Demystifying Venture Debt with Ajay Hattangdi Managing Partner Alteria Capital

Ajay Hattangdi is the co-founder & Managing Partner at Alteria Capital.

Ajay is one of the early pioneers of the Indian venture ecosystem and has worked with startups for over 20 years. He started the country’s first venture debt program in 2005.

He is currently the co-founder and managing partner at Alteria Capital. Prior to co-founding Alteria Capital in 2017, Ajay was the founding CEO of SVB India Finance, India’s first and largest provider of alternative financing solutions to venture backed companies. He led SVB India as CEO from 2007 through a buyout in 2015 following which, SVB India was renamed InnoVen Capital.

Through the next phase of his work at InnoVen Capital, he was responsible for introducing venture debt in other markets in Asia, having set the strategy and supervised the Group’s expansion into South East Asia and China

Listen to the podcast to learn about

1:31- Ajay’s journey from Citibank to Alteria Capital

2:38- What is venture debt?

4:45 - Value proposition of Venture debt

7:30 - Where can you use Venture debt

8:30 - What is the right time for an entrepreneur to think about Venture debt

12:00 - Assessing a company looking to raise Venture debt

14: 34 - Best time for a company to raise Venture debt

17:38 - What are the downsides of taking venture debt

19:25 - How a venture debt firm evaluates

23:40- What are the interest rates, equity warrants, duration

27:11- Myths and misconceptions about venture debt

Read the complete transcript below

Amit Somani 1:07

Welcome to the prime Venture Partners podcast Today we have with us Ajay Hattangdi, Managing Director of Alteria Capital, a venture debt firm based out of India. Welcome to the show Ajay.

Ajay Hattangdi 1:18

Thanks for having me Amit.

Amit Somani 1:19

Ajay you’ve been around, doing this for a while, almost 15 years. Silicon Valley Bank, which is known as the kind of legendary firm that started this whole venture debt category. Can you tell us a little bit about your journey here in India?

Ajay Hattangdi 1:31

Sure. So I actually started doing venture debt, before I started with Silicon Valley Bank at Citibank. And that was kind of a five year mission to get it started. And finally, got it started in 2005. And then I ran that product for Citi for two years. And then at the end of 2006, I decided to leave to start NBFC for Silicon Valley Bank, there was kind of the first initiative that Silicon Valley Bank had outside the US.

And then I ran that business for about 10 years. Along the way, we did a buyout to the business, renamed it Innovent Capital in 2015, got Temasek and UOB Bank in as investors and subsequently left in 2017 to start Alteria capital. And my co-founder, Vinod Murali and I came out together from Innovent, launched Alteria and that’s what we do today.

Amit Somani 2:26

Wonderful. I think so let’s talk a little bit about what venture debt is. A lot of entrepreneurs and listeners are perhaps not very familiar with this, and some of them maybe, can you just give us a quick overview of what venture debt is?

Ajay Hattangdi 2:38

Yeah, sure. I mean, look, the historical definition of venture debt was actually venture leasing, because that’s how it started originally, in the early 80s. When a leasing company that is doing equipment leasing basically got into providing that to the startup as a way of helping them finance the growth. Today, however, that definition has expanded a little bit to mean any form of debt financing that’s provided to a company that is still dependent on venture capital financing to fund this operation.

So literally speaking, it covers a bunch of typical uses. So there is, equipment financing or it can be used for financing equipment or can be used for general corporate purposes, which is a euphemism for saying financing anything, it could be used for financing revenue growth of a bridge between equity rounds, or for even refinancing existing debt. Perhaps the best way to illustrate what this is with an example, just taking some numbers here. So let’s say you have a company that has raised a $5 million round of capital.

And given that it’s an early stage company still burning, perhaps, let’s say $350,000 a month, given that it raised 5 million, it has, let’s say 15 months of life, before the cash runs out. And within those 15 months, the whole idea is to scale the company to the next level of growth, make it ready for Series B, and in the process basically hit some milestones that makes it more valuable. But generally, what tends to happen is that hitting those milestones, takes sometimes more money and more time than originally anticipated. And the last thing that you want to do is to go into fundraising for Series B before your milestones are hit, because that means your valuation takes an off.

