Founders know that if they want to build world-beating businesses, they need access to capital. Delivering future profits requires upfront capital investment and growth funding, before free cash flow supports the generation of profit streams in the future. It’s a tale as old as business itself.
However, financing that growth isn’t always as straightforward. There are two main paths, equity or debt funding. But finding equity investors or accessing debt funding might not be a simple matter of going to a lender and applying for a loan or drafting a creative pitch deck for VCs. For one, most traditional banks won’t entertain companies that don’t have stable cash flow or collateral to support “asset-based lending.” And secondly, when pitching venture capitalists to raise equity startup CEOs often find themselves giving up a large chunk of their ownership to raise funds—and that’s not always ideal.
In light of the financial realities of young firms, specialist lenders and investors have developed several innovative financing vehicles to benefit both sides of the exchange. Here, we discuss some of the benefits and differences between venture capital and venture debt.
What’s the Difference Between Venture Capital and Venture Debt?
Venture capital is a popular cash-raising vehicle for new companies. Here, venture capitalists – typically technology investment firms focused on very early stage companies or wealthy individuals – seek promising startup ideas to invest in, buying equity stakes in young companies while they are still private enterprises. Cash is provided to the company in exchange for equity – a stake in the company’s future profits. In that sense, it works somewhat like traditional equity investments.
Expected returns in the venture capital and private equity market are higher than those in the public markets. This incentivizes investors to allocate capital to the private markets and take on the risk of betting on as-yet unproven ideas in the venture marketplace. Investors will only see a return if the underlying company achieves profitability or realizes an exit (sale or IPO).
Venture debt is a different animal. While it might sound similar to venture capital, it has important distinctions.
Venture debt is a loan provided by a specialty lending firm or a bank that must be repaid. Such agreements will often come with a warrant – a legal document that allows the lender to purchase an equity stake in the company at a future date. This reinforces the alignment of interests, as both the lender and the borrower are focused on the long-term success of the business, much like the partnership element of venture capital.
At first, venture lenders may provide some period of time where the borrower only has to make interest payments. After this “interest only” period, the company begins to repay the principal in installments (called amortization) until the final maturity date.
While more startups take on venture capital than venture debt, both can be effective funding strategies. Typically, venture debt is most effectively utilized by companies that have established strong revenue performance and proven customer bases. Note, though, that the purpose of venture debt is largely similar to venture capital. It is a financing tool that provides funding to push the company to the next phase in its growth in the hope of greater future profits.
Which Type of Growth Funding Should You Choose?
While accessing venture and growth funding can be a high bar for a company to achieve, in some situations, you may have a choice – in which case, it’s worth knowing the costs and benefits of each form of financing.
Founders and startup owners love venture capital for several reasons:
- Accessibility: Venture capital tends to be more accessible at earlier stages than traditional or venture loans. Banks won’t lend to unproven companies, but VCs hungry for high returns will take that risk in exchange for an ownership stake in the company.
- Active investment: The VC takes on the risk by buying equity in the firm and will be highly engaged in the business and may help guide the company through operational and financial decisions in pursuit of growth.
- Permanent capital: Venture capital is not typically structured as a traditional loan or debt obligation, so the company does not need to pay it back under defined terms.
Venture debt offers important advantages too:
- Lower cost: Venture debt works out at a lower cost, reducing existing shareholders dilution in their equity interests. However, as it is structured as a loan or debt obligation of the company and must be repaid, so the company takes on that performance risk. In exchange founders and shareholders of the business can access the capital they need to finance expansion without selling a significant portion of the equity in the company.
- Lighter touch: Venture lenders do not typically take board seats, allowing the company to raise additional growth capital without adding more voices around the table at board meetings. An additional benefit for some companies, is the opportunity to raise additional growth funding without needing to set a new valuation for the company.
- Access to relationships: Furthermore, companies still get access to lucrative relationships since venture lenders, like venture capitalists, have an incentive to ensure that the company performs. They are likewise willing to provide substantial personal input to ensure that happens.
In summary, venture capital tends to be the best financing vehicle for fresh seed and early stage startups, while venture debt can be better suited for more mature operations, but there is always overlap. Venture debt typically works out as cheaper while providing important growth capital to accelerate value creation by the startup.