Great companies that take venture debt often share several characteristics – solid business fundamentals with strong unit economics; a clear understanding of who the customer is; remarkable founders and leadership teams that execute well; and more often than not, top-tier equity sponsors that bring invaluable investing experiences with them.

A solid Deal Structure plays a vital role in Venture Debt success.

When companies think about raising venture debt, they often think about getting the lowest interest rate. However, there are other critical elements in a venture debt deal that are perhaps not as obvious and the venture debt deal structure is certainly one of them. 

Like any well-built house, it is important to have a sound structure. A sound deal structure is no different. The optimal venture debt deal structure not only plays an important role in helping companies maximise their cashflow potential, but it also ensures alignment of interest between the lender and the borrower and serves as a foundation to help companies raise new equity rounds in the future at higher valuations. As Warren Buffett reminds us, “Only when the tide goes out that you learn who has been swimming naked.” Poor structuring could have a trickle-down effect that could hinder companies’ ability to repay which in turn becomes an obstacle to future equity raises. 

Questions for every startup

Now I know you’re asking, “So what’s the most ideal venture debt deal structure?” First, we seek to understand what the debt is really being raised for (e.g. to fund working capital, growth expansion, refinance, acquisition)? Second, what is the real cash runway in the different growth scenarios? Third, how might a downturn (as we are experiencing now) affect the ability to repay? 

Related Article : The Venture Debt Investors Journey in Southeast Asia

Depending on the answer to these (and many other) questions, we think about the kind of debt structure that would suit the needs of these companies. It can be an amortising term loan with a 2 to 3 year repayment period; a revolving line of credit (or revolvers); or even revenue-based financing where debt repayments are tied directly to the company’s revenues. No two businesses are the same, and so no two deal structures should be the same either.

Amortising Term Loan

What if a company wants to use venture debt to fund expansion, buy equipment or acquire another target company? For these longer-term assets, they should ideally be financed with longer-term liabilities such as term loans. The company borrows, say US$1m today, and pays a combination of principal and interest over the term of the loan with the entire amount being repaid by maturity. The exact terms will also vary from company to company depending on their risk profile. 

Revolving Line of Credit

A revolving line of credit helps to smooth out fluctuations in working capital that seasonality or delayed invoice payments can cause. For instance, an eCommerce retailer wants to fund a seasonal inventory build-up between September to December for Christmas sales. This creates a need to fund the increase in inventory and account receivables. 

Related Article: Launch of Southeast Asia Independent Venture Debt Financing Business

A revolver will be most useful in this scenario to cover for the company’s short-term operational cashflow needs. Unlike a term loan, the borrowings are repaid once the account receivables from the sales peak are collected, for example 60 days later.

Revenue-based Financing

This form of financing is mostly suitable for companies with high gross margins and subscription-based revenue models (such as SaaS). With a meaningful traction from the monthly recurring revenue and low churn, monthly repayments will be based on a certain percentage of the monthly top line revenue. 

If you like to explore raising venture debt as part of your overall capital needs, drop us a note and we will work with you to understand your needs. 

The first quarter of 2020 whizzed by so quickly. In continuation to my previous post, let’s dive into what a founder should look at when considering venture debt. First up, venture debt is not convertible debt. I still get asked a lot if we can do convertible financing. The straight answer is no. Venture debt is a form of debt investment that augments a portion of the equity need. It also provides a funding mix shift for equity-sponsored start-ups who are raising early growth capital here in Southeast Asia.

Clever mix of venture equity and debt capital markets

Most startups have negative working capital and operate in a dynamic and uncertain environment. Even more so in today’s climate. As a founder who is embarking on a fundraising plan and doing an extensive financial modeling exercise, the appropriate question to ask should be (1) do you raise 100% of what you need, or (2) 100% plus some extra buffer? Let’s take the current Covid situation to illustrate the financing conundrum. If a founder had raised adequate funds without any buffer, the unforeseen decline in business could put the company in a precarious situation and financing dilemma. Reducing the opex is one way of extending the runway, or raising some cash buffer initially could have helped cushion some of the impact. 

How much debt should a founder seek to raise

Assuming a founder needs $x million of capital to take the business to the next value inflexion point. The founder now has an option of raising $x + $y million where y is the venture debt amount and x represents the equity portion. Some founders opt to raise $x – $y million where the difference is the equity portion. This alternative allows the founder to minimize equity dilution and this stems from the venture lender entitlement to some option rights as part of the transaction. Venture lenders also typically limit average equity to debt ratio of 3:1 to avoid an overleveraged situation.

