One of the most important tasks every entrepreneur will eventually be faced with is successfully funding their business to facilitate growth. Bootstrapping will only get you so far, and in order to really grow your business from a small start-up to unicorn status, business owners will have to rely on outside funding to take their company to the next level.
With so many funding options available, it can be difficult for entrepreneurs to decide with confidence which option is best for them.
Two of the most popular financing methods used today are venture debt financing and venture capital. Both provide entrepreneurs access to considerable amounts of capital they can use to hire new employees, expand into new markets, and develop new products.
However, both also work in very different ways from each other, and depending on the needs of your business, as well as your desire to retain control of your company, will significantly influence which form of financing is best for you.
To help entrepreneurs decide between venture debt or venture capital, this article will cover the ins and outs of each, as well as highlight the most important determining factors for entrepreneurs looking to raise capital efficiently.
What is Venture Debt?
Venture debt is a form of debt financing, usually in the form of a non-convertible senior secured loan, used by entrepreneurs, often in conjunction with other forms of capital raising techniques, to supply their business with working capital.
Venture debt lenders are financial institutions that specialize in taking on higher amounts of lending risk in exchange for the potential of higher returns. The duration of venture debt is usually much shorter than a conventional loan or venture capital funding, with the expectation a business will repay its loan within 1-3 years. Because of this short duration of time, venture debt is often used for short-term projects or operational improvements that can be implemented quickly by a growing business.
What is Venture Capital?
Venture capital is a form of private equity financing where investors provide capital to fast-growing start-ups in exchange for an equity stake in the business.
Venture capital investors come in many different sizes, as both large institutions, as well as single investors, are able to provide venture capital funding. Whereas venture debt relies on business owners to repay the borrowed amount while also making interest payments, venture capital investors receive an equity stake in the business with the intention of selling their shares at a later date for a profit.
Receiving venture capital backing is a popular strategy used by entrepreneurs, as it doesn’t require you to pay back the money received and also opens the opportunity to receive advice from venture capital investors who are usually successful entrepreneurs themselves.
How Does Venture Debt Work?
Venture debt is provided by specialized financial institutions that understand the risks involved in lending to early-stage companies. These specialized lenders don’t have to be traditional banks, as venture debt is a form of financing provided by hedge funds, venture capital firms, and other business development firms.
The amount of capital available to start-ups through venture debt will vary, but a general rule of thumb to follow is venture debt amounts will be between 25-35% of a company’s latest valuation. Meaning if a company were recently valued at $1 million from their most recent venture capital raise, this start-up would be able to secure between $250,000-350,000 in venture debt financing.
Similar to pitching your business to venture capitalists, securing venture debt financing will require entrepreneurs to show a detailed business plan, strategy for growth, projected financial statements, and a detailed outline of what they will use the financing for.
In terms of how venture debt is structured, most venture debt terms and agreements come in the form of non-convertible debentures (NCDs), which are coupon-bearing instruments issued by the borrower (the company taking the loan) to the lender (the financial institution providing the capital). This structure, combined with the lender also receiving warrants from the borrower, gives the financial institution the right (but not the obligation) to receive a predetermined amount of equity in the business at a set price within a specific period of time.
In essence, venture debt combines both traditional debt financing methods with venture capital financing to help mitigate the risks taken on by the lending party while also reducing the amount of equity business owners must give up when receiving capital.
Venture lending is a niche form of financing used by entrepreneurs in tandem with other forms of capital raising methods. And because of their unique structure, they are best used by companies looking for smaller amounts of capital.
Some of the most common reasons why business owners utilize venture debt financing include:
Reducing equity dilution
Relying on venture debt funds instead of traditional venture capital funding allows business owners to access considerable amounts of financing without having to reduce their equity position significantly.
Increasing cash holdings in-between funding rounds
Sometimes businesses require small to midsize cash infusions in between their large venture capital rounds. Venture debt can be an efficient option to help growing companies keep higher cash amounts needed to sustain their growth.