So what venture debt does is it provides some additional capital to extend the cash flow runway for the company, which gives it more time to hit those milestones. So in this case, the company has raised 5 million, adding another million of debt, basically gives the company another three months of life. So the runway is extended from 15 months to 18 months. And those three months could often be the time that a company needs to hit its milestones and get more valuable. So very simply put, the real value proposition of venture debt is that it leverages equity capital in order to increase valuations between equity rounds, reduced dilution and also therefore enhanced founder and investor return in the process. There are also a few tangential benefits to this.

So for example, it enhances the appearance of financial stability, for example, and staying power for prospective or existing customers when a company goes and approaches them. It could also help unlock restricted cash in the form of rent deposits, for example. So there’s multiple different uses of venture debt. And it can play into a number of ’n’ use cases.

Amit Somani 5:22

Absolutely. But one really important thing, one of course, it has to be tied with an equity round, or at least the company should have raised some reasonable amount of venture equity capital is also the company’s ability to service that debt, because at the end of the day, it is debt, so you have to be able to pay the principal and the interest and therefore, nominally has to be a business, which is generating some level of cash or cash flow to be able to service that.

Ajay Hattangdi 5:47

That’s how you might traditionally think about it. But the real proposition of debt lies in the fact that it takes a look at the stock of cash the company has today, how it’s, you know, burning through that cash, and how that stock of cash gets replenished with Series B, and the debt is simply a tool, which helps you to push those two apart as much as you can. So while the company may or may not have cash flow to repay, it does have cash stock. The question for a company is, is it better to, let’s say, it needs the equipment for a half a million dollars. Now, Is it better to pay that upfront, deducted half million from your for $5 million raise and buy that equipment upfront?

Or does it make sense to defer the cost of the equipment over three years, knowing that somewhere in the process before the next three years, and certainly in the next few years, you’ll end up raising more capital at a much better valuation. And therefore, the alternative is to keep that half a million dollars in your bank account, use a line of leverage to finance equipment, and keep that half a million because you might need it later at the end of month 15,16,17 to extend yourself a little bit more. So it does help for a company to have cash flow. It is unlikely companies at this stage have positive cash flow. And what you’re doing, therefore, is really using today’s money to push out further dilution from tomorrow’s money. In a way, you’re giving yourself more time to get valuable.

Amit Somani 7:23

Makes sense. We do a lot in FinTech in Prime Ventures, things like FLDG or is there a restriction on where all you can use this venture debt for in particular, let’s talk about FLDG for fin tech companies, because that is usually something that both the entrepreneurs and the VCs are bit sensitive about in terms of not wanting to dilute the cap table for that.

Ajay Hattangdi 7:42

Right. I mean, one of the aspects of venture debt is that there’s typically no end use restriction on what that money can be used for. Debt and cash is fungible. So typically, how companies tend to think about it is use your cash for the most core activities around your business. So R&D for example, is a very core use, which pays itself back over a long period of time. So use equity for that. And use debt for the more tactical spend that you have along the way, whether it’s, buying equipment, whether it is renting an office space, whether it is using it for rent deposits, whether it is using it for FLDG and so on. So the end use is really open and unrestricted. So you can use it for a number of things in concert with equity.

Amit Somani 8:26

Understood. So as an entrepreneur, when should you consider taking debt of this nature? Just from a lifecycle perspective, let’s say you’re about to raise a series A in another three, six months, or you just raised it or is it just like you said on an opportunistic basis, saying, depending on wherever I’m in the cycle, assuming I qualify, we’ll cover that later, you can raise it at any time, so to speak.

Ajay Hattangdi 8:50

Let’s understand what a startup is going to use that money for. Company should ideally raise debt capital when it has the ability to repay that. So debt, unlike equity, carries an obligation to repay which equity doesn’t, equity that pays for itself in different other ways as a multiple of the exit and so on. But when you take debt as a founder, you’re under obligation to return that back with principal and interest. So the question is, obviously, when should a company feel that it has the ability to return that money with the principal and the interest. Companies at this stage at an early stage tend to have very uncertain cash flows in their business and companies tend to do well in certain quarters and might have certain quarters that are flat or even down.

