Venture Capital And Venture Debt Comparison
This is part two of a three-part series on venture debt financing. You can read part one here.
If you’re reading this then you’ve likely either seen Shark Tank, pitched to a VC, or follow news about how much money startups have raised. As a result you probably have a pretty good understanding of venture capital. The purpose of this article is to discuss venture debt and how it relates to venture capital.
Debt lenders operate differently than equity providers because they have different risk profiles. VCs are comfortable making investments in companies knowing full well that many of those investments will not provide a material return on the capital invested. This comfort is the result of the VCs business model in which a few of the investments have huge returns and offset the losses of the many that fail. Lenders, such as banks, have a different business model that does not tolerate such losses. Most traditional debt providers that would provide home mortgages and car loans are not able to get comfortable with the inherent risk of providing debt to early stage startups that have yet to prove themselves financially stable. However, as mentioned in my previous post “What is Venture Debt?”, there are specialized lenders that underwrite loans differently and will provide money to early stage startups in the form of venture debt. Let’s explore the basics around how these venture lenders are both similar and different than venture capitalists.
The first big difference was just mentioned — risk tolerance. Venture capitalists are closely aligned with the entrepreneurs; if things go well for the company both parties will experience terrific returns on their investment. As the VCs are often taking a meaningful ownership position in the company in order to make the potential return match the risk, they will commonly take a seat on the company’s board of directors. The board seat allows them to both coach the management team and to have a say in the strategic decisions the company is making. Most VCs view themselves as true partners to the entrepreneur because they will succeed or fail together. In this way equity attempts to align the incentives of management with those of the investors and hopefully positions everyone to make decisions that will allow the company to thrive. This can be a great benefit of equity.
On the other hand, a lender providing venture debt has a different return profile and does not take on the same risk as the VC. The lender’s gains will be associated with interest, fees, and warrants; the costs of which will vary based on the type of debt product as well the lender themselves (a topic I will write about in a future post). Lenders will typically not be involved in strategic company decisions and will not take a position on the board, but because their capital is at risk, they will require regular reporting from the company on its financial health. They will also monitor covenants that measure the company’s performance relative to a plan that the company and its Board of Directors felt was reflective of the goals for the company. In situations in which venture debt is available, it is important to consider whether or not covenants will be included in the debt structure. If it is a scenario in which the debt provider has included covenants then the company should be confident it will be able to meet those covenants. The debt provider will most likely try to structure covenants on metrics that are aligned with how the board of directors is measuring the success of the company; in this way the VCs and debt providers are aligned and the management team is operating against a consistent set of objectives.
Another key reason it is important for a startup to work with a VC is that VCs typically provide a larger portion of the total capital mix between equity and debt. When significant capital is required in order to get a venture of the ground, VCs are a great option. From the founder’s standpoint, the biggest downside to venture capital is that it can be very dilutive meaning founders must give up a significant portion of ownership in the company. It also involves giving up complete autonomy with regards to decision making as key decisions will require a consensus of the Board of Directors which will include the VCs. However, the trade-offs to these two issues is that it often allows for a much greater return for all parties involved and therefore answers the question “Would you rather have all of nothing (or something small), or a piece of something large?”
Venture debt, however, is typically structured such that it has very limited dilution for the company’s owners which is a key benefit and one of the main reasons that founders will seek out venture debt after they have raised equity capital from VCs. By combining cash raised from debt with cash raised from equity, founders are able to extend the time horizon between their equity raises. Although the amount of debt that will be lent will vary for every situation, a general rule of thumb is that venture debt providers will be able to lend the company enough capital to extend its runway by 3–6 months. Through providing additional time to hit key milestones, a company can increase the valuation of its next round which is beneficial to all existing shareholders (and usually more than offsets the dilution experienced as part of the venture debt warrants).
Another important consideration for entrepreneurs is that for most venture lenders like Square 1, venture debt is typically available only after VCs have already put money into the company. In this way it complements the capital raised from VCs as opposed to competing with it.
The processes around raising equity from VCs or venture debt from lenders are similar as both will want to understand topics such as how technology differentiates the company in the market and what problem it solves for potential customers, the size and competitive landscape of the addressable market, the management team’s experience and ability to execute, and the performance of the company to date. When planning to raise capital from VCs, entrepreneurs should anticipate a meaningful diligence process that could take several months. Venture debt lenders can often move much quicker some of their diligence is expedited through conversations with the VCs to understand how the VCs were able to comfortable making an investment.
Hopefully this high-level overview has provided some clarity on the similarities and differences between venture capital and venture debt. Both can be great instruments used to support the growth and success of startups.