Startup Financing: Is Venture Debt an Alternative to Venture Capital Equity? [Start-up, finance]

Startup, Funding, Capital, Finance, VC, Debt, Tech, Venture Capital, Unicorn, Start-up Growth.

By Ayomide Awoyemi

Oyemaja; Startup Financing: Is Venture Debt an Alternative to Venture Capital Equity? [Start-up, finance]

Introduction

The modern global economy has become largely influenced and driven by innovative ideas and technological disruptions. This millennium is just about two decades old, yet, it is almost unimaginable that many of the inventions and technology that we enjoy today did not exist at the start of the millennium. These inventions and technological developments were birthed by disruptive ideas backed by capital to bring them to fruition.

As a start-up founder, one of the main tasks that you have to contend with is raising capital to ensure that your products and services are delivered to your target consumers. However, this task has become even more challenging in light of the slowdown in Venture Capital (VC) funding after years of consistent growth. In light of what has been tagged an “equity crunch” in the tech ecosystem, different alternatives (most notably venture debt) have been suggested as the next best financing option for startups. In 2022, the African tech ecosystem attracted $6.5 billion in funding. Debt funding alone doubled from the previous year to about $1.5 billion while a slight decline of 6% was recorded for venture capital equity. In the first half of 2023, the ecosystem recorded a 54% drop in VC funding in comparison to first half of 2022.

With the consistent decline in VC funding and debt funding becoming a more attractive source of financing for startups in Africa, the recurring question has been whether venture debt is a direct alternative to private equity. In the paragraphs that follow, this piece will attempt to answer this question. There will also be an examination of key considerations that founders will have to make when choosing a source of capital.

What are Venture Capital and Venture Debt?

There is no gainsaying in the fact that equity and debt are the primary forms of financing that business ventures employ in funding their activities. For startups and early growth-stage companies, venture capital equity (or private equity as they are generally referred to) and venture debt are the “go-to” types of financing. Venture capital typically refers to equity financing provided to startups with high growth potential by venture capital firms in exchange for some ownership in the business venture. Venture debt on the other hand comes in the form of a loan advanced to the startup with a specific repayment date with predetermined interest to be paid on the loan and does not require the startup to give up part of its ownership.

The non-dilutive nature of venture debt financing exists as the primary distinction of venture debt from venture capital. However, venture debts often come with warrants which have future dilutive potential. Warrants operate in a similar fashion to employee stock options; they are securities that lenders require to afford them the right (not an obligation) to buy a specific amount of the company’s shares at an agreed price on a predetermined date. This allows lenders to benefit from an increase in the value of startups they helped fund. This “equity” element in venture debt makes it somewhat similar to venture capital. Essentially, both private equity and venture debt are specifically designed to provide the much-needed capital that startups require to scale up their business. It may therefore be said that venture capital and venture debt are two sides of the same coin.

How is Venture Debt different from a traditional loan?

While venture debt as described above bears striking similarities to traditional debt financing, it is essential to point out that they do not operate in the same way. Traditional debt financing often comes in the form of bank loans or credit from similar financial institutions. The provision of debt financing is usually predicated on the ability of the borrower to repay the loan.

A business owner often provides this assurance by providing some form of collateral or proof that the business is generating enough cash flow to meet up with repayment obligations. With startups at the early stage, there are usually no tangible assets to deploy as collateral, neither is the company established enough to guarantee consistent cash flow. These intrinsic conditions make startups largely unattractive to creditors and limit the access of startups to traditional debt financing. With venture debt, there is more flexibility as lenders are not particularly fixated on metrics like past performance or profitability. Instead, venture debt lenders consider the amount of venture capital support the startup has garnered and how much potential it holds. It is therefore important to point out that venture debt is not an exact alternative to venture capital as it is a cherry on top of the cake rather than a new cake in itself. Essentially, a VC-backed startup is better suited for venture debt than a startup at seed funding stage. This is because the existence of VC funding signals the strength and growth potential of a startup which in turn makes it attractive to lenders.

Venture debt is therefore a more suitable source of finance for startups looking to raise additional capital in between `private equity raises. For instance, if there are two companies: “X” and “Y”, and X has raised one round of equity backed by a VC firm while company Y is still at seed funding stage, institutional lenders would be more willing to offer venture debt to company X than Y.

How is Venture Debt different from a traditional loan?

The Pros

As a source of financing, the stand-out and most attractive feature of venture debt is that it is non-dilutive as it typically does not require the issuance of new shares. Thus, unlike with VC equity, founders do not have to worry about giving up part of the ownership of their companies in exchange for an inflow of capital. Another upside to venture debt is that it is relatively cheaper in comparison to VC equity. This is because creditors require lower returns when compared to equity investors. It is important to also note that interest payments on venture debt are allowable expenses for tax purpose which operates to reduce the overall cost of securing the debt capital. Another important benefit of venture debt is that it offers an avenue for startups to access a quick injection of cash into the business without having to jump through the extensive technical and administrative hoops that come with rounds of equity raises. This particularly makes venture debt attractive as a stopgap when a startup is in between rounds of equity raises.