And leverage can really help when a company is doing well. But when the company tends to flat or when has flat revenues or when the quarter is bad, debt becomes an obligation that sometimes gets heavy. And so generally speaking companies should not raise equity, unless it has the ability to tide through those temporary quarters or months of poor performance. So in our parlance, a company should take debt when it has one of two things going in its favor. Number one, it has business cash flow that enables it to build a certain reserve of cash that can be used in tough times to continue to fulfill its loan obligation.

That is one scenario when debt can be taken. Another scenario is in the absence of those cash flows, and the company has a stock of cash from Series A or Series B. Then it has the ability to tide through those difficult times, that’s another time that they can potentially take debt to take it. In the absence of these two events, when a company either has sufficient stock of cash from equity round or stock of cash that needs from business revenues, is generally a bad idea to take debt. Because those few quarters when things go sideways, and you’re not able to meet your debt obligation, that creates a real burden on the company and on top of everything else, the debt obligation can magnify the downside scenario for the company involved.

Amit Somani 10:56

So if I am to triangulate the company’s own kind of expectation of value creation of revenue generation, etc? Should they think about that as well? So like you said, there are two parameters one is these lumpy capex opex, sort of one of things that keep happening from time to time? Second, is your cash that you’ve already got on your balance sheet because of your, you know, equity financing? Or otherwise? How about their own ability to grow revenues and predictability of that? Should that be a factor that should go into this? Or you don’t worry about it saying, look, if you raised 5 million series A, you’re only taking a one or two millions of debt who cares? Like, don’t worry about the predictability yet.

Ajay Hattangdi 11:33

As on all things, I think there is no one factor we look at, it’s a combination of several things. The most important factor, of course, is the presence of an investor and the presence of strong enterprise value in the company. And of course, the fact the company has raised 5 million from a large top tier investor is an important factor for us. But the second question that we have to ask ourselves, and which is really the heart of the assessment, is what is the company’s ability to raise to the future rounds of capital of equity, because the ability to raise further rounds of capital is what enables the company to stay liquid and therefore continue to repay the loan obligation?

And when we assess that, aspects such as what is the business that the company is in? Is this a business that is likely to be interesting for investors? 12 months, 15,18 months down the road, when the time comes to raise the next round? Is revenue generation an important element of that attractiveness of the company? Or is it one of those situations where the company is developing new business models? Where it’s about buying credibility and acceptability first, then followed by revenues? What is that parameter which keeps the company rolling forward and continuing to grow valuable? I think those are the aspects that we look at. So in that context, we look at how is revenue scaling up? What is the track record? What is the trajectory looking like going forward? And how is the company positioned against all of these? And will it continue to remain attractive for someone for 18 months down the road.

Amit Somani 13:04

Understood. So very interesting point I didn’t realize is that, in some sense, the true to the term venture, even though this is venture debt, you’re also evaluating companies, which have the potential to grow into something much later, even if the actual cash flows or revenue generation and all that might have later so long as it’s called ability to grow into a valuation and to be able to raise subsequent rounds of capital.

Ajay Hattangdi 13:25

That’s right. Because at the end of the day, that’s the only real assessment that any lender makes, which is, irrespective of whether you’re as a lender making a loan to an individual to a large corporate or a startup, the only relevant questions are two. Number one is the willingness and the ability to repay a loan. So assume that willingness to repay the loan is not the issue, because you have VCs on the board. The question is the ability. And in large companies, you have collateral, you have cash flow to kind of satisfy yourself with in the case of lending to an individual, that’s again the person’s income, their assets. In the case of startups, you really have very little to go on. I mean, you have to look at beyond the numbers, what is the company’s business model? And how attractive is it and how attractive will it continue to be? And that is the metric that you look at oftentimes to understand.

Amit Somani 14:17

Understood. How about Ajay, when should people reach out to folks like yourselves, from a timing perspective? Is it when that opportunistic need arises? Or is it around the series A or B or anywhere in between is how you cultivate these relationships and when you kind of get into an actual engagement?

Ajay Hattangdi 14:34

Yeah, look, the best time for a company to raise capital is alongside a series A or Series B. Like I said earlier, it’s important that the company has a certain minimum threshold of capital that they raised, so that they have that reserve of cash that they can rely on to meet difficult times difficult months, quarters, whatever. And ideally, it should be along with an equity round because at the time of the equity round is when the company has the most amount of cash.

