Private equity and venture capital have a lot in common. Both involve acquiring or investing in promising companies, creating value, and then exiting on predetermined timelines. A key difference between those investing strategies is that while venture deals have historically been funded with equity, PE transactions typically use material amounts of debt in the funding stack.

In part, that’s because the two strategies invest in different kinds of companies. Private equity buyers tend to look for mature companies with substantial assets and operating cash flows. Those businesses can support servicing large amounts of debt, so the buyers can fund the bulk of the purchase price and thereby maximize their equity returns.

Venture capitalists, traditionally, take a different route. They are backing startups, most of which are unsuitable for traditional leverage. Instead of generating cash that can be used to pay down debt, they consume cash to drive growth. Plus, they have few or no tangible assets. That rules out traditional loans as a funding strategy and leaves equity as VCs’ default source of capitalization.

But is that really the best option? Could startups and VC investors be better served by capital structures that more closely mimic the ones that private equity professionals use? And, more specifically, what could they gain from using debt in their capital structures?

Why Debt

Debt is cheaper. First, its claim on a company’s cash flows is senior to equity holders, making it less risky than an equity investment. That lower risk means that a borrower doesn’t have to pay as much for senior funding as it does for equity capital. On top of that, most tax codes favor debt-servicing costs relative to equity, since interest payments are generally tax-deductible. Dividends, in contrast, come from after-tax earnings.

Because debt is a senior, contractual obligation, while equity is a residual claim on cash flows, under normal circumstances the cost and value of a given debt instrument are fixed. In other words, regardless of whether the value of the business rises or falls, the value of the debt is constant.

That means that if a CFO were to fund 80% of a $100 million business with debt, and the value of that business doubled, it would still only have to pay back $80 million. Meanwhile, the $20 million equity investment would now be worth $120 million, a six-fold return. Even after adjusting for interest and other costs, the increase in the value of owned equity would have gone up dramatically.

Of course, if a buyer funded the entire cost of a purchase with equity, it would still have made a substantial nominal profit. It’s just that the change in the value of the company would have to be shared with all the other shareholders that contributed capital to the business. If a business is 100% equity-financed, then doubling the value of the business doubles the value of the equity. And while that’s pretty good, it’s certainly not as good as the levered investment described above.

Venture Equity Costs

The technical way to calculate the cost of equity is to combine a number of inputs, including the risk-free borrowing rate, the equity risk premium, and the correlation between the stock in question and the broader market. Those aren’t easily obtained for private companies, but we can use the returns to the buyer as a proxy for the cost of equity to the seller.

Venture capital firms typically target annual returns of 25%, for a fund with a 10-year term. But the cost to the issuer is much higher than that because of the dynamics of venture capital fund management.

As a starting point, venture capital firms typically target annual returns of 25%, for a fund with a 10-year term. But the cost to the issuer is much higher than that because of the dynamics of venture capital fund management.

First, a significant percentage of a VC’s available funds don’t actually get invested. Instead, they’re used to pay a variety of expenses, such as audit and legal fees, which can add up to 15% of a fund’s assets. That 25% return on each dollar of assets has to be earned off the 85 cents of each dollar in the fund that is actually invested in portfolio companies. That implies that each dollar an entrepreneur receives has to nearly triple in value over a decade to meet the VC’s target.

Of course, nobody expects to earn uniform returns across a portfolio; a venture portfolio will generate a wide range of outcomes. Knowing that some percentage of their portfolio will produce a total loss, venture investors look for outsized returns on the investments that do work.

Since VCs have no way of knowing which investments will be winners, they prefer to invest on terms that leverage their initial commitments if a thesis develops positively but minimize their initial commitments if it doesn’t. Attaching warrants to an equity round is an example of this approach. But, in general, VCs will try to structure each investment so that they can capture an outsized return from it if it works while overcoming the drag on the portfolio from the investments that inevitably fail.

The bottom line is that venture capitalists can’t invest 100 cents of each dollar that their investors give them, and some of the dollars that they do invest will be completely lost. That suggests that they need very high returns on their successful investments, which in turn implies that the cost of those investments for the shareholders (business owners) selling them is very high. It could be as much as 100% per year, and certainly well in excess of the 10% to 15% that venture debt might cost.

Historical Barriers to Debt

Historically, young businesses haven’t been able to borrow. Companies with negative earnings before interest, taxes, depreciation and amortization (EBITDA) and negligible assets weren’t very attractive to potential lenders. Plus, since the business risks of startups are so high, few founders wanted to compound them by adding financial risk in the form of debt.

But once a company has proved that it can meet a real market need and experiences rapid growth — even if it’s not yet profitable — then its business risk reduces materially. And, as the business risk recedes, the relative costs of capital should be a larger consideration for the company: it can consider adding debt as a permanent part of its capital structure.

Today’s specialist lenders understand that business risk isn’t just a function of how long a company has been operating or how old its chief executive is. That understanding has allowed venture lenders to engineer new tools that let young, rapidly growing businesses borrow.

For example, the advent of the sofware-as-a-serve business model has spurred recognition of the value of having an installed client base, even if that value doesn’t show up on a prospective borrower’s balance sheet. Practitioners have also developed analytics to understand the risks and qualities of companies they might lend to. Meanwhile, sector specialists cultivate and forge deep relationships with founders and managers that yield a qualitative overlay to their numerical analyses.

As debt has become more widely available, so too has its benefits become more widely understood. Venture debt can serve as a tool to fund working capital and mergers and acquisitions, to add resources to research and development, and to bridge to better terms for equity raises. As noted above, it can also be a far cheaper way than equity to fund these kinds of initiatives and investments.

Debt also solves for a number of other issues that can arise in terms of equity financing, such as having to give up board seats and managerial flexibility.

Private equity partners have benefited from these dynamics over a long period. Now that the option is open to them, perhaps more VCs and entrepreneurs will look at the lessons they could learn from their peers in private equity.

Gordon Henderson is the managing director, portfolio management, at Espresso Capital, a provider of venture debt and growth financing solutions.

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One response to “Startup CFOs: Consider Adding Debt to the Funding Stack”

  1. Agree with the opinion expressed in this article, VC is indeed an alternative to getting cheap funds to increase the company’s business capital capacity, but it should be remembered that the VC participation model is equity participation by acquiring ownership in the form of shares, whose value is based on the value of the capital investment.

    The level of risk lies on the side of the VC, if the company fails to expand its business growth, therefore the VC syndication must be mature in calculating the level of the company’s ability to get its source of income on its operating & operating expenses, as well as the allocation of the use of VC’s capital funds.

    If you are not careful, it is certain that the VC syndication will “Total Loss” even though the value is not too significant, for the capital participation, for example, there are too many VC failures, most of them are too tempted by the value of the income generated, but they forget that there are other calculations that reduce that income.

    If the allocation of VC to be used to finance debt should be avoided because the company’s condition is in deficit, to recover it the company must go through two stages, namely;
    – Event Point Break Stage, or to the normal point but no gain at all.
    – Growth stage to get a source of profit.

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