Financing Alternatives: Venture Debt vs. Venture Capital

by Adarsh Raj Bhatt in August 11th, 2021

Key Takeaways

  • Venture debt is a cumulative term used to describe loans specifically created to provide support to startups backed by investors. Venture debt is generally used for startup companies that deal with products and services in the field of technology, life science, and other inventive economies.
  • Venture capital is a type of financing where investors provide capital to companies (in their early stages of development) that show great potential for growth in the long term. Venture capital is generally provided by experienced investors who have been in the business of backing up startups for a long time (generally >10 years).
  • While venture debt and venture capital serve the same goal of providing capital to startups, they can differ in a few ways. The factors where they differ include equity, value, repayment, valuation, and ownership.
  • When weighing the advantages and disadvantages, venture capital seems to be best suited to a company that has been doing business for a few years and has created a solid structure (or org design). The startup must also be in an industry that is currently in high demand. When these factors are present, the founder would typically already have the necessary knowledge to deal with venture capitalists
  • Venture debt is best suited to companies that are in the early stages of establishing their products and/or services. Under these circumstances, you are generally not making any impressive leaps with your revenue and require quick money to cover expenditures such as making key hires and investing in marketing. 

What is Venture Debt?

Venture debt is a cumulative term used to describe loans specifically created to provide support to startups backed by investors. Venture debt is generally used for startup companies that deal with products and services in the field of technology, life science, and other inventive economies. It’s targeted at small startups with venture capital backing rather than startups that have borrowed capital from friends and family. 

Most of the credit that is available to startups is based on their ability to generate cash flow. Another category of lenders is the one that provides advances against a startup’s liquid assets. These lenders rely on collateral as a source of repaying the borrowed money instead of cash flow. 

Both of these approaches are not recommended for startups that are in the early stages of generating revenue. In the case of venture debt, repayment depends on the startup’s ability to raise more capital which will fund growth and also repay the debt. 

What is Venture Capital?

Venture capital is a type of financing where investors provide capital to companies (in their early stages of development) that show great potential for growth in the long term. Venture capital is generally provided by experienced investors who have been in the business of backing up startups for a long time (10+ years). While their investments generally take a monetary form, they are also known to provide valuable technical and managerial advice to founders.

During a venture capital deal, ownership to chunks of the company is sold to the investors with limited partnerships generally established by the venture capital firm. Venture capitalists take a major risk by investing in new startups but the payoff if the company goes public / is acquired more than makes up for the initial investment. They generally get paid by selling their stakes in the company at a point of earning maximum profit.

Venture capitalists work at venture capital firms (or “VC firms”) and are known to invest in small businesses at later stages of their existence. However, in the early days of a startup, angel investors play a very important role in providing funding. Angel investors could often include High Net-Worth Individuals (HNWI). These are individuals who have retired from their days of business and now look to provide early investment to entrepreneurs. Startups that have received angel investments for some time have a better portfolio -- which benefits them when they apply for funding from venture capitalists further down the road.   

Difference Between Venture Debt and Venture Capital

While venture debt and venture capital serve the same goal of providing capital to startups, they both can differ in a few ways. The following are some of the factors in which venture debt differs from venture capital. 

Equity

Investors provide founders with capital to build their startups in the initial stages. Venture capitalists tend to ask for a good chunk of equity in the company in exchange for the capital. In the case of venture debt, on the other hand, the issuers tend to avoid taking any stake in the company. 

Value

In the case of venture debt, the cost of debt remains constant and is limited to interest rates which are agreed upon by both the company and the issuing party. Venture capitalists tend to rely upon equity, the value of which tends to fluctuate over time and sometimes does so drastically depending on the company’s stock performance. 

Repayment

Venture debt is similar to a bank loan -- repayment includes the principal amount plus the interest that the lender would have imposed on the borrower (i.e., the startup) in the beginning. In the case of venture capital, borrowed money is not paid back like it is in traditional loans. Rather, the investors buy a significant stake in the company which they can sell as the overall value of the startup increases over time. The exit strategy for venture capitalists generally comes into play when a company plans on going public, when there's a merger, or when it is acquired by a larger organization. 

While venture debt returns have less risk when compared to those of venture capitalists, the average payout for venture debt is less than that for venture capital. 

Valuation

Business valuation is a process where the total economic value of a business is calculated. This is used to identify the fair value of a business. In the case of venture debt, a startup does not need to be evaluated, a circumstance that reduces the complexity of due diligence. However, in the case of venture capital, a startup will be thoroughly scrutinized with a rigorous due diligence process. 

Ownership

In the case of venture debt, there is no requirement to provide a seat to the lenders on the startup's board. The lender lets you retain 100% ownership of the company and does not weigh-in on the way you run the business. By its very nature, venture capital generally requires a seat on the board. This is primarily because venture capitalists, in addition to money, provide technical and managerial advice to the startup. However, this tends to cost the founders a certain loss of control in the business.

When to Use Venture Debt?

While venture debt can be a great asset to a budding business, there are a few instances where it is advantageous. This is especially true in cases when venture capital might not be right for a startup.

