Equity vs Private Debt: Why you should always have a Plan B

You’re considering funding your company and want to understand the key implications of equity investment?

Maybe you’ve also heard how Private Debt is withstanding the current rougher financial climate, and you’re considering it as an option? If any of these applies, this article is for you.

this article was updated last on 24/06/2024 at 13:42

In this article you will learn:

1. What is Venture Capital?
2. Advantages and Disadvantages of Venture Capital
   
3. What is Private Debt
4. Advantages and Disadvantages of Private Debt
5. Capital Structure and Risk Planning

Without further ado:

Venture Capital and Private Debt

Venture capital and private debt are two distinct forms of financing. Each comes with its advantages and drawbacks. It’s your role as an entrepreneur to understand their differences before initiating your funding operations