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Venture debt fills important funding gap, says InnoVen; but it may lower valuations

Trinity Chua
Trinity Chua7/3/2017 08:00 AM GMT+08  • 7 min read
Venture debt fills important funding gap, says InnoVen; but it may lower valuations
SINGAPORE (July 3): GuavaPass, the start-up that sells fitness centre subscriptions, is profitable and could probably raise equity from venture capitalists quite easily. But the KFit rival prefers to take on debt. “It is less expensive than equity,” s
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SINGAPORE (July 3): GuavaPass, the start-up that sells fitness centre subscriptions, is profitable and could probably raise equity from venture capitalists quite easily. But the KFit rival prefers to take on debt. “It is less expensive than equity,” says Robert Pachter, GuavaPass’ co-founder. And, taking on debt allows the relatively young startup to grow without further dilution.

Pachter is not the only start-up boss opting to take on debt. Given the low interest rate environment, debt is relatively cheap. Venture investors may seek returns of between 20% and 30% a year, but venture debt interest rates typically hover around 10% to 15%, says Adrian Chng, co-founder of venture capital (VC) firm Fintonia Group. As such, Southeast Asian startups are increasingly turning to this form of fundraising. This year, Indonesian hotel booking site RedDoorz raised $1.4 million in venture debt. Malaysia-based stock photo start-up 123RF, Thai e-commerce platform Pomelo and local digital media firm Conversant Solutions also took out venture loans.

The growing demand is good news for the likes of InnoVen Capital, a venture debt provider that is partially owned by United Overseas Bank and Temasek Holdings. Chin Chao, who is the Singapore and Southeast Asia CEO at InnoVen, says venture debt is filling an important funding gap in the local market. “Most scenarios are like this: The company has just raised funds, and three months later they find new opportunities that [they did not plan for]. If they raise another equity round so soon, they are unlikely to get a higher valuation. So, they turn to debt to minimise dilution.”

This was the case at RedDoorz, which took on debt to expand in Southeast Asia. “It could help to get a higher valuation for high-growth start-ups like ours, as we could raise a smaller equity round, then leverage the venture debt to get to the next milestone,” says RedDoorz founder Amit Saberwal.

InnoVen’s loan transactions totalled US$70 million last year. This year, InnoVen has lent out US$40 million ($55 million). The company, which has operations in India, Southeast Asia and China, has reportedly loaned out more than US$225 million across some 150 transactions. Loan sizes average around US$1 million to US$2 million per start-up, and InnoVen charges between 9% and 16% interest a year.

Chao thinks there is room for the industry — and InnoVen — to keep growing. “In developed markets, venture debt can range from 5% to 15% of total VC investment,” he says. “In Southeast Asia, we’re still [nowhere close]. We expect to do 40 to 50 deals in India and 20 transactions in Singapore this year.”

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Understanding start-ups

There are relatively few venture debt players here, and nearly all of them are linked to major banks. UOB launched a venture debt programme in 2014, followed by DBS Group Holdings in 2015. All three of the locally listed banks have also partnered SPRING Singapore to launch a $500 million venture debt scheme.

InnoVen, the former India-based venture arm of SVB Financial Group, was acquired by Temasek and UOB in 2015 for US$48.1 million. Temasek and UOB subsequently put in US$100 million each into InnoVen. But while InnoVen is linked to a bank, it does not operate on quite the same rules. Start-ups do not need to post collateral for loans. And, characteristics that might disqualify a company for a local bank loan — such as having all its operations overseas with only a local holding company — would not necessarily disqualify a start-up.

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“In stressful situations, when a lender gets nervous, the first things they do are to pull the line and call back the loan,” says Chao. “But we understand start-ups, so we don’t get nervous when cash balances go quite low or businesses pivot.”

Venture debt providers also act as part lenders and part dealmakers for start-ups. Both DBS and InnoVen say they link start-ups to potential partners and investors all the time. “Inno- Ven Capital was very proactive in helping us meet partners in China, Japan, Malaysia and Indonesia,” says GuavaPass’ Pachter. “We’re in conversations with some of them [to be our potential investors].”

Loaning money to start-ups is risky. Chao says to mitigate risk, InnoVen mostly deals with start-ups backed by venture capitalists with a healthy cash runway of 12 months.

“We evaluate the existing shareholders’ ability to follow on. Most seed investors will stay on in Southeast Asia because the increase in valuation is not enough to get people to sell. They are likely to sell only in a Series C or D round,” he says.

The reward for the banks behind the venture debt programmes, meanwhile, is the ability to build new business relationships. “Startups receiving venture debt offered by banks will establish early relationships with banks and potentially obtain preferred banking support,” says Hau Koh Foo, director of the Institute for Innovation and Entrepreneurship at Singapore Management University.

Drawbacks for start-ups

For now, SMU’s Hau thinks the growth of the venture debt ecosystem will be limited. “In the region, many are first-time entrepreneurs. They are likely to exit at the first chance of securing their pot of gold. So, I think deal flows for venture debt could be limited until the ecosystem becomes more mature,” he says.

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InnoVen’s growth will depend partially on its ability to continue persuading start-ups to take on venture debt. There are still quite a few criticisms of this form of start-up funding.

“The reality is, no equity investor would like to buy into a company that is highly leveraged,” says Rachel Lau, co-founder of private investment firm RHL Ventures. “We do not invest in companies that are more than 20% leveraged since that would affect the company’s valuation.” InnoVen says it typically limits its loans to 20% of the value of a start-up’s last funding round.

Having debt on its books would also negatively impact a start-up’s cash flow, says one local start-up founder. Money that could be used to expand the business or pay salaries would instead have to be used for monthly interest fees or loan repayments.

SMU’s Hau says start-ups may also be constrained by the debt. “The key shortcoming of venture debt is that the covenants may reduce the autonomy of a start-up in executing its strategy,” he says.

But Chao argues that the industry fills a gap in the start-up ecosystem. His involvement in venture debt dates back to 1999, when Keppel TatLee Bank collaborated with VC firm TDF Management to set up the Keppel TatLee Tech- Financing Centre. The collaboration offered financing to technopreneurs and technology ventures without requiring collateral. Chao, who was at the time a managing director of Venture TDF Singapore, was among the co-founders of the TechFinancing Centre and also served as a key member of the management team.

The programme was dismantled after Oversea-Chinese Banking Corp acquired Keppel TatLee in 2001. Since then, Chao has founded his own VC: Sirius SME. Among the companies he invested in were Reebonz, an e-commerce platform focused on luxury goods that is reportedly considering a Nasdaq IPO; and Jason Parquet, which was listed in 2012 and has since been renamed Jason Holdings.

Two years ago, after ownership of InnoVen changed hands, Chao was asked to help run the company. The same conditions that led him to enter the venture debt scene then still exist. “Without venture debt, existing investors will have to continue to fund the company until it gets bought out,” he says. Companies such as InnoVen give start-up founders an additional option.

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