A unique moment for venture debt investing in Asia

MANY investors know venture capital (VC) well. Fewer are familiar with its unassuming cousin, venture debt.

The name itself feels like an oxymoron. “Venture” suggests an endeavour that’s daring and risk-on, while “debt” implies an instrument that’s less exciting and lacking in upside. The two make for strange bedfellows.

Yet as an asset class, humble venture debt has been growing steadily. Between 2015 and 2021, venture debt activity in the United States rose from US$17 billion to US$30 billion. Outside the US, venture debt remains under-profiled, but that may soon change.

A different form of startup financing

Venture debt is a form of private credit – a specific type of lending to startups. In a typical fundraising round, startups issue equity to VC investors in exchange for capital. In some cases, a venture debt lender comes along for the ride, either within the same round or not long after.

Startups must be generating revenue to be seen as suitable borrowers. Venture lenders might offer them 1- to 3-year loans, usually not exceeding 30 per cent of the venture capital raised.

This is termed “venture debt” to distinguish it from other types of loans. Unlike conventional bank loans, venture loans are extended even in the absence of two “C”s that banks want to see but startups tend to lack: sufficient collateral and cashflow.

Instead, venture loans are made on the basis of growth potential. That is why venture debt and venture capital go hand in hand, as VC funds have the necessary expertise to assess growth potential. Moreover, when VCs sign new funding cheques, they are boosting the chances that a startup’s growth potential will be realised.

For startup founders, venture debt is welcome because it lets them raise extra capital over the same period. They can put the money to work and realise business plans to a greater extent. Essentially, the firm’s growth is supercharged.

More importantly, the extra momentum does not come at the expense of diluting the founders’ shareholding – because this financing takes the form of debt, not equity.

Venture debt funds usually ask for warrants as part of the deal, giving them the option but not the obligation to purchase shares in the future, according to a pre-agreed formula. Warrants do represent dilution, but to a more limited extent. For venture lenders, warrants properly compensate them for the risk associated with a startup. The theoretical alternative to warrants is having much higher loan rates – but that may mean the loan no longer makes financial sense to the startup.

If all goes well, everyone gets what they want: Startups receive non-dilutive capital for turbo-speed expansion, while venture debt funds get a fixed-income return on investment, with modest potential upside.

Poised for take-off

Globally, the venture debt scene is most mature in the US, where the value of venture debt deals has generally been about 15 to 20 per cent of venture capital value in recent years. In Asia, that figure is less than 5 per cent, which suggests room for growth.

Why the differing levels of activity? First, the US has the largest global market for VC investments. A deep VC market is naturally conducive to the development of markets for ancillary or adjacent services, like venture debt.

Second, there are fewer venture debt providers in Asia. This means startups are less familiar with the idea of venture debt, because they do not come across many providers who offer it. This probably contributes to their hesitation.

Investors themselves do not have an abundance of choice for putting money into venture debt funds with proven track records. They therefore lack a grasp of how venture debt works, and as the saying goes: “You should only invest in what you understand.” In short, this may be a classic chicken-and-egg problem.

That said, the winds may now be starting to blow favourably for venture debt. There has been a general pullback in VC funding globally this year. In Singapore, too, VC funding fell 30 per cent in the first half of the year, compared with the same period in 2021.

The reduction in equity financing has put pressure on startups, who face shortening runways and widening funding gaps. This makes debt financing more attractive, especially since the word is now spreading to Asia from the US.

Even startups that can still raise venture capital might confront lower valuations, which means more dilution per dollar raised. Again, this makes venture debt – the non-dilutive alternative – seem worth exploring.

Among investors, VC funds too are looking less interesting than before. Investors are in more of a risk-off mood, and with the pathway to an initial public offering looking fraught with difficulty for the short to medium term, venture debt could become the sweet spot between growth and income. Furthermore, digital platforms are now able to fractionalise venture debt funds, giving access to a wider segment of investors.

In Singapore, awareness of venture debt is growing thanks to a government programme piloted in 2016. In Budget 2021, the Finance Ministry reiterated its commitment to the Enterprise Financing Scheme – Venture Debt programme, under which the government shares up to 70 per cent of risk with lenders for eligible venture debt loans.

This public-private partnership has served as a catalyst. As venture lending approaches critical mass, the hope is that, eventually, government support will no longer be seen as a decisive factor.

Every asset class has its day. The current market environment presents a unique moment for venture debt – from the point of view of both investors and startup founders.

If this non-dilutive form of debt financing gains traction in Asia and plays as significant a role as it does in the US, the startup ecosystem in Singapore and Asia will benefit from a richer tapestry of financing options.

The writer is chief executive officer of ADDX, a private market exchange backed by Singapore Exchange.