The Cons

The main downside of venture debt as a method of startup financing stems from the risk of defaulting on the repayment of loans obtained. The risk of default is often tied to how stringent the financial covenants in the loan agreements usually are. It is also important to point out that the limited flexibility in the repayment terms and schedules which is common with venture debt may put undue financial pressure on the startup

What are the factors to consider when choosing a source of capital?

In the previous sections of this piece, the distinctions between venture debt and private equity have been well highlighted. The question at this point is: “Which of these sources of financing should a startup adopt?” It is clear from the points raised earlier that each of these sources of financing has its benefit and shortcomings. Thus, an “appropriate” choice will be dependent on the specific needs and financial position of a startup. In view of this, there are key considerations to be made, some of which will be discussed below.

The Growth Stage of the Startup

The stage of development of a company in its lifecycle should primarily inform the type of financing that its managers will seek out. For startups that are at the stage of seed funding, venture capital firms are the go-to for raising capital. At this stage of development, the company requires a huge deal of capital for its product development. It also requires considerable technical and managerial support that only private equity firms will be willing to offer.

Financing Needs of the Company

For startups at their early growth stage who have raised some rounds of equity, their capital needs may range from long-term investments in capital expenditure to meeting short-term working capital obligations. While VC equity is more appropriate for long-term investments in the company because of the flexibility it offers, venture debt is more suited for the short-term capital needs of the company.

What are the factors to consider when choosing a source of capital?

Ownership and Control

While contemplating the appropriate source of financing to adopt, the startup founders will also have to consider the amount of ownership and the level of control they are willing to relinquish to investors in exchange for raising capital. A company that has already given up sizable shareholdings to equity investors may be better off considering venture debt for raising additional capital rather than further diluting the shareholdings of existing investors and giving up more control of the company's management. It should however be noted that while venture debt are not primarily dilutive, the existence of warrants in most loan agreements creates a potential for future dilution. Thus, the terms and conditions of individual loan agreements will ultimately determine the potential impact on the company’s ownership structure.

Cost of capital

Generally, debt is a cheaper source of capital when compared to equity in any form. The fact that interest payments are allowable expenses for tax purposes also contributes to the reduced cost of raising debt capital. It should also be noted that going through a round of equity often comes with huge legal, due diligence and administrative costs. With venture debt, these costs are reduced because of the reduced burden of due diligence and regulatory compliance when compared to equity

Conclusion

It is clear from the foregoing that capital is a necessary tool for every startup to realize its full potential. It has also been well established that private equity and venture debt are the principal sources of capital suitable for startups. Ultimately, these two sources of finance provide the path to cash injection into the startup. However, as emphasized throughout this piece, each of the sources has its distinct value proposition that is best maximized under specific conditions. Thus, one is not a direct alternative to the other and in fact, the company headed in the right direction is one which maintains a healthy blend of both venture debt and private equity in its capital structure.

References

1. Partech Partners, “2022: Africa Tech Venture Capital” https://partechpartners.com/2022-africa-tech-venture-capital-report/

2. Ephraim Modise, “Africa VC funding dips by 54% in H1 2023, as accelerators lead the way in cheque-writing” https://techcabal.com/2023/07/11/africa-vc-funding-h1/

3. European Investment Bank, “What is Venture Debt” < https://www.eib.org/en/stories/what-is-venture-debt>

4. Silicon Valley Bank, “What is Venture Debt” https://www.svb.com/startup-insights/venture-debt/what-is-venture-debt

5. De Rassenfosse, G. and Fischer, T., 2016. “Venture debt financing: Determinants of the lending decision.” Strategic Entrepreneurship Journal, 10(3), pp.235-256.

6. The OECD, “New Approaches to SME and Entrepreneurship Financing: Broadening the Range of Instruments” < https://www.oecd.org/cfe/smes/New-Approaches-SME-full-report.pdf>

7. Jared Hecht, “Which type of funding is actually best for your business” https://techcrunch.com/2019/06/05/which-type-of-funding-is-actuallybest-for-your-business/

8. Kjartan Rist, “Venture Debt: Is It A Loan? Is It Equity? Is It An Opportunity?” https://www.forbes.com/sites/kjartanrist/2020/02/17/venture-debt-is-it-aloan-is-it-equity-is-it-an-opportunity/

9. Darian Ibrahim, 2010. “Debt as Venture Capital” William & Mary Law School Scholarship Repository

Originally published by Ayomide Awoyemi on Linkedin

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