In the last topic, we covered how venture debt can benefit startups and aid them in achieving high impact milestones without losing too much equity.
It is important to note that Venture Debt is not a substitute for Venture Equity but complements it. It allows startups to borrow money even though they would not otherwise be creditworthy from a traditional debt perspective.
The fundamental premise behind Venture Debt is not to take equity risks. Its investment thesis is based on backing companies that have raised institutional equity and have strong ability to attract follow-on equity interest. Therefore, Venture Debt providers collaborate with VCs to help their investee companies succeed. Though there are separate funds which offer Venture equity and debt.
How The Existing Venture Equity Investors Can Benefit From Venture Debt
- Faster scale-up of portfolio companies: The main aim of an equity investor is to scale portfolio companies and help them hit key metrics leading to an increase in valuation. Time is money and this is especially true in case of rapidly growing businesses. Growth triggers can range from aggressive marketing campaigns to acquisition opportunity or even a global expansion strategy, all of which require timely capital. Without Venture Debt, these companies would be under constant pressure to raise next round of equity investment within 12 to 15 months of the previous round.
- Sizably less investors’ equity dilution: Venture debt covers the cash needs of high growth companies extending their runway to around 24 months. This gives founders the space they need to focus on growing their business. As a result, these companies are able to raise subsequent equity round at much higher valuation. Also, equity investors are able to avoid dilution from new investors in an interim equity round. Having a longer runway also gives VCs more time to evaluate the startups’ worthiness for a follow-on round.
- Steady capital flow: Venture debt allows VCs to delay and/or reduce the amount of capital they are forced to draw down from fund investors, which improves the VC’s internal rate of return (IRR). As with any investment, VCs want to diversify and create a portfolio of investments. Having Venture Debt as an additional source of capital allows Venture equity investors to reserve capital for follow-on investments in portfolio companies or fresh investments in other companies. This enhances their ability to judiciously allocate capital and mitigate their risk.
- Complementary working styles: In addition, Venture debt providers complement VCs in their working relationship with portfolio companies. While VCs have a hands-on relationship with investee companies, by design Venture Debt investors are more hands-off. They are less involved than VCs in the management of the company and typically only provide strategic guidance. This also enables equity providers to avoid any potential conflict between investor/board role and lender role.
- Aligned interest with VC and founders: The interests of Venture Debt providers are aligned with interests of VCs and entrepreneurs. While VCs have a longer perspective, typically 7-10 year life of the fund, Venture Debt providers are focused on next 15-24 months. Thus, while VCs are looking at probability and bottom-line, venture debt providers are focused on the probability of survival of the company. For founders, both survival and profitability are key but of course, they need to survive in order to keep growing. In that sense, Venture Debt also acts as insurance, particularly in a bearish environment when raising equity capital is tough for startups.
There Are Also Collateral Benefits
- Build track record: Taking debt early in their lifecycle allows these companies to build a track record while they are young. Having a healthy borrowing history enables them to access conventional pools of debt capital later in their lifecycle.
- Adoption of fiscal discipline: It also gets them in the habit of managing cash flows, allocating costs and reporting metrics on a timely basis. Adopting these habits of fiscal discipline, reporting and investor relations proves very beneficial for equity investors.
From investor (LP) perspective, since the risk-reward profile of Venture Debt is very different from Venture Capital, they attract investment from different pools of investor (LP) dollars.
While Venture Equity follows high risk – high returns profile, Venture Debt risk-reward profile is a more moderate risk- high return. Allocation to Venture Capital usually happens from LP’s alternate investments pool, whereas, many times, investment in the Venture Debt happens from LP’s Debt portfolio.
Accordingly, venture debt is not an alternative to investing in venture capital funds but instead an opportunity for LPs to participate in the venture ecosystem through a high-yield strategy. It helps cautious investors (LPs) not comfortable with high risk – high return profile of Venture Capital explore early-stage ecosystem without getting their feet wet.
In this sense, Venture Debt primes LPs for the early stage ecosystem and make them comfortable allocating to VCs over a period of time.
In sum, Venture Debt helps good companies get even better while simultaneously generating returns for equity investors. It complements Venture Equity and helps VCs make their investee companies succeed. It also primes investors (LPs) new to the early-stage ecosystem, making them comfortable allocating to VCs over time. By using a judicious combination of equity and debt, companies can optimize their cost of capital, minimize dilution and enhance return on equity for their sponsors.
[This article is part of 4 article series on Venture debt funding. You can read more articles here.]