Read More : The Venture Debt Investors Journey in Southeast Asia

Highlights of venture debt transaction

There are several key terms in a venture debt capital markets transaction, with reference to deals here in Southeast Asia. Interest rates are typically in the low-teens and venture lenders would ask for a small fraction of equity (<2%) as a warrant option. These terms would be risk-adjusted based on parameters such as the stage of the company (e.g. Series B vs Series A), quality of equity sponsor, and country of operations etc. Depending on the quantum, there are commitment and legal fees involved which may be upwards of 1.5%.

A start-up’s perspective of venture debt

Horangi Cybersecurity was Genesis’ 1st venture debt portfolio and just recently in March 2020, the company announced it has completed a Series B round (https://www.horangi.com/blog/horangi-raises-us20m-to-strengthen-cyber-security-offering-in-southeast-asia). Kevin Lee, Executive Chairman, Horangi Cybersecurity shares his experience with venture debt. As a leading cybersecurity company in South East Asia, Horangi is growing and expanding fast. Kevin highlighted the challenges faced by a young startup and said “our working capital needs are growing even faster, as we need to spend up front to acquire customers through sales and marketing activities, while collecting revenue over the lifetime of the customer. We therefore knew we wanted to take some debt capital markets to complement our equity capital as it is a good fit with the financial profile of the business, and could allow us to continue growing while reducing our dilution. As a startup with a short operating history, it is almost impossible to get normal bank loans, which is where venture debt nicely fills in the gap as venture debt providers know how to underwrite startups much better than banks”. 

Read More : Venture Debt for tech-backed companies during Covid-19

Kevin goes on to share how he eventually decided to go with Genesis. He said that “because we were not just looking for capital – we were looking for partners who could add substantial value to our business. Genesis sets themselves apart from the other venture debt providers in the region on this front, whether it is in terms of helping us with business development to introduce potential partners and customers, advising us on strategy and fundraising, and even government relations. We are very happy that we chose to work with Genesis and look forward to building the company together with them over the long term”.

A venture lender wants to be aligned with the best interest of the founder, the company and the venture investors. Conversely, look for a venture lender who is committed and understands the business needs. The outcome will be a win-win situation for everyone.

In a recent article, Private Debt Investor reported that “venture debt is blossoming” and suggested that “venture debt will surf” in Covid-19’s wake. US venture debt companies are reporting an uptick in dealflow from both existing and new clients notwithstanding “startup layoffs and drying up deal opportunities”.

This might sound counter-intuitive; why would companies leverage up during these difficult times? 

Understanding the principles around venture debt might provide an insight into this emerging trend and help leadership teams assess the suitability of venture debt as a financing option.  

Venture debt today. 

According to Kruze Consulting, US$10bn of venture debt was raised by venture-backed companies in 2019 in the United States alone. Venture debt raised by companies in Southeast Asia is at a fraction today. However, venture debt financing is growing strongly in the region partly given the massive inflows of equity funding (which is a forerunner of venture debt), the maturing ecosystem generally and maturing companies that benefit from alternative forms of funding, including less-dilutive funding, as these companies grow. 

Cash is king. 

Raising venture debt to extend the runway in order to allow the company to gain additional value by the next round of financing has been a key attraction to raising venture debt. Given today’s environment especially, where most companies will be confronted with revenue and growth pressure over the next 6 to 12 months, adding cash to shore up the balance sheet in order to extend the runway is probably a good idea for most leadership teams (and their investors). This is especially so in the case where VCs slow-down funding in the immediate quarters to come. 

Read More : Repost: Venture Debt Market Reaches All-Time High According to Largest Study Ever

Flight to quality. 

Investors are more and more pivoting towards profitability over growth. WeWork’s troubles, coupled with the woes of SoftBank Vision Fund, probably accelerated this view in the last months of 2019. This is now further exacerbated by the new realities of Covid-19. Companies that prioritise profitability (or cashflows) over growth form the staple of venture debt lending. At Genesis, for example, a key part of our investment approach is to seek out solid equity-sponsored companies with strong positive unit economics and without heavy leakage into buying growth. Your company should consider venture debt funding if this sounds like you. 

Less-Dilution. 

Strong companies will continue to successfully fundraise during Covid-19. Historically there have been many opportunities for companies, founders and investors alike in downturns, and hopefully Covid-19 will be no different. However, a common feature during downturns, even for companies that are successfully fundraising, are valuations that are lower (even significantly lower) than previous rounds. And here’s a situation where venture debt can step in to help the company and its founders raise part of this cash without the sting of that additional dilution. 

