Venture Debt : Good, bad or ugly?

DBS has just launched Venture debt for tech startups in Singapore. I think this is a first by any Asian Bank and a new product for SE Asia. Silicon Valley Bank (SVB) has been active in India and China but they don't have any presence in SE Asia. Here is the link to DBS' announcement - http://www.dbs.com/newsroom/DBS_launches_venture_debt_for_tech_start-ups_in_Singapore

Startup community in Singapore has welcomed the move and rightfully so, this opens up options for many startups. However, before jumping on the bandwagon, startups and VCs need to clearly understand its pros and cons. 

The Good : Venture debt

• Extends the "cash flow runway" for the company and makes it easier to achieve the next valuation milestone
• Venture lending represents a less dilutive type of financing than venture capital financing since venture lenders generally require less of an ownership position
• Venture lenders typically take less of an advisory role in its portfolio companies and do not serve on the corporate board of directors

According to SVB website, the best time to raise venture debt is in conjunction with or immediately after raising a round of equity, i.e. when there is the most capital in the company.  It can be done at other times, but often with less favorable terms. Venture lending is appropriate at the following times:

• As part of a funding round where, for example, rather than raise $10 million in a funding round, a company can raise $7.5 million in equity and $2.5 million via venture debt
• To extend cash runway when a company knows that it will need to raise another funding round in 12 months, but would like to extend that timeframe to 18-24 months
• As the last round before an exit instead of, or in addition to, an internal round where taking venture debt will help the investors/promoters receive roughly the same amount with less investment on their part if a venture loan is taken to top up growth capital
• As working capital in a situation where even though a company has sufficient operating cash, it needs cash for working capital and can extend its resources via a debt facility
• To finance purchase of equipment or finance office expansions and buildouts, for which equity would be a more expensive alternative

For startups in Singapore, DBS bank has put in these following criteria:

• Must be strongly backed by DBS’ partner venture capitalists. 
• Should have raised at least SGD 1 million of Series A funding
• Be incorporated for at least two years, be in operation for at least one year and have demonstrated that their business model is commercially viable.

In simple words, that means DBS is prepared to come in as early as immediately after Series A round.  They are basically relying on the ability of their partner VCs to assess the startups that are commercially viable. Startups that have the confidence to reach inflection points can make good use of this Venture debt. Leverage can amplify the returns for all shareholders.

So what is NOT so good about this Venture debt?

1. Accepting Venture debt too early

Accepting venture debt too early in the life of a Startup is risky. Leverage is a double edged sword. It good times it can improve returns for all but in bad times it can cause more harm. In case the Startup fails to reach its inflection point, it might become nearly impossible for the debt loaded Startup to raise follow on funding from other investors or pivot. It is best when debt is used to fund organic and inorganic growth at later stages. 
  

2. Covenants and other default clauses

It is also important to learn how DBS writes its loan covenants. In case, the business growth is not as expected, the bank might recall its cash when the startup needs it the most. It is hard for banks to behave like VCs. “Material adverse change” and other “subjective default clauses” can allow a lender to recall their loan due to events beyond the company’s control (e.g., an existing equity investor deciding not to participate in a future round).

3. Using venture debt financing as a last resort

Venture debt doesn't suit a company which is unable to raise follow on equity financing and expected to run low on cash. This would over burden a non performer and eventually make it harder to turn around. 

To conclude: We would have to wait and see the details of terms and conditions DBS is going to propose. Assuming that they are at par with SVB, venture debt is a strong option for venture-backed companies who want to add capital and minimize dilution. Though more expensive than traditional working capital lines, venture debt offers far greater flexibility. However, excessive debt or loans with heavy restrictions can be detrimental to a business, and the terms of any potential financing should be considered carefully.