Therefore gives the most amount of comfort to a lender, and every subsequent month as that level of cash reduces because the company is burning cash, the credit in a sense gets weaker. So the longer a company waits, the less that you have the ability to do as a lender for that company, so I say that the right time to engage with the lender is perhaps just ahead of a round closing so that you’re able to close the debt and the equity sort of coterminous with each other. And it also gives the founder some sense of how much debt can be potentially raised. So that they can get the right size, the overall fundraising that they’re looking to get.

Amit Somani 15:38

Ajay this might be a naive question, but for companies that are raising, like seed rounds that say, a million million and a half, is this sort of completely out of the question? Or do you guys also build positions where if somebody is raising one and a half million rounds, you might come in with a half a million dollar debt? And then as the company grows, you might consider or know that like that 5 million is a little bit of a mark?

Ajay Hattangdi 15:58

I think for us, the assessment really is about who’s putting the money in, and what is the long term interest from that investor to keep investing in that company. Now, in companies where they’ve received a small amount of capital, you can define what small is, but let’s call it a million. At that point, a lot of these 1 million checks are written more as experiments by the investors, because they are not quite sure how the company is going to pan out. And these are early checks, where you essentially write a few of these and see which ones then have sort of reached a level where you can enter into a serious series A and then you will follow through with the larger check in those instances.

So there’s still a lot of experimentation that is being done at that stage, which makes it very uncertain about whether the next round of capital will happen or not. And so what you have to look at is, as a lender is ultimately going back, what is the confidence that you have, that the investors who stepped in and provide more capital will be 12-18 months from now? And if it’s an experiment, for which a million dollars in investment, very hard to read into that, so typically, for us, 5 million is I mean, it’s not a hard threshold, but it’s generally a sort of a softer number that we have in our minds, because at $5 million there is a serious indication of interest from the investor that they want to follow through, and they think this is an opportunity worth investing in and scaling up. And therefore, as a lender, we have some reasonable amount of confidence that more money will come in. So for us, we’ve done deals earlier as well, it’s just a matter of drawing a line and saying, at what level what size of investment are we comfortable with?

Amit Somani 17:34

Makes sense. Let’s go on the flip side, what are the downsides of taking venture debt? And when should you absolutely not take it as an entrepreneur, even if you have the option to?

Ajay Hattangdi 17:44

So we’ve, I think, we clarified already that you shouldn’t take it unless you have the threshold of cash. But let’s assume you have that threshold of cash and you’ve raised the $5 million. The situation, then I would say you should, perhaps avoid is if there is an element of some binary risk about the survivability of a company where for instance, you may be doing r&d on a new program or new product, and it’s not certain that the product will work. And if the product doesn’t work, the company will fail. Or if there’s an element where the company needs a certain license to operate, and getting that license is contingent on the funding coming in, for which the funding has been raised, but there’s no guarantee that the license will come in either on time or at all. So in those situations, if the product doesn’t work, or the license doesn’t happen, then the company’s life in a sense is terminated at that point.

So there’s no further capital that can come in. And then on top of everything else, you don’t want to have the obligation of unpaid debt on your head, I’ll say, save those kinds of binary situations, I would say, practically any type of company can benefit from taking debt,

Amit Somani 18:51

Understood. Now switching gears as to how you underwrite the risk, I know we’ve covered a little bit of it, but whether it’s Alteria or some of your other kind of fellow competitors or whatever, in terms of how do you guys decide beyond just of course, all these things we’ve talked about right cash flow amount of equity raise etc, who to fund or not, is it a very venture like process like how we would be deciding at a seed or series A in terms of evaluating the business, the teams, etc? What are some of the things that you guys look for?

Ajay Hattangdi 19:22

So the process is different from how a VC would look at it. I mean, our approach is really one of underwriting debt or the credit. And so there’s a more lender- like diligence process that we run, so there’s a few elements we look at, like I mentioned, the first very important element to look at is whether it’s backed by a top tier venture capital. I think that’s one of the most important conditions for us. Now, the reason for that is that VCs provide a strong layer of capital, an active role on the board of these companies and additional equity reserves, all of which support our debt position. Also remember, we do not take board positions, we do not take observers. And the VC on the board is actually our proxy for the eyes and ears in the team. So that’s a very important one.

