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Debt for growth: Brazilian entrepreneurs start falling for Venture Debt

Venture debt is useful for leveraging startups' growth without eroding the founders' equity and entitles creditors to bonuses if the venture succeeds

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Known for some time in North America, venture debt is an investment format that is slowly becoming more popular among Brazilian startups as an option for raising funds. Considered a “cheaper” type of investment for the entrepreneur, since it dilutes less the founders’ equity when compared to venture capital, venture debt can even be a complement to equity rounds, used for more operational purposes such as credit origination or purchase of physical assets.

Last year only, companies such as BTG Pactual, Brazil Venture Debt, and Brex announced plans to back startups through debt funding, betting on the idea of lending to promising businesses as a way to boost new businesses in the country.

But, after all, what is venture debt?

Back in the 1970s, venture debt was used to refer to a kind of loan taken out by early-stage companies, when the borrowed capital was used to finance the assets needed to start their operations, such as machinery, computers, or even laboratory equipment.

The same funding approach was later offered to startups, especially in the US economic context, when lenders such as Silicon Valley Bank or WTI started providing funding to startups backed by renowned venture capital funds. There emerged the concept of “debt financing”, which structures debt in a personalized way, giving priority to the shareholders’ equity, with long-term maturity and generally tied to guarantees based on potential receivables (even if non-performing) and company shares.

READ ALSO: US funding firm Partners for Growth wants to bring venture debt more popular in Latin America

The advantage for companies that offer venture debt has to do with a structure that works as a kind of “subsidized loan”. In addition to receiving a fixed income remuneration (the payment of interest on the loan made), there is also the opportunity to also get as a “bonus” a variable income based on the startup‘s success.

“The difference to an ordinary debt is that debt rounds include compensation if the startup is successful. That is, in addition to the debt terms, with payment of interest and principal, there is also an option that, if the startup is successful, this partner will get an extra condition besides the agreed interest and principal,” says Liliam Carrete, professor of finance for startups at the University of São Paulo (USP).

On the other hand, startups that choose venture debt find it a “cheaper” way to raise funding, since, unlike what happens in a venture capital round, entrepreneurs do not need to “sell” part of their equity to those investors.m “With debt funding, the entrepreneurs don’t have to dilute the company’s equity; they are able to preserve 80 to 90 percent of the equity they would give up in a venture capital round. It’s a cheaper cost of capital for the company,” said Julia Figueiredo, head of Partners for Growth (PFG) operation in Latin America in a recent interview with LABS.

READ ALSO: SMU prepares to kick-start its secondary market for crowdfunding in Brazil

Venture debt is, typically, a loan taken with an investment fund that must be repaid within a certain period, either with funds from liquidity, profit generation, or even (but less recommended) with a new round of investments.

Because of this characteristic, experts on the subject say that venture debt is ideal for startups or companies that are in a growth stage so that they can consider future receivables or even future profit prospects as payment sources for the debt funding round.

Greater entrepreneurial maturity has it all to boost venture debt in Brazil

According to Pitchbook data, the US market saw a jump in venture debt operations between 2017 and 2019, slowing down a bit in recent years. Part of this, according to Carrete, has to do with the US entrepreneurial ecosystem’s maturity level, where investments in later-stage companies are fiercer. “Investors in the U.S. are moving to early-stage investments because of the huge competition to access the best investments, and venture debt becomes an alternative to differentiate themselves from venture capital,” she says.

According to Gabriela Gonçalves, partner and director of Brazil Venture Debt, the companies that usually use venture debt are those with a large growth rate and that tend to be “cash burners”, for which the perspective of a venture debt investor is more interesting than that of a traditional venture capitalist.

“That was the case with AirBnB, which in early 2020 did a $3 billion venture debt round. The goal was to be able to wait for the situation to improve and do the IPO, which was already scheduled to happen, without the risks and volatilities of the beginning of the pandemic,” recalls the investor.

In the Brazilian and Latin American scenario, venture debt rounds are still discrete and, therefore, difficult to track. Besides anecdotal cases, such as the venture debt investments from Itaú BBA, BTG Pactual, and Galapagos Capital, there is a lack of data about this type of investment in Brazil. Gonçalves and Carrete agree that part of the reason for this has to do with the maturity of the regional entrepreneurial ecosystem.

“Venture debt is a piece, a sub-market of the venture capital ecosystem, and it can only exist if there is a mature VC market; it grows as VC also develops. We already have reasonable numbers of VC in Brazil, but this market in Latin America is still young,” explains the investor. Gonçalves believes that there is also an issue concerning the maturity of venture debt as a product, which has existed in the USA for over 40 years but is still getting shaped to the Brazilian market and finding the best ways to be structured locally.

READ ALSO: READ ALSO: LAVCA: venture capital mega-rounds in Latin America jumped from 1 to 12 in 2021

Besides the issues of market and product maturity, there is also the challenge of the maturity of the entrepreneurs, who, especially in a country that tends to be averse to the concept of debt, do not always understand the potential of debt funding as a driver for growth. “I would say that 90% of Brazilian entrepreneurs are well prepared to negotiate equity deals, but they are not so well versed to discuss debt deals, because they have never done that before,” she says.

Another critical aspect, Carrete argues, has to do with our high-interest rate and default. “A startup can’t afford a basic interest rate of 12% plus the risk of default,” she warns. However, there are expectations of venture debt growth in Brazil, especially with the arrival of international investors.

With a market of 200 million potential consumers and many problems to be solved, the country presents itself to the world as a source of business opportunities. “Investors look at Brazil, which generates an expectation of incoming funds and leads to a competition for the best startups. This opens space for international investors to come in with this type of funding that is cheaper for the entrepreneur,” she predicts.

(Translated by Carolina Pompeo)