Also, if a leadership team is raising funds to shore up its working capital needs during this difficult time, raising equity to do so can be a pretty expensive exercise for shareholders (especially with the above in mind). Understanding your working capital needs, and balancing unnecessary equity dilution versus the cost of debt capital, will perhaps push leadership teams to view debt financing more favourably in such circumstances. 

Read More : The Venture Debt Investors Journey in Southeast Asia

Stable VC Presence & Funding in SEA. 

The Southeast Asia tech ecosystem will benefit from recently raised VC capital pre-Covid-19. In addition to the US$20 billion deployed across Southeast Asia tech companies in 2018 & 2019, an estimated additional US$4 billion of capital will be made available by funds for deployment in the region. Armed with this liquidity, VCs will deploy into companies with strong fundamentals and/or companies that can capture the value of markets in a post-Covid world. Together with VC funding, venture debt will be a valuable complement for companies looking to build-up their balance sheets during this time. 

If you’d like to explore raising venture debt as part of your overall capital needs, drop us a note and we’ll work with you to understand your needs. 

Funding Hardware Startups and The Challenges Ahead

Finally some down time as I head out to Tokyo on a 7 hour flight. Traveling can be a hassle but it does give one a good clear mind with no access to Internet (or limited with planes all touting wifi these days). I chanced on a nice article written by the founder of a hardware company (see article title at the end of this post). In the article, Andrew Thomas shares that “Hardware is HARD”! And how true it is. As an engineer and venture investor with prior experience in hardware startups, the challenge can be another level.

Andrew Thomas is not belittling software companies but I concur with his view that hardware companies do take an extra level of risk, execution and vision. And quoting from his article, The costs are higher, you must carry inventory, and since you can’t just “change code” with hardware, a single mistake could kill you. Sounds dramatic, but it’s not an exaggeration.

As a venture lender, I enjoy funding hardware companies as much as software ones. As an engineer, I relish the challenge of rolling up my sleeves with an early stage hardware startups with my knowledge of manufacturing processes, supply chain and achieving an optimal cost of goods structure.

Hardware start-ups requires an extra layer of debt financing for the company to leverage an efficient cost of capital to grow its customer base. Across my venture portfolio, I have matured together with more than a handful of hardware companies including a life sciences instrumentation “unicorn”, a lighting-as-a-service, a kitchen robotics as well as an electric vehicle company. Donning the role of a board member, I had to help find solutions  to  overcome the challenges of scaling manufacturing. This is not just cost related to supply chain, but also production and process, talent and an efficient logistics hub.

Read More : Singapore’s Grain, a profitable food delivery startup, pulls in $10M for expansion

Most hardware companies work with a contract manufacturer but need to align a vision towards achieving a consistent manufacturing process and ensuring low (and eventually zero) reject and return rate that will in evidently ensure great customer satisfaction. Having two manufacturing locations – one located in a non-earthquake zone and politically stable country is becoming a key consideration factor.

Besides all the of the above, a young upstart company needs to find a  venture investor who can invest patient capital but also bring strategic value add. Andrew Thomas shared a list of US VCs who belong to this category. In the Asia region and specifically to Southeast Asia, there are fewer investors who are comfortable with hardware companies. The early stage hardware investors I know range from Seeds Capital (Enterprise SG), SG Innovate and a few strong believers like Wavemaker Partners, Cocoon Capital, OpenSpace Ventures, ST Engineering Ventures, FocusTech Ventures. This is not an exhaustive list but it will be great to have a go-to list of investors for these hardware companies to approach.

Venture debt has its original roots in the US funding hardware companies some 3 decades ago and today still counts as a majority part of the funding to help hardware companies scale up. In Southeast Asia, hardware start-ups are beginning to get comfortable with debt financing with the availability of venture debt. For funding working capital needs to build inventory, supply chain and manufacturing processes, debt becomes a more efficient use of capital alongside equity. The start-ups that I engage enjoy not just the financial and debt structuring conversation but more importantly how we can use prior experience to help them avoid some of the costly mistakes and scale faster, exponentially. Reach out to me for a conversation to see how Genesis Alternative Ventures can help.

Article:18 Investors That Could Fund Your Hardtech Start-up

Hardware is hard. These investors know how to make it work.

By Andrew Thomas Founder, Skybell Video Doorbell

Featured Image Photo by Nathan Dumlao on Unsplash