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Will venture debt be a white knight for startups in Southeast Asia?

In the wake of the COVID-19 pandemic, venture debt is set to boost its position in Southeast Asia’s startup ecosystem.

Image by Nattanan Kanchanaprat from Pixabay

Startups — a bundle of hopes and dreams, seasoned with brainpower and a heavy dose of uncertainty. Little wonder that venture capital and traditional financial institutions are especially careful when picking which startup to back, as nine out of ten startups fail, triggered by business plans without a solid product-market fit, marketing problems, and team breakups, according to a study by Startup Genome in 2019. This is even without considering the disruptive effect of the coronavirus pandemic, which has put entrepreneurs through serious challenges.

In a tech ecosystem affected by an uncertain environment, could venture debt, a  less mainstream form of debt financing, be a white knight to save startups in Southeast Asia?

Venture debt, a type of financing typically used as a complementary method to equity venture financing by early-stage companies and startups, first gained prominence in Southeast Asia around 2015 with the launch of DBS bank’s venture debt program, and Innoven Capital. In the US, however, it has long been a fixture on the market, with 35-year old industry pioneer Silicon Valley Bank (SVB) backing around 50% of venture-capital-backed companies with IPOs in 2017.

“Venture debt brings significant benefit as a complementary form of financing as capital that is almost equivalent to equity without dilution. For small and medium enterprises (SMEs), debt capital can also bring an optimum cost of capital,” said Jeremy Loh, co-founder and managing partner at Singapore-headquartered private venture debt firm Genesis Alternative Ventures. Previously, Loh and his partner had led DBS bank’s pioneering venture debt initiative, Venture Growth Partners between 2015 and 2018.

Paul Ong, director at Innoven Capital, which was formed when Temasek acquired the Indian arm of Silicon Valley Bank, added that the demand for venture debt has skyrocketed in the aftermath of a slowing private market activity due to the pandemic’s effects, boosted by the still uncertain markets.

For example, pandemic-induced travel restrictions posed challenges to investment. “Activity in Q2 was fairly strong, but closings will be more challenging for Q3 and the remainder of the year. Many funds are finding it difficult to complete the necessary due diligence, [to initiate or close deals]” said Ong.

According to Startup Genome, global venture capital (VC) funding dropped 20% since the coronavirus crisis hit in December 2019, while a tracker maintained by Layoffs.fyi indicates that 574 startups have laid off a total of 79, 313 employees since the coronavirus was declared a pandemic on March 11.

“Many startups were clearly negatively impacted by COVID-19, but some do believe that the pandemic is just a temporary hit to their numbers and do not believe that they should be taking a significant valuation discount. In contrast, investors now feel that valuations should be managed, which is stalling deal flow. Startups think that if they need capital, why not get it from a source that doesn’t peg it to valuations?”

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Separating the wheat from the chaff

Still, restrained valuation pressures by no means indicate that venture debt is an easy route. “Because demand has gone through the roof, venture debt providers have to be more conservative and selective in picking which startups to fund,” Ong affirmed.

“We don’t carry out company valuations ourselves. We are primarily lenders that focus on managing our return profile on interest. We note the company’s ability to repay, and we analyze a large number of data points to decide how to put in guard rails in terms of loans. But still, we wear both a creditor and a VC hat. Our risk management analysis is significantly more nuanced than banks, which may run numbers through a system that can tell you whether something can be done and at what price.”

For Loh, he looks specifically at companies within the business-to-business (B2B) vertical, which might be less impacted by COVID-19. “We do our own bespoke due diligence process on each company. [To enter a deal with these prospective partners,] we need to be comfortable with their company’s business model, technology, and their shareholders,” Loh explained.

Jeremy Loh believes in the power of bespoke financing packages for worthy startups. Courtesy of Genesis Alternative Ventures.

General financing parameters in venture debt have not changed much, despite recent variability in demand and market conditions in wake of COVID-19, according to Loh and Ong. Genesis Alternative Ventures typically funds between USD 1 to USD 5 million dollars, while Innoven Capital typically carries out a 20% funding round with loan durations typically among two to three years long, similar to pre-COVID financing structures.

Both venture debt providers emphasized that their general funding structure and terms remain sensitive to the company’s purpose. In addition, bespoke conditions may be offered to tailor to each company’s circumstances.

