a result, this section is essential for any investor considering investing in your startup. Mention your internal and external management teams, their resources, and the general availability of human resources. Because investors base their decision on how well your management team performs, make sure you mention their qualifications and how they will impact the startup's operations.
As a result, this section should explain your ownership structure (your company's legal structure), internal and external management team structure, and human resources. There are numerous suggestions for what this section should include. One suggestion is to form an advisory board to serve as a management resource. This will be used in startups whose primary goal is to raise capital.
An advisory board assists you in providing critical aspects of your startup's idea. See, at the beginning, you need different perspectives on your startup to figure out where you stand in the market and what the gap is between where you are and where you want to be. That is why an advisory board is required to provide you with the expertise that your startup lacks. It will only strengthen your business plan and assist you in attracting more investors. You can decide how to set up an advisory board and how many members should be on it. An advisory board may play an important role in increasing the investor's trust in you.
Finance and operational costs
This section is critical for any type of funding. This section is split into two parts: the operating costs plan and the financing plan. The operating cost describes how your business will operate, including information about your employees, assets (if any), how your product is manufactured, how many employees you will need if sales increase, and so on. It must cover every aspect of your company's day-to-day operations in order for the investor to gain a better understanding of it.
In addition, the financing plan should include three items: your current financing, your anticipated funding needs, and your projected income. Your project income will give the investor an idea of your financing needs, so include all of these details by including your income statement, balance sheet, and cash flow statement. These three documents are the most important.
A brief summary
An executive summary is a summary of the entire business plan in which the main points of the business plan are highlighted with keywords. Furthermore, the appendix can include any additional information about the company.
The Benefits and Drawbacks of Venture Debt
The first impression of venture debt financing is that it is easier to obtain because no collateral property is required. This, however, should be considered a disadvantage. It is because, in the absence of collateral, it may not be a safer method of financing. Because this is similar to borrowing money via loan, the lender may require personal guarantees. As a personal guarantee, you can use your home, car, or any other type of investment.
When you have a high-growth business, you should consider debt financing because you will need constant capital to grow it. You can also choose debt financing for short-term purposes, which you can easily repay within a year or so of maturity. However, startups should be wary of the impact these types of financing have on their credit rating.
Conclusion
Debt financing is a faster way to get funding for startups, but it involves a number of factors that must be carefully considered before proceeding. The same rule applies to investors and individual lenders in the business of providing venture debt funding. Risk assessment is something that both parties should consider before making a decision. Finally, because venture debt financing is derived from the venture equity market, one must closely monitor the same to understand the right time and the right method to obtain debt funding.