And we have, over time, worked with several VCs in the market, we’ve developed this great level of trust with them. And that’s a very important aspect of underwriting. The second one is, in the absence of cash on collateral, enterprise value becomes a very important metric to determine the value of the company. And so a company raising $5 million in the previous example, at a $20 million valuation. So the VC investing in the companies ascertaining or ascribing a value of 20 million to the company, to me, mine debt of 1 million is supported by the assessment that the company is worth at least 20 million. And as long as the company continues to do what is doing well, 20 goes to 21 to 22, and 23.

And it gives me additional comfort to underwrite the process. The third thing is, I think, as I mentioned earlier, good cash reserves following a VC round, essentially translates into lower repayment risk on the debt. So which is why we like to come in alongside the series A, series B whatever you call it, when the cash reserves that have been best, which is when we can put our best foot forward and give the best terms to the company. And one other thing is that, we typically want companies to have at least 12 months of cash when we look at them. And the reason for that is that the runway of at least 12 months gives the company enough time to demonstrate business growth, and position itself for further equity raise. So a company, with say three months of cash or 4 months of cash, unless it’s already fairly advanced in the equity round, might take a little bit longer than the next three to four months to raise.

And that carries its own risk. Bridge loan is therefore, something that we generally don’t do. So that carries the highest risk in terms of all of these types of things. And I think the other thing we look at is, of course, the company’s high growth, but that would stand to reason if the VC is in it, because high growth companies increase the ability of the company to raise the next round remain attractive for investors and again, which ensures that the debt obligation is not compromised. And, obviously, finally, I think it’s the presence of a great team.

That’s very important, because it’s the ability of their team to execute, is really what’s critical to the long term survival and growth in the company. So when we look at a deal, we look at all of these five parameters, six parameters, whatever. And we need to know that it clears all of these hurdles for it to qualify. And the last part of the process is, of course, a touch and feel with the VC involved to understand their rationale for the investment. And what they want the company to achieve in the next 12 months? What is the plan underwritten to, what is the milestones that need to be achieved to get to the next round of funding.

So unless the VC is absolutely comfortable with us being there in the debt, in a debt capacity, we generally will not extend the debt, because we need to make sure that all three of us, the founder, the VC and us are all rowing in the same direction. So I say broadly, these are the aspects we look at.

Amit Somani 23:12

Very, very good. So switching gears, talking a little bit about some practical tips and some basic numbers. Maybe I know your mileage may vary. But what are the typical kinds of interest rates and equity warrants and durations and so forth for these kinds of instruments? Again, let’s just take a prototypical example sticking with a 5 million round, raising a million or million and a half in venture debt, what would a typical thing we’d like for founders to evaluate whether they want to consider this?

Ajay Hattangdi 23:40

Yeah, I mean, there are essentially three components to structure the first is the debt component, which is usually a two year to three year kind of loan structure or a debt investment structure. The debt carries a monthly repayment of principal monthly payment of interest, the monthly repayment nature is therefore primarily, making sure that we are able to manage our risk in the deal. And we don’t make it too cumbersome for the company to end up paying the entire loan back in one balloon repayment, which then gets very difficult to do. So chop it up into bite sized pieces, spread that across two or three years. And so, companies generally pay us on a monthly basis.

Usually there is an initial period of when just the interest is payable and then the principal becomes repayable there after a few months. So, the interest rates are typically in the mid teens to about 14 and a half to 15%. in that range. The debt also comes in without requiring any promoter guarantees. Any guarantees from the VC. It is generally a secured loan to the assets of the company. And so we are actually often the first and only lender to the company that stage. So generally we take a pledge on all of the assets in the company. The second aspect are the warrants or the partly paid shares, where we have a right to buy a certain number of shares at a predetermined price, which is actually the series A price.

And usually the warrants are taken for between 10 and 15% of the amount of the loan equivalent. So if I’m giving a million dollar loan, in this case, the million dollar loan itself is repayable over three years at 15%. And then you get warrants for about $100,000 - $150,000 where the strike price is set equal to the series A price, that’s the second component, and those are generally longer term options Amit and the idea there is for us to make an upside, when the company gets more successful as a way of claiming back some of the commercials in the deal to for the risk that we take in the transaction, obviously, we are not going to want to lower 20% or 25% interest rate on the company, because then it becomes more of a burden to companies and their health.

