Why startups are walking in the venture of debt, By Rarzack Olaegbe

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How #EndSARS ended fintech’s finest year, By Rarzack Olaegbe
Rarzack Olaegbe

Hyper loops burst onto the scene in 2013. Elon Musk detailed a new type of train service in a low-pressure tube that would reach speeds up to 760 mph. The train would float on a cushion of air and be powered down the tracks by magnets. Musk didn’t invent everything from scratch. He took existing ideas. He re-packaged and rethought them. He did this, hoping to carry humanity towards a brighter future. But critics aren’t yet entirely convinced the new Hyperloop thinking can solve old issues.

Here is why. Magnetic levitation was already used on high-speed trains in Japan and Germany. Besides, low-pressure pneumatic tubes have been used to move objects since the early 19th century. But, combining the two would, Musk insisted, make higher speeds possible. Trips between the county lines of Los Angeles to San Francisco would take 35 minutes. It would be much cheaper. It would be faster. It would be faster than high-speed rail.  Hyperloop is novel. But rail is not novel. Hyperloop is interesting. But it is also an old idea.

The professor of a Carnegie Mellon University, Molly Wright Stevenson who studies technology, communications and design said in a CNN Business report that, “we still face a lot of the problems we faced in the 19th century. We’re trying to get people very quickly across time and space. But we still have to contend with traffic.” He is quite right. All of us are contending with traffic. But Fintech startups are confronting different traffic. They are battling with a lack of equity funding. The outbreak of the Covid-19 has turned things topsy-turvy. Startup founders are holding the short-end of the stick. They are under pressure to raise capital for their businesses. They are not getting the finance they expected from venture capitalists.  Equity funding is in short supply. Because of this gap, they are forced to walk the route of venture debt. Now, that is the new normal.

he outbreak of the Covid-19 has turned things topsy-turvy. Startup founders are holding the short-end of the stick.

Many startups have been walking in the valley of venture debt in the last six months. For instance, music streaming app, Gaana, has raised $51 million from Tencent and parent company, Times Internet. Grocery delivery unicorn, Bigbasket also raised $3.5 million from Trifecta. Cloud kitchen startup Rebel Foods got $4.9 million from Alteria Capital. This year alone, a total of $841 million has been paid to startup founders as debts. Last year was four times lower. With the raging Covid-19, startup founders lack contingency plans. As such, they are going cap in hand, begging for handouts. Although venture capitalists are not showing interest because they want a higher return on their investments.

On the one hand, giving a loan to a startup founder carries a lower risk. It guarantees double-digit returns. The high return, it has been discovered, has caught the attention of high net individuals. Another party, the traditional bank, is also interested in the game.  Ordinarily, the banks don’t lend to startup founders. This is obvious. A startup founder has little to offer. What he has does not interest the banks. He has an idea. He has his codes. He has talent. The banks cannot accept talent as collateral. The bank wants assets. The bank needs guarantees from the company directors. A bank needs concrete items; not codes, not lines, not insights.

Anyway, the founders cannot give personal assurances. Besides, most of the board directors of startups are venture equity people. So a startup is not an ideal fit for bank loans. In some cases, the high net individuals favoured equity investments in startups. Despite the higher risk, such equity investments have fetched an average return of 15 to 18 per cent. Now, it has been discovered, venture fund managers are persuading the moneybags to walk the debt avenue. Why not, the risk is lower. The return is high. Another key reason that is pulling the moneybags to venture debt is that the Central Banks in emerging markets have cut their rates in the last 18 months.

According to CNBC, the US Federal Reserve have “cut interest rates to essentially zero” to shelter the economy from the effects of the Covid-19.  Reuters also reported that emerging market policymakers have slashed interest rates, “taking their lead from major central banks including the U.S. Federal Reserve and the European Central Bank. They are joining efforts to shore up their economies.” The report added that Central Banks across a group of 37 developing economies have rate cuts.

Therefore, this means that the return from fixed-income assets would not be attractive to the moneybags. On the other hand, if the moneybags go for fixed deposit, inflation would erode its value. The next option is venture debt.  Well, in the game of venture debt, can startup founders hold their own? Can they deal with multiple stakeholders taking control of their financial resources? Research has shown that in India, about 90 per cent of startups failed in the first five years.

As it stands, startup founders are cut in two. One sources fund from private equity. The other gets it from venture debt.

So, why are the startups walking the valley of debt? According to research, the equity versus venture debt funding boils down to one factor: the risk and return on capital for investors. Venture capitalists fund promise returns in the range of 30 per cent to 40 per cent. But you are not sure about that. Venture debt is lower. But repayment is a guarantee.  “Venture debt is best when you are taking it for the purpose of enhancing growth by way of plugging in as working capital,” Ashish Fafadia, the chief financial officer of Venture Capital firm Blume Ventures said in a media report.

Besides, most startup founders pursue venture debts because they do not want to dilute the equity in the company. They do not want to have multiple stakeholders. They reasoned that it is not healthy for the future of the nascent company. So, they accepted debt financing to “extend the cash runway” before raising the next venture capital round. Venture debt is a gateway to bigger rounds, especially, if they can prove that they have been able to keep the revenue steady and had regularised returns for their venture debt investors.

With venture debt becoming a trend to avoid multiple stakeholders, will it act as a force multiplier for startups? Will it make them pawns in a game that’s not in their interest? I don’t know. But it is known that Europe and Silicon Valley is no longer the leaders. Singapore and Beijing have taken over. Ant Financial is an example. Besides, emerging markets are growing fast. Fintech in this market are filling unmet needs rather than disrupts. Based on this matter, and the Genome’s report, I spoke with a seasoned Fintech expert.

He is an executive director in one of the top three leading Fintech firms. He told me that Africa is where the idea resides. That is why more foreign venture capitalists are coming with outstretched hands. They are in Nigeria with a bulging briefcase. They are here to fund ventures; not give venture debts. However, Nigerian venture capitalists don’t play that game, too. As it stands, startup founders are cut in two. One sources fund from private equity. The other gets it from venture debt. Well, they both solve the same problem in a totally different way, like the Hyperloop train.

*Olaegbe (psalmsonolaegbe@gmail.com,  Tweet @RarzackO   Skype:rarzackolaegbe)

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