There are many ways to raise funds to grow one’s business. Yet, more often than not, many companies are still grappling with the challenge of securing enough funds to propel their business to the next level.
For the majority of the start-up founders with whom we have worked with, securing funds to expand their business has traditionally comprised of equity crowdfunding from trusted partners and friends (commonly known as “equity fundraising”) and/or plain vanilla debt (also known as “conventional loan” or “secured lending”) from financial institutions.
However, a key challenge that comes with plain vanilla debt is that most financial institutions require a due diligence process that demands a certain level of confidence in the company’s viability and financial health (usually measured in terms of, among others, historical profits, earnings visibility and cashflow) or the availability of tangible assets (such as land or properties) as collateral for the loan.
For young companies that are still in the midst of growing its cashflow and assets, this proves to be a chicken-and-egg situation where the challenge remains today.
As for equity fundraising, aside to its many advantages, entrepreneurs may need to be mindful that using equity to raise funds could lead to an irreversibly high cost of capital in the long run as the company’s valuation increases over time (ie. cost of equity increases). In most cases, the cost of capital could end up being disproportionately larger than the original value of the funds raised in exchange for equity (as illustrated by our case study below). Therefore, on an absolute returns’ basis, debt is always cheaper than equity.
Fortunately, with the maturing Malaysian fundraising scene where sophisticated business intelligence tools and know-how are increasingly utilised by industry players to formulate the most optimum funding strategy (ie. through various cloud-based platforms designed to track growth and operational metrics), entrepreneurs are starting to diversify their fundraising options with venture debt to complement their equity plans.
What is venture debt?
Venture debt is a form of debt financing that is typically used as an alternative fundraising method to equity financing. But unlike equity-based instruments, using debt financing reduces dilution of the equity stake held by a company’s existing investors and stakeholders, including its employees.
HIGHLIGHTS:
- Venture debt is commonly used a complementary fundraising method to traditional equity financing, where capital funding is obtained in exchange for shares in the company.
- It is a form of a less-dilutive funding (ie. loan) for early-stage high-growth companies.
- Due to the inherent risk that lenders are subjected to (given the lack of collateral or financial track record that most traditional lenders are accustomed to), many venture debt providers include the option for warrants in the deal, which may be exercised (by the lender) to purchase equity in the borrowing company (up to an agreed percentage of the debt amount) to help balance the economics for both parties in the venture debt.
How much could an entrepreneur miss out on if too much equity is given out upfront?
The numbers vary depending on the commercials and in a practical example laid out below, initial shareholders could lose out as much as 50% of their equity value for not optimising their capital right early in their journey.
Scenario A: Company A equity funding without venture debt
Say for example, Company A would like to raise RM4 million in a Series A equity fundraising and a subsequent RM10 million in Series B equity fundraising over a period of two (2) years with an eventual 25% equity dilution from each series, Company A’s founders will end up holding just 56.25% of the diluted equity shareholding after completing their Series B fundraising, valuing their stake at RM22.50 million (please refer to the table and chart below).
Scenario B: Company B’s equity funding with venture debt
Say for Company B, if one-third of the required funds can be replaced with a venture debt facility (typically for early-stage high-growth enterprises with corresponding unit economics) without compromising the targeted capital funding required from each funding series, it will reward founders with a much lesser equity dilution and result in retaining a higher overall ownership of 66.93% (valuing their stake at RM24.54 million, with an implied positive increment in the equity value of the stake held by the founders of about RM2.04 million over a period of two (2) years) – compared with Company A (please refer to the table and chart below).
What is Liquidation Preference?
Liquidation preference is essentially a clause in a contract that specifies the payout order for debtors, investors and stockholders in the event of a trade sale, initial public offering (“IPO”) or exit. Liquidation preferences are usually included in venture debt contracts as a form of downside protection in the event of less-than-expected returns from the sale of the company.
Venture debts are often at the top of the preference stack (ie. the loan amount is repaid ahead of other instruments, subject to negotiated provisions among funding partners), thereby safeguarding the amount invested by the venture capital firm.
Scenario A: Company A’s liquidation preference without venture debt
As shown above, scenario A (without venture debt) will result in RM14.00 million worth of liquidation preference from equity funding (ie. RM4.0 million from Series A and RM10.0 million from Series B), followed by distribution of proceeds to equity holders (ie. RM14.63 million to founders with a stake of 56.25%, RM4.88 million for Series A equity holder of 18.75% and RM6.50 million for Series B equity holder of 25.00%).
Scenario B: Company B’s liquidation preference with venture debt
As illustrated above, Company B will have a repayment of only RM9.34 million to equity investors (ie. RM2.67 million from Series A and RM6.67 million from Series B), and a markedly higher equity value for its founders at RM20.52 million with a stake of 66.93%, followed by RM5.57 million for Series A equity holder of 18.18% and RM4.57 million for Series B equity holder of 14.89%.
Summary
In short, a 1x multiple with full participating preference (all equity fundings are repaid in 1x multiple) – without venture debt – would mean a lesser equity distribution of RM5.89 million to founders in the event of a trade sale of the company [ie. equity value for founders of Company A after trade sale @ RM14.63 million (no venture debt) compared with Company B @ RM20.52 million (with venture debt)], on top of the RM2.04 million opportunity cost arising from unnecessary equity dilution during the early growth stage of the company [ie. equity value for Company A’s founders at RM22.50 million at 56.25% post-Series B equity funding (no venture debt) compared with Company B’s founders at RM24.54 million at 66.94% (with venture debt)].
A simplified aggregate of RM7.93 million of “loss” in proceeds from trade sale (combining RM2.04 million from equity dilution and the RM5.89 million from the impact of liquidation preference) is shouldered by initial shareholders or founders of the company before raising a Series A funding works out to approximately 66.08% of their initial RM12.0 million value of the company’s shareholding.
What’s the catch then?
As the name implies, venture debt is a form of debt. While debt is typically the cheapest form of capital funding that entails a tighter covenant (ie. agreed lending conditions) and is applicable under more restricted use cases (generally applied to businesses with highly ‘sticky’ and predictable revenue stream(s)), the trade-off that entrepreneurs and business founders can appreciate is that it helps them optimise their shareholding (ie. reduce equity dilution) and thereby ensure that they continue to have a high level of incentive to run the business (through sustaining a higher equity ownership and value over a longer period), as well as a lower payout to equity investors in the event of a trade sale when used in conjunction with equity funding.
Often overlooked but no less important – company owners would also have to ensure that their management and operations team are well prepared and equipped to adhere to the fiscal discipline that comes with venture debt (ie. monthly repayments), while maintaining a healthy working capital buffer at all times.
OSK Ventures International Bhd has been the capital provider of choice for many of our partner-entrepreneurs. Let’s keep the conversation going and speak to us to find out if your business is ready for accelerated growth.
OSK Ventures International Bhd is a Malaysia-based investor with more than 20 years of investment track record. We support our exceptional founders in their entrepreneurial journey with timely capital and put their business on a value-added platform.
OSK Venture has launched a new venture capital investment fund that invests in fast-growing companies and scalable businesses engaged in high-demand sectors. If you’re keen to be part of our success story as an investor, please reach out to us today.
Let’s keep the conversation going and contact us to find out if your business is ready for accelerated growth.
Have more questions? Get in touch with us:
Jimmy Tham
Investment
T : 03-2161 7233
E : contact@oskvi.com
