Venture Debt vs Venture Capital, What is Your Best Option as a Startup?
Funding can be challenging for startups. Receiving the correct type of funding during the life cycle of a startup is crucial to its survival and profitability. We are dealing with a pandemic during which investors, Venture Capitalists (VC), are unsure as to how much they want to invest in ideas and keep reinvesting. We are seeing founders forced to raise capital with large equity dilution to survive. With the looming possibility of down rounds there is more venture debt available in the market as we see investors being more safe than sorry with their investments. With that being said this blog post will talk about two funding mechanisms out there; venture capital and venture debt. We will go over what they are, their benefits, advantages, disadvantages and examples of what would suit your startup best.
So, what is venture capital? In simple words, venture capital is a financing tool for companies. These investments cannot usually be accessed until a liquidity event, such as when a company is acquired or goes public, at which point VCs realize their profits from their initial investment. Venture capital is characterized by high risk/ high reward. Venture capital is present mostly in Business to Consumer (B2C) software, Business to Business (B2B) life sciences, and Direct to Consumers (D2C).
Advantages of Venture Capital
- Since it is not a debt you are in no obligation to pay back the money and it is interest free. All monetary risks are taken by the VC themselves and other shareholders.
- VCs are knowledgeable and can guide startups in their journey. They can connect startups with additional resources, connections, and hiring. They would bring their entire network to the table.
- There are regulatory bodies that ensure no foul play is committed by any VC. They are easier to find than angel investors. This is mainly due to the fact that they are always looking for high potential investments.
To know more about various venture capital investment trends, click here.
Now, we have seen how VCs can be a big help to a firm, but they can be difficult to get a hold of, which is a good segue into the next section;
Disadvantages of Venture Capital
- Let us start with loss of control. When you have a VC on board, you are trading equity for funding. This may allow them to have a say in business decisions within the board of directors. If their perspective for your startup does not match, it will be worrisome.
- Be prepared to hand some of your shares to your VC. There is the added risk of you losing the ownership of the company. Founders can end up with minority shares of the company.
- Startups also want to keep what they are working on under wraps, so they would require VCs to sign a Non Disclosure Agreement (NDA). However, not all VCs are willing to do so. Ensure all the legal terms and conditions are properly laid out before signing on any VCs.
- Time is money; Investors are very cautious with their money and can take a long time to make the investment decision. They are cautious because they run the risk of losing money i.e. if the company is acquired at a lower valuation in a subsequent round e.g. in the case of ElementAI. The period between finding a VC and being able to make the deal to receive the money can be a major disadvantage to your business.
So, now you as a founder must be outweighing your options and thinking, there must be a different way to finance your business, receive money quickly, and not give too much control to VCs. This brings us to venture debt. It is a type of debt financing obtained by early-stage companies and startups. In 1970–1980, we saw the coming of age of the modern venture industry. A lot of these startups and VC firms were capital constrained. Entrepreneurs and investors sought alternative investing and looked into leasing high-tech equipment leasing industry as a form of finance that could help satisfy the needs of the startups at a time when substantial capital investment was required.
The debt itself is short to medium term in nature (one to five years). It is usually provided by banks or dedicated venture debt funds as a complement to equity financing. The principal amount of debt is determined by using the amount raised in the last round of equity financing. There are some resources that startups can tap into to get debt financing without raising initial rounds. Venture debt instruments use interest payments. These payments are usually based on the prime rate. In venture debt financing lenders receive warrants on a company’s common equity as part of compensation for the high default risk. The total value of the distributed warrants represents 10% to 20% of the principal amount of the loan.In the future, warrants could be converted into common shares at the price per share of the last equity round. These warrants provide the biggest returns to borrowers relative to the appreciation potential of the company’s common shares. However, it is relative to how your business is advancing to negotiate debt terms.
When should you use debt financing? You have to think about:
- The size of the debt
- The duration of the loan
- The price of the loan (its fees and interest rate)
- Covenants (It allows borrowers to prepare for their repayment before and during the agreement. In case a borrower defaults in payment or breaches the covenant, the lender is entitled to claim the sum of the loan in full)
- Timing of the amortization (when do we start repaying the loan?)
There are 4 types of financing: line of credit, term debt, equipment financing, and royalty monetization.
Advantages of Venture Debt
- Venture financing can help extend a startup’s runaway (how much time a company has before they run out of money) as well as the capital needed to reach certain milestones. Reaching these milestones makes the company more valuable to investors before they make the next round of equity. This will help reduce equity dilution for investors and the founders will still have a considerable amount of control over their business.
- It can be used as an insurance policy or safety blanket to provide a buffer against certain risks or as a way to finance opportunities like big capital expenditures. It helps companies reach profitability and not just growth, which venture capitalists focuses on.
- Debt is also cheaper than equity. While equity changes are based on company evaluation, debt arrangements are made favourable to the borrower. They are not required to adhere to stats like cash flow, debt to income ratio, or structured top-level leadership.
- If a company is acquired at a lower amount than the market valuation, debt holders are paid before shareholders which mitigates their risk.
Disadvantages of Venture Debt
- While the interest rate is quite low you have to pay it back. There is extra work to be done to keep the lenders happy.
- There is a lot of paperwork in terms of reporting. Lenders can take a collateral against your assets, which is basically a right to keep your asset until you pay them back.
- There are large scale legal costs associated with the debt on top of the actual debt amount.
- The most concerning downside for startups is the possibility of dangerous financial covenants. For example: if you do not grow your business as fast as you anticipated, then you may not meet certain metrics required in your loan documents like net income losses or coverage ratios. When you are in default and the loan is due, this will be a huge blow for the business.
This graph represents the financial life cycle of a business. Companies that get venture debt, are usually in the 1st, 2nd, or 3rd round of funding. This is because companies in their seed round of funding do not have the backing of any VCs. Lenders usually look for a strong VC backing to understand the company’s trustworthiness. To know more about the capital raised, type of investors, and type of traction in each round of funding click here and swipe to slide 8.
So how do you decide what is best for you? venture capital and venture debt are both viable options, but if not used appropriately, it can derail the functioning of your business.
Example1: Company X is trying to sell a new kind of meal prep business app in the market. Your product is home-cooked meals prepared by people and delivered to other people daily. You have just finished a round of angel funding, and are hoping to scale enough until you reach a market valuation that gets you the first round of venture capital funding. However, you are not making enough MRR because you realize your product is not able to find its product-market fit. You realize you are in competition with established companies like UberEats, DoorDash, etc. Your customers have not realized what sets your company apart. You decide to change your strategy and invest in marketing and introduce new features like weekly delivery (meal prep for the whole week) to attract new kinds of customers. How will you finance your business in this scenario?
Here, it is recommended to use venture debt to finance your business. This is because you need quick cash to invest in marketing and cover any capital expenditures. Many investors use venture debt as a lending mechanism only when they see good financial backing from a VC. You don’t have to make profits but ensure you are making enough revenue to be profitable in the future. You will have to take the time out to find someone that understands your business, your goals, is comfortable with the risk, and is willing to provide a loan structure that allows your startup to draw multiple disbursements as necessary.
Example 2: Company Y has developed a food waste solution app. Which allows excess food to be redistributed amongst others who can put it to good use. It is a revolutionary idea. VCs were already on board with your idea and they have invested in your business. You have reached the third round or Series B and are eyeing the next round of investment. You are looking for a $25 million capital raise. However, this was a time when Covid hit and investors are wary of investing their money.
You are already well established and you seem to have the first mover advantage. Now more than ever people need food, as there is food shortage and its excess can be used to feed other families. Here, venture capital is the answer. However, you should not be bootstrapped for cash used in operating expenses such as
- Rent and utilities
- Wages and salaries
- Accounting and legal fees
- Overhead costs (selling and administrative)
- Property taxes
- Any interests on previous debts
Make sure you know how much control in terms of equity was given to investors in previous rounds, so you do not give up more diluted shares than anticipated to new investors and lose control of your business. However, if you think Covid will affect your profitability and market valuation for the next round, you will need to think about taking in venture debt to ensure your business survives and operates during a pandemic. This will also ensure that you reach the market valuation you require for the next round.
So, there is no one way of financing which is proven better than the other. It solely depends on your startup’s situation. Venture capital is great for growing startups who have passed their angel round of funding, are scaling and whose long term growth is positive. Venture debt is suitable for firms looking to manage shortage of cash or money necessary to fund capital expenditures. In the current environment, many startups and their investors are renewing their focus on venture debt to get faster access to capital, avoiding a potential flat or a down round, avoiding suboptimal deal terms. Founders should look to their existing investors to support them with venture debt to ensure survivability.
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