“We wouldn’t say that we are more ‘hot’ on certain sectors,” says Ong, “but we do like to look at companies who seem to be at the top of their fields, or that have grown despite the COVID-19 happening. Such companies could be very well funded, and we would like the opportunity to bolster their cash balances, get room for growth, and ultimately get further ahead of the competition.”

Solid partners are crucial

Founders new to the concept may wonder — is it possible for startups to obtain venture debt financing without having prior support from equity financers? “Venture debt always occurs concurrently with an equity financing round. If a company is not raising money from investors, then venture debt is not designed from this kind of deal structure as we want to be part of a total financing package,” says Loh.

“Without venture capital, it is a little too early for us. To connect that early [in the firm’s life cycle], we need venture capital. For early-growth companies, leveraging debt alone is not sustainable because the debt-to-equity ratio is too high. Venture debt is best suited after raising an equity round.”

The tight-knit nature of the startup ecosystem means that more than not, prior equity interest is a good signal on market expectations for private companies. “The private markets ecosystem relies greatly on asymmetrical information, so we do our best to communicate with investors, industry insiders, and customers to get a better picture of each company’s health and prospects,” suggests Ong.

“We are part of the ecosystem and we look to the quality of institutional investors tied to the company we want to invest in,” he added.

Research also points out to synergies between venture debt and equity deployment. A report published in July 2020 by Davis, Morse, and Wang on venture debt in Silicon Valley suggests that taking on debt in early-stage firms increase entrepreneurs’ “skin-in-the-game,” with founders becoming more sensitive to the rewards and risks associated to their own strategic choices. 

Venture debt is also preferable from a VC’s perspective, as entrepreneurs do not dilute their ownership stake in exchange for capital. This preserves the alignment of interest between entrepreneurs and their companies, incentivizing entrepreneurs to implement high risk and high-value strategies that have the potential to increase returns for VCs.

Still, startups bereft of prior equity financing need not despair, according to Ong. “We are happy to speak to any entrepreneur out there. We see ourselves as part of the ecosystem and do want to uplift it as much as possible. We try to help everyone we talk to in some shape or form, even if it is redirecting them to partners more suitable to financing them, or even other business partners that can help them even outside of their capital needs.”

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Where is the industry headed?

“Venture debt is going to explode in Southeast Asia,” according to Dave Richards, co-founder and managing partner of US-based Capria Ventures, which ventured in the region when it invested in Genesis Alternative Ventures in June 2020.

“If you look at the US, [venture capital] it is very developed. In India, it is also quite developed, while in Southeast Asia it’s very nascent. This is proven in the US, China, India, it’s a form of very important capital for fast-growing businesses,” said Richards to KrASIA.

Loh is similarly optimistic. “Taking a leaf out of the USA’s book, we believe that venture debt will play a bigger role in the future because it will grow in tandem as the venture equity market grows. In fact, we announced another deal just last week, and there are several specific use cases for venture debt.”

Yet, despite the arguably increasing popularity of venture debt in Southeast Asia, it is yet too early to conclude that this will become a mainstream form of financing for startups, even with COVID-19 as an accelerator of change, and promising venture debt providers like Innoven Capital and Genesis Alternative Ventures in play, according to Ong.

Read more: ‘Venture debt is going to explode in Southeast Asia’: Q&A with Dave Richards of Capria Ventures

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“I do not necessarily think COVID-19 will make venture debt more mainstream…it will help make founders more aware of this as an option, but not necessarily become more mainstream. Rather, it will become more top of the mind as a synergistic tool to raise equity capital,” Ong explained.

For now, venture debt players in Southeast Asia are more collaborative, rather than competitive, according to Ong. Instead of focusing on competing for slices of the pie, the overarching goal is to grow a bigger pie for all by educating the market first.

From Ong’s point of view, there is still a long way to go for venture debt to take off in the region. “The US has nearly 30 to 40 years of head-start in market understanding, while India, we have already been there for 12 years. In these two markets, venture debt as a tool for financing startups is much more prevalent, and founders will know what to do when it comes to reaching out, finding benchmarks, and speaking to more than one player.”

“So, in Southeast Asia, a lot more market education is required. The best is yet to come, and the relationship in our industry is now more collaborative, because a rising tide lifts all boats,” Ong suggested.