How Venture Debt helps founders and VCs maximise returns
TL;DR
- Venture debt generally has a lower cost of capital than traditional equity funding from VCs.
- Venture debt reduces founders' dilution, increases their equity returns, and boosts VCs' internal rate of return (IRR), assuming the company does well.
- Venture debt is a more flexible and time-efficient funding option compared to equity.
- Founders should use venture debt wisely. Overleveraging can deteriorate a startup’s risk profile due to unaffordable fixed financial obligations
In my previous post, I discussed how startups can use venture debt to unlock growth in a challenging fundraising environment. In this article, I explore venture debt's benefits, particularly how it amplifies returns on equity for founders and early investors.
What is Venture Debt?
Venture debt is a non-dilutive form of finance available to startups and scaleups who have already raised equity finance from institutional investors and have a clear path to profitability.
The cost of debt is generally lower than the cost of equity
To understand how venture debt aids in maximising returns for founders and early investors, it’s important to understand the concept of the Weighted Average Cost of Capital (WACC). Simply put, WACC is the price startups pay for utilising external capital. While the cost of debt capital is straightforward, consisting of interest and fees on borrowed funds, the cost of equity isn’t as apparent. Unlike debt, equity promises a share of returns upon exit (and dividend payments, if applicable).
Like lenders or debt investors, equity investors also require a certain level of return from exit proceeds to justify their investment. Therefore, startups need to demonstrate that their valuation can grow at a rate that can justify VC investment. This required rate of return from VCs is the cost of equity capital.
Debt and equity investors calculate their required rate of return (aka the startup’s cost of capital) based on an investment risk assessment. Equity investors assume more risk than debt investors in startups. This is due to lower liquidity preference (in case of liquidation, lenders get paid before shareholders) and longer holding periods (debt has a typical term of 4–5 years compared to 7–10 years for equity). To compensate for these risks, the investor usually makes the cost of equity higher than the cost of debt.
The diagrams below show the difference in risk profiles between venture debt and equity funding:
Roughly 95% of venture debt investments return more than the invested amount, while only 50% of VC (equity) investments do the same. This makes equity the riskier asset.
During periods of elevated risk (such as now in 2024), VC funds require even higher returns, prompting them to offer lower valuations to startups to generate an excessive return on exit. On average, a VC fund demands a target return of 30–40% annually, while a venture debt fund seeks a target return of 15–20% annually.
Debt reduces the total cost of capital
Let’s break this down with an example:
A startup with £50m post-money valuation needs £10 million to fuel its next growth stage. The founders have two options:
- Raise the full amount through VC equity.
- Raise £7m through VC equity and £3m through Venture Debt.
The startup exits in 4 years for £200m.
Note: As a rule of thumb, startups can usually raise VD worth up to 30–40% of external equity raised to date.
Option 1: Full VC equity
- Equity dilution: 20% (£10m / £50m)
- Future equity value at exit: £200m * 20% = £40m
- Total cost of capital: £40m
Option 2: Combination of VC equity (£7m) and Venture Debt (£3m)
- Equity dilution: 14% (£7m / £50m)
- Interest rate on venture debt: 12% pa
- Future equity value at exit: £200m * 14% = £28m
- Total interest paid on venture debt: £3m * 12% * 4 years = £1.4m
- Total cost of capital: £28m + £1.4m + £3m (owed to lender) = £32.4m
This translates to a saving of £7.6m
By combining VC (equity) and VD, the startup reduces the total cost of capital from £40m to £32.4m, resulting in a saving of £7.6m. Therefore, incorporating VD can reduce the overall cost of capital and help founders retain a greater share of their company.
Similarly, VCs can maximise their return per $ invested using venture debt, boosting their IRR. Therefore, we recommend considering debt in the overall fundraising strategy for startups with a clear path to profitability.
Venture Debt provides benefits beyond the cost of capital
For Founders, Venture Debt offers:
Flexibility—Founders enjoy greater flexibility on drawdown schedules and repayment terms, allowing them to use funds more efficiently based on their business growth plans.
Faster funding — Accessing venture debt facilities is typically quicker than raising an entire equity round from start to finish.
Increasing cash runway— An injection of debt allows startups to increase their cash reserves, providing an extended runway to hit essential valuation milestones before the next equity round, reducing the overall risk of failure or a down round.
For VCs, Venture Debt offers:
Capital structure optimisation—Debt financing complements VC investments, allowing portfolio companies to go farther with the invested equity capital, reducing the risk of a failed investment.
Enable growth while pursuing portfolio diversification—When founders receive non-dilutive funding from external sources, VCs can reserve more of their fund’s capital for making new investments, reducing concentration risk, and building a diversified portfolio.
While venture debt can provide founders and investors with immense strategic benefits, it’s important to evaluate the potential drawbacks carefully as well:
Fixed financial obligation — Unlike equity, venture debt creates a fixed repayment obligation on the startup. Missing payments can trigger default penalties.
Restrictive covenants — Debt facilities often include operational and financial covenants, which could be more restrictive than VC equity covenants, limiting a startup’s optionality in certain scenarios.
Venture debt can be a great option for startups if used correctly and at the right time. However, only startups with strong financials and a clear path to profitability in 12–24 months can use it. An experienced advisor is crucial to helping startups get the best terms and avoid risks.
How can we help?
As Europe’s leading early-stage fundraising advisor, Mountside Ventures has developed market expertise to guide startups and investors through debt funding.
Our venture debt advisory team focuses on structuring and executing the optimal venture debt facilities to ensure founders and VCs extract maximum strategic and financial value. Revenue-based financing can also provide an attractive alternative to venture debt for early-stage start-ups.
Please fill out this form or contact me on LinkedIn if you want to learn more.
