Venture Debt vs. Equity

Many Entrepreneurs face the daunting task of raising money. If that wasn’t hard enough, you now need to determine whether to take on debt and have to repay it or give up a portion of your company in order to raise sufficient capital. The following post highlights the key process and outcome of each.

Equity

Raising money through equity is more likely for companies that are just starting out, don’t have any inventory, or are simply in ideation phase (preparing their product/service to be sold). Notably, equity investors such asKleiner Perkins and Greylock practice the ‘bucket method’ as part of their selection process.
 Albeit a very simplistic way of thinking of this process, the bucket method is simply a numbers game.

Imagine you have a $100 million dollars to invest, in order to diversify your portfolio/strategy; you will invest in more than one or two companies. Let’s say that you invest $10 million in 10 companies: statistically 7 of them will fail or won’t return your investment, 2 will make the minimum return ($10 million), and 1 of them will exceed expectations and return 10x = $100 million.

To summarize, you invested $100 million made $120 million as of result, returning 20% - not bad for your first investment. You can now take the additional $20 million pay management, investors, and daily expenses; the other $100 million will be reinvested and the wheels turns and turns.

For the Entrepreneur, in order to receive that $10 million, they will need to go through the VC’s due diligence process, funding terms, and showcase that the team/management can deliver their promise. Once those criteria are met, they will painfully give up 30 to 60 percent depending on the stage, size, and post-money evaluation of their company.

On the debt side, the players think of a little differently.

Debt

The debt market has recently (past 10 years) been experiencing a surge of players who provide either debt or mezzanine financing (debt and equity). Overall debt VC’s are very similar to banks, they will extend a loan and expect to be paid back in interest and the initial principle amount.

Debt VC’s tend to look for companies who ALREADY have other equity Venture Capital investors, they feel slightly more protected since they’re not the first money in. Additionally, they tend to take little or no stake in the company which is favorable to the Entrepreneur. However, their investment is usually protected by some sort of collateral ie. inventory, fixed assets (buildings, machinery, etc…), or even Intellectual Property that the company has developed.

In the event that the company is not performing as expected, the VC can use legal actions highlighted in a document called Loan Security Agreement which entitles the investor to sweep bank accounts, seize assets, or remove management in critical times.

To better prepare yourself, check out my previous posts: When to raise money for your Venture?, Top 3 Places to Look for Money , and 3 Factors When Choosing a VC
 

Think about raising money as being in a marriage, you definitely want to know who you get into bed in with at night. The same concept applies here; whether, its debt, equity, friends/family, or begging out in the street do your homework from where you will be getting money.

Have any other information that can help our fellow Entrepreneurs on the difference between debt and equity financing? Please share it below.
 

If you have any other questions, be sure to send me an email or post a comment.
Ashkan

Ashkan[at]greenhornconnect[dot]com