Superior working capital method
Venture debt is a preferred method of financing for companies that need quick access to working capital. This capital isn’t meant to execute large-scale projects but rather supports the day-to-day operations of a company.
Building a favorable credit track record
Venture debt allows business owners to build a strong credit background for their company which will help them secure larger-sized loans as their company continues to grow.
How Does Venture Capital Work?
Venture capital consists of business owners pitching their company to equity investors who are looking to provide capital to promising businesses in exchange for partial ownership of the company.
Unlike venture debt, which outlines a repayment schedule and the ability of the lending party to acquire shares at a set price, raising money through venture funding (also referred to as growth funding) doesn’t require a business to repay the received capital. Rather, business owners must give up equity in their business in exchange for capital.
The amount entrepreneurs can raise through venture capital financing varies significantly, as business owners can perform multiple rounds of VC capital raises and ask for consistently increasing amounts as their company continues to grow. In order to secure VC funding, startup founders should come prepared with a pitch deck, business plan, financial statements, and a well-thought-out plan as to why their business is worth investing in (to learn more about how to secure venture capital funding, check out our other post here).
Venture capital does not come with the detailed loan agreement or steady interest payments associated with venture lenders, which alters the strategic purposes as to why a business owner would choose venture capital over venture debt. Some of the most popular reasons why young companies choose to fund their business through venture capital include:
Business owners looking to avoid monthly payments
VC funding comes with the added benefit of not having regular monthly payments. Businesses that don’t have consistent cash flow typically look to raise capital in ways that won’t burden the company financially.
Venture capital funding comes with expert advice
Partnering with a venture capital firm opens the opportunity for business owners to receive valuable advice and networking opportunities from their new business partners. This is a luxury not typically associated with venture debt, which provides little resources other than capital.
Increases publicity and legitimacy of businesses
Successfully securing VC funding helps growing businesses prove their legitimacy within their market and oftentimes comes with added publicity that may help the business grow further.
Makes additional funding rounds easier
Growing businesses require multiple cash infusions to facilitate growth consistently. And securing your first round of VC financing will make the second, third, and fourth rounds easier. Choosing to pursue VC funding can be a strategic decision by business owners who intend on seeking larger sums of capital further down the road.
Venture Debt vs. Venture Capital – Which One is Better?
Venture debt and venture capital are both powerful tools business owners have at their disposal to help grow their business and receive the cash they need to expand into new markets, develop new products, or hire an ever-growing team.
And while both provide significant opportunities for entrepreneurs, they also have distinct characteristics that may make one method more advantageous than the other.
The good news is that these financing methods aren’t mutually exclusive, and business owners can utilize both forms depending on what their business currently needs. Depending on the aspirations of the founders, the current financial state of the company, and financing requirements will influence which form of funding is most appropriate for founders to pursue.
To help make this decision easier, we’ve provided a quick breakdown of which financing method is likely to be the better fit:
Venture debt is best for:
- Businesses that need smaller amounts of capital
- Entrepreneurs who don’t want to give up equity in their business
- Companies that have consistent cashflow and won’t have a problem making regular payments
- Businesses that are looking for short-term cash solutions in between rounds of equity financing
Venture capital is best for:
- Business owners who want access to other resources other than cash (such as networking opportunities and expert advice)
- Businesses that need significant cash infusions for large-scale projects or new growth initiatives
- Companies that don’t have consistent cash flow and may struggle to repay borrowed amounts
- Entrepreneurs who plan on raising multiple rounds of funding for their business
In conclusion, whether a business owner chooses to pursue venture debt or venture capital ultimately depends on their specific financial needs and long-term goals. While both financing methods offer distinct advantages, understanding the differences between them is essential in determining which is most appropriate for their business. In many cases, combining the two can be a powerful way to balance short-term financial needs with long-term growth goals.