Analyzing and weighing the odds

And even for startups with relatively steady cash flows, debt can be a bit of a touchy topic. Because they know their cash flows are deceptive, at best, and won’t stay the same.

Imagine a ride-hailing company that has to give out more incentives for driver-partners because drivers threaten to jump to a competitor. It looks healthy one month, and the next thing you know, expenses go up, payments don’t come on time, and it goes into a downward spiral.

Utilizing digital technology

Which is why Ezetap, which makes point-of-sale or card payment devices, stayed away from taking on venture debt. Even though the company is well-funded and counts the who’s who of venture capital as investors—from Social Capital to Jonathan Soros. In 2017, when the company was evaluating venture debt, CEO Byas Nambisan (then the CFO) felt it was an unnecessary expense even though they wanted to expand their manufacturing capacity.

“We were in between fundraisers and the idea was that we can reduce the amount of stake we had to dilute by opting for debt. But I wasn’t comfortable with my operating costs going up. So we decided not to take it,” says Nambisan. Ezetap’s bank clients, he says, don’t always make timely monthly payments, leaving his cash flows less certain than needed for regular debt payments.

And sometimes, it is not all about the math on paper.

On paper, equity is a costlier form of capital than debt. While the cost of venture debt after tax deductions is about 10%, the “notional” cost of building a business via equity would be about 30%, estimates Trifecta Capital’s Kothari. And with equity deals, founders obviously have to part with valuable stakes in their companies.

But the reality is a little more complicated, especially for startups able to raise Series B or later rounds ($5 million-plus investment rounds, usually).

Right now, there are far more venture capital funds chasing Series B deals than there are “fundable” startups. The demand-supply mismatch, if you will, has seen startup valuations shoot up. This means that founders can part with a smaller stake for the same funding—reducing the cost of the capital to the point where venture debt’s relative cheapness isn’t attractive enough.

Making up with the unit economics

Moreover, debt makes sense if a company has nailed its business model and unit economics. Then it can be the fuel that will deliver predictable growth. But in India, there are few companies, even among late-stage startups, who have managed to do this by the time they hit Series B or C. This means capital is used for business model discovery. Something which venture debt funds find risky.

“We don’t invest in concept-stage companies. That kind of risk is for equity investors,” says Kothari.

All of this has made debt tough for startups to reconcile with. “Founders historically have developed a framework for using equity to grow. But debt comes with commitments to payback and they have a personal obligation (which is fair), making it harder to the stomach,” says Ashish Fafadia, a partner at Blume Ventures.

It explains why for some like Hari Menon, co-founder, and CEO of online grocer BigBasket, the rules for taking on debt are almost set in stone. Menon, a seasoned entrepreneur of 20 years, believes equity should be used to fuel growth and debt is for capital expenditure or working capital needs.

What is equity?

“Equity is the best way to double down on growth needs because you need large sums of it, something you can’t do with debt,” he says. BigBasket took debt only after its Series D round in 2016 when it had demonstrated the ability to generate consistent cash flows. And then too, it took less than $50 million, compared to the $886 million it raised.

And while Menon says BigBasket is in a position to take on more debt now, there’s another hurdle—there’s still not much venture debt capital.

Larger companies can get larger ticket sizes of debt only when the corpus of venture debt funds can grow to be much larger and portfolio diversification is possible, says Alteria Capital’s Murali. Today, Alteria is in the process of building a Rs 1,000 crore ($145.7 million) corpus, Trifecta, a Rs 1,500 crore ($218.5 million) one.

But the way venture debt firms in India operate and are structured still holds them back.


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