Deciding Between Venture Capital and Venture Debt

The upheaval with Silicon Valley Bank is prompting founders to reevaluate their financing approaches and explore bootstrapping or alternative growth capital sources to finance their startups. While many founders are familiar with seeking angel and venture capital investments, an increasing number are turning to venture debt solutions as a more sustainable choice. Nevertheless, the application processes for VC funding and debt financing differ significantly. In this article, we outline some of the principal distinctions and offer guidance on what to anticipate during each journey.

1. Eligibility

There are venture capital investors that cover all company stages from pre-revenue, early-stage or high-risk companies with a compelling growth story to later stage companies.

Not all businesses are suitable for venture debt, however, as lenders typically require some degree of traction, revenue, or a strong financial statements. There are many types of debt financing lenders — from short term lenders to specialty lenders — and each one focuses on a different market segment. For example, TIMIA focuses on recurring revenue technology businesses with between $2 and $20 million in ARR.

2. Application Processes

When considering an investment, a venture capital investor will focus on the company’s growth potential, market opportunity, and the ability of the management team to execute the business plan. Venture capital investors seek high-growth companies with the potential for substantial returns on investment.

A VC application typically includes a pitch deck, executive summary, business plan, financial projections, and a cap table. Additional materials may include market research, customer testimonials, and product demos.

Debt providers, on the other hand, focus on the company’s financial health, creditworthiness, and ability to repay the loan. As such, debt providers look for companies with a solid financial foundation and a lower risk profile.

A debt financing application generally requires more extensive financial documentation, including historical financial statements, detailed financial projections, budgets, and information on existing debt obligations. 

3. Deal Structures

Entrepreneurs should consider the implications of giving up ownership and control with venture capital versus taking on debt.

Venture capital involves selling equity stakes in the company in exchange for capital. This process often involves issuing preferred shares to investors, which can include certain preferential rights, such as liquidation preferences, anti-dilution provisions, and dividend rights. Read our recent post about VC terms for more information.

Debt is a loan that needs to be repaid over time with interest. It is usually structured as a term loan or a line of credit. The loan’s terms will generally include an interest rate, repayment schedule, and maturity date. Not all debt is the same, however, so do your research. Short-term loans or MRR to ARR loans can do more harm than good in the long term.

TIMIA’s debt solutions are different. Our interest-only loans allow founders to keep as much working capital in the business for as long as possible to help fuel growth and our amortized loans are ideal for recurring (or repeat) revenue technology businesses since the repayments start low and increase over time (hopefully as your business grows).

4. Dilution

Venture capital can result in dilution of ownership and control, as investors often require preferred shares, board seats, and certain governance rights. This dilution can affect the founders’ decision-making power and the value of their shares in future financing rounds or exits.

With debt, entrepreneurs maintain control and ownership of their company, as long as they meet the terms of the loan. There is no direct dilution of equity, but warrants may be included, which can lead to some dilution if exercised. Note that TIMIA’s debt financing solutions never include warrants.

5. Use of Funds

Venture capital is used to fund long-term growth, hiring key personnel, and launching new products or services. It can help companies scale more quickly and navigate through competitive markets. 

Debt is typically used for short-term needs like sales and marketing, equipment financing, or bridging gaps between financing rounds. It can also be used to extend a company’s runway, allowing it to achieve key milestones and potentially increasing its valuation before raising another round of equity financing.

6. Cost of Capital and Exit Expectations

The cost of capital for venture capital is higher than debt due to the higher expected ROI sought by equity investors. Venture capitalists typically target high-growth companies with the potential for substantial returns and expect a return of around 40% per year from their investments. For example, if they invest in your company at a post-money valuation of $10M, in 7 years they expect you to exit at $100M. That works out to about 40% per year.

VC investment can also result in pressure for startups to pursue specific strategic directions to achieve an exit within a certain timeframe, which may not align with their long-term goals.

For companies that have achieved a significant flywheel and are not under time pressure to exit, taking on venture capital may not be the most cost-effective option in the long term. Additionally, venture capitalists may pressure companies to spend money, take risks, and operate in ways that may not align with their vision or values.

In contrast, debt providers have no direct influence on a company’s exit strategy as long as the loan is repaid on time. This makes debt a potentially more attractive option for startups that prioritize maintaining control over their strategic direction. Furthermore, the cost of debt is typically lower than the cost of venture capital since it is based on interest rates rather than expected ROI.

We often talk about the “hierarchy of growth capital” where we advise founders to:

1. Source as much recurring monthly or annual revenue as you can up front
2. Ensure you’ve maximized your startup grants from government sources start where the cost of capital is the lowest
3. Speak to your bank and try to access lines of credit
4. Once you’ve tapped out the bank credit, research other non-dilutive sources of capital such as TIMIA’s interest-only or amortized loans. 
5. Keep revisiting non-dilutive options any time you’re considering additional financing down the road.

Wondering if debt is right for you? Visit our website for more details on our finance offerings or contact our team. 

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