The idea is to price the loan at say 15%. And the balance upside to make it contingent on whenever the company and the founder and the VC make money, then we start to make a little bit of an upside. And hopefully on a portfolio basis, we can get a few more percentage points of return with some of the warrant gains that we make, the third element of our structure is usually a small right to co-invest in the next round, which is up to a maximum million. And it’s on the same terms and conditions as the next round. We use that very judiciously because our essential approach to the transaction is more debt risk. And we don’t want to add too much equity risk in our portfolio.

We use that very sparingly. Back to the current fund, we made only about three investments of that nature. And we fully recognize that we are better credit underwriters than we are equity investors. We’re not really equity investors. But that’s more of an ability for us to get an opportunistic upside. For some of the companies where we see, we’ve been there a while and we’ve seen how the company has stacked. So those three components together is what constitutes our engagement.

Amit Somani 27:02

Great, what are some kind of myths and misconceptions about this category? Like what are some of the things you hear and laugh about or dismiss?

Ajay Hattangdi 27:11

Yeah, I mean, I think there’s a few, sort of misconceptions as you put it, that we come about, we hear very often. So first, I think that venture debt is just cheap equity. And really nothing could be further from the truth. Debt is debt, it is not cheap equity, it is always debt, it needs to be paid back and can be recalled under certain circumstances. When we underwrite debt, we underwrite it with the expectation that our returns and our risk will be commensurate with debt and not with equity. But some types of debt can take equity like risk from time to time, especially in big situations, as we talked about, but they will be priced accordingly. And that is not the debt that we’re talking about.

So the type and the amount vary based on sort of capitalization, the stage of development, other factors. But I think the bottom line is that venture debt is underwritten very much in the style of traditional lending, except that the matrix that we use to determine it to satisfy ourselves is very different from the one that traditional lenders use. So I think that’s an important aspect. So companies should be very clear about the expectations or debt when they take it is intended to be debt and repaid and the obligations it creates. The second one is that venture debt doesn’t really add a runway that I’m really borrowing on my own cash.

I think venture debt can and often does add runway. The issue of when it doesn’t add runway, when this perception comes in, misconception comes in is mainly when borrowing from lenders that require companies to either maintain excessive liquidity covenants or which require companies to keep cash deposits to them against which they lend. So liquidity covenants being where a lender would say that look, you need to have an X amount of cash in your bank, even though the bank account is not with us, but you need to have a certain amount of X amount of cash with you at hand at all times. Otherwise, it’s a breach of covenants. And that really forces you to keep that cash unproductively and at some point, you will have an issue where your cash balance goes lower, and then you have to scramble to either repay that loan or to raise more equity.

And, of course, several banks, they’re asked to keep deposits, then you’re not really adding fresh debt into the equation beyond the point whereas, genuine lenders have no problem as long as something continues to be attractive to VCs, raise further rounds, in which case the debt can be genuinely structured to provide good strong cash runway. So I would say watch out for cheap deals with excessive liquidity covenants or when deposits are required, which are not really adding to the runway and if I may add, the third aspect, the last one, just to pick on is that the misconception that all deals of a certain type are created equal.

And from my experience that’s one of the big ones because there can be significant differences between similar looking offers. What to look at is the amount that is being offered, the factors that determine availability of how the company has drawn that facility, you need to look at the all in cost, the timing of the expenses, things like interest calculations, prepayment penalties. And another important one is collateral and sacrifice of future decision making flexibility, because of all the constraints that lenders sometimes tend to put, and there’s a whole bunch of subjective factors that we can get into about how do you assess the lender?

And how do you in a sense, quote, unquote, get married to the lender, because that has a huge bearing on your continued ability to run the company as the company wants you to take in the debt from a lender. So I would say these three are the top three that I would pick as a lot of misconceptions out there.

Amit Somani 30:56

Wonderful, Ajay, very enlightening. And, you know, I really feel like you demystified some of these. So thanks again so much for being on the podcast.

Ajay Hattangdi 31:06

Pleasure. Pleasure to be here.

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