Asean's top venture lender InnoVen increases its tempo

Singapore

SOUTH-EAST Asia's top venture debt firm InnoVen Capital sees room to be more active in deals this year, as startup founders look to reduce equity dilution without losing sight on growth, said a senior executive from InnoVen.

InnoVen closed 17 deals in 2018 with a loan disbursement of US$35 million, exceeding its internal targets. In 2019, it is aiming for 25-30 loans that translate to more than US$50 million in disbursements, Chin Chao, CEO of InnoVen Capital's Singapore and South-east Asia business, told The Business Times.

InnoVen, which was started in South-east Asia in 2015, has seen no defaults from the first cycle of its portfolio from this region, with portfolio names cutting across sectors, said Mr Chao. They include online retailer Pomelo Fashion, live-streaming firm M17 Entertainment, payments startup InstaReM, cloud software player Deskera, and co-working space firm The Great Room.

The gears will now turn quicker for InnoVen as eight in 10 of its prospective deals today come from founders, rather than leads from venture capital funds - as was the case when InnoVen began - said Mr Chao.

"It's a good sign that founders are waking up and saying there are alternatives, rather than just only taking venture capital," he said.

Venture debt is common in Silicon Valley, but a nascent funding track in Asia. InnoVen, a venture debt outfit jointly backed by Temasek Holdings and UOB, steps in to provide debt to high-growth companies still in the early stages of development. At this stage, cash burn is very high, and profits are very much non-existent.

Traditional venture capital funds that are keen to pour some money into their startups of choice invest in return for a stake in the company. But as startups grow, and more venture capital funds want a piece of the action, the founders of these firms inevitably have to give up more equity in return for investments to push the business to further growth.

Typically, founders looking for Series A funding will dilute their respective stakes by 20-25 per cent. At Series B, that stake is further diluted by another 20-25 per cent.

Most funding rounds today are still fully done through equity, said Mr Chao. But three months later, founders may call up InnoVen, mainly because business momentum has suddenly picked up.

To boost growth now with more funding would allow the startups to drive valuations higher at the next funding round. But founders may be reluctant to return to their existing investors because the additional funding from them will be priced at levels from the last round of valuations. With this approach, founders get diluted at the same valuation, even though the business is doing better.

So they turn to venture debt. Given the volatile nature of these early-stage firms, the structure of venture debt from InnoVen tackles the embedded risk. Venture debt from InnoVen is 24 to 36 months in tenure and is structured so the company pays down the loan throughout the term.

"We don't do bullet structures, whereby all the money is due at the end of three years. That would put a little too much risk on us as lenders. It would feel that we're almost taking equity-like risks for only debt returns," said Mr Chao.

If compared to mortgage repayments in its structure, the venture-debt structure typically translates to an effective interest rate of about 10 per cent per annum.

Venture debt also typically comes with an option for the lender to take a small stake in the startup at valuations in its early stage of growth.

For example, a startup founder that raised a fresh US$5 million may then take 20 per cent of that through venture debt - or US$1 million - and that loan comes with the option for the venture lender to buy US$200,000 - 20 per cent of US$1 million - worth of shares, to be exercised in five to seven years, typically as a trade sale or IPO occurs.

But this equity kicker is also where venture debt firms have tripped up. Mr Chao points to several banks in Silicon Valley that have gone belly-up. Tempted by the potential rich valuations behind the equity kicker, they had underpriced the debt.

"My introduction to the venture debt business came from old guards from Silicon Valley Bank, from almost 20 years ago. The way they ran their business was a little bit different from the way people run venture debt today," said Mr Chao. "I've basically taken the old-school approach, whereby I'm focusing much more on the credit risk and the underwriting."

InnoVen in South-east Asia has an internal rate of return of 12-14 per cent, when the equity kicker is included.

To assess startups, InnoVen looks closely at the financial projections, and analyses how long a startup's existing cash is going to last. Startups that are likely to run out of cash in three to nine months are typically excluded.

InnoVen also looks at the purpose of the funding. Two out of three times, these funds are used to accelerate growth, be it in opening a new office, ramping up staff count, or to spend on research & development and marketing.

InnoVen then researches the team behind the startups, their industries, and their competitive advantage. Critically, InnoVen looks at the venture capital funds behind these startups.

"In times of stress, we want companies to be backed by people who will support them," said Mr Chao. "We've had cases where shareholder A thinks the company is going one way, and shareholder B thinks the company is going another way."

Out of 100 deals that InnoVen reviews, it takes on just about five. InnoVen has done some 35 deals in South-east Asia in all. It also has an office each in China and India. Across its three offices, it has provided debt to more than 170 companies.

"The first wave of our loans came due last year, and so we made it through the first cycle okay. That gave us a little bit more confidence. The team realises that the model works, and we should feel confident in what we're doing," said Mr Chao.

"We were comforted that we did not experience any defaults. It's bound to happen - we're in the lending business - but so far, it has not."

Asked about the staying power in the venture funding business, Mr Chao cautioned that the venture world can be painful without patience.

"In venture capital, it takes five years before you get your report card. But companies fail a lot quicker than the successes to be built. The younger generation is not used to waiting so long for feedback. But venture investing doesn't provide that instant feedback, unlike investing in hedge funds or in FX," he said.

"Cycles come and go. If you stick with it, time is more your friend than the enemy."

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