The following are some of the scenarios when you can use venture debt:

Insurance

You can come across various obstacles while running a new business. Many times, to overcome these hurdles, you will need some kind of monetary cushion. Venture debt can come very handy in such situations to avoid any lasting damage to the business and help it keep moving forward at a smooth pace. If the startup takes longer than anticipated to reach its next developmental stage, then venture debt could come in handy as insurance.

Fund larger expenses

While running your startup, you may come across scenarios where you need more money. These expenses will generally have something to do with the expansion, scaling, or acquisition of valuable assets. If you require extra capital during these moments, then opting for venture debt is a fairly safe option available to you. It the cheaper alternative of options available to you. 

Covering under-performance

You cannot always expect your profit graph to be pointing upward. There will come points, especially in the early days of running a business, when you will be underperforming. During a downturn in the market, you may fear a decline in your next tally of capital. Venture debt comes in handy in this situation as it will help finance your business during this time so that you don’t take any significant losses until the market stabilizes. 

Milestone boost

When running a business, you will likely set certain milestones which, when achieved, will be an indicator of transitioning into the next phase of the venture. However, while you may be making a steady profit, you may still fall short of hitting your next milestone. In such situations, venture debt acts as a kind of a stimulus to provide the remaining capital.  

Avoid Bridge Rounds

Bridge rounds are small fundraisers that raise enough capital for startups to help them survive till the next major infusion of funding. They are generally implemented throughout the life of a company. However, raising a bridge round from your investor can be an expensive endeavor and potentially create a poor image. Venture debt can help fill these portions so that you can make it to the next milestone without requiring a bridge round.

When to Use Venture Capital?

Venture capital is a smart and established way for businesses to raise capital to get things going. 

The following are some circumstances where venture capital can come in handy:

Early-stage

As mentioned above, venture capital is a great way for startups to obtain the money to acquire the assets that are required in the early stages of establishing a business. Early-stage financing can take multiple forms based on why you require the capital. 

Seed financing is when startups request a minimum amount that will help the founder become eligible for a startup loan. 

Start-up financing, the next step in early-stage capital, is where financial support is provided to a company in its early days to finish the development of products and/or services. 

The next form of early-stage financing is when financial support is provided to a startup for pushing it into full-scale production.   

Scaling project

After a startup has been running for some time and has found a comfortable pace at which it can develop and deliver its products and/or services, the next big step would be to expand the business. An expansion could entail anything like moving from a small office to a larger office, adding more to your infrastructure, growing the team significantly, or expanding to international markets. 

Expansion financing can take various forms based on the amount being raised and its use. One of these types is called second-stage financing which is provided to companies looking to begin the process of expansion. The amount of capital needed in this type of financing is rather large and used to cover all facets of initial expansion efforts. Another form of expansion financing is bridge financing. This type of financial support comes with short-term interest and is used as monetary assistance for companies that use an Initial Public Offering as their standard business strategy. 

Acquisition

After a certain point in running your business, opportunities to expand into newer avenues will arise. One of the ways to go ahead with this expansion is by buying entire companies or certain parts of them. The acquisition and merger of two companies, regardless of their size, will almost always be an expensive venture. 

In such situations, venture capital funding can give you the right push to make acquisitions go smoothly. 

Which is better: Venture Capital or Venture Debt?

To understand which one of these options is better for you, founders must understand the advantages and disadvantages of each of them.

Advantages of Venture Capital

  • Since VC funding is not a loan, there is no need to pay the money back and it is free of any form of interest. The risk completely lies with the venture capitalist. 
  • Venture capitalists are a great font of experience and knowledge related to running a successful business. Other than knowledge, they can also provide crucial guidance and support in the form of valuable networks and quality hires

Disadvantages of Venture Capital

  • Venture capital is provided to businesses in return for equity in the company. This allows venture capitalists to have their voices heard during important board decisions. There is potential for some clash in beliefs between founders and VCs as the latter assert their ownership. Since founders give up some percentage of the total stock, there is an added threat of losing ownership of the company. 
  • Since most of your projects will be confidential before the official release, members will be asked to sign an NDA (Non-Disclosure Agreement). However, some VCs tend to avoid signing any documentation in this regard. 

In weighing the advantages and disadvantages, venture capital seems to be best suited for a company that has been doing business for a few years and has created a solid structure (or org design). The startup must also be in an industry that is currently in great demand. When these factors are present, the founder would typically already have the necessary knowledge to deal with venture capitalists

Next, let’s look at some of the advantages and disadvantages of venture debt:

Advantages of Venture Debt

  • Venture debt helps startups extend the time after which they run out of money (their runway) and help provide the necessary boost to reach certain milestones. This increases your value to investors without you losing significant control of your business. 
  • Venture debt works great as a safety blanket for businesses that are trying to cover a drop in profits

Disadvantages of Venture Debt 

  • You will have to pay the money back over time along with the interest. Sometimes, to qualify for venture debt, you are required to keep some assets as collateral. 
  • In case you are not able to reach the goals that have been laid out in the loan contract, your image starts to falter and lenders tend to lose faith in you. 

Considering the aforementioned advantages and disadvantages, we can safely say that venture debt is best suited to companies that are in the early stages of establishing their product and/or services. Under such circumstances, you are generally not making any impressive leaps with your revenue and require quick money to cover expenditures (such as making key hires and investing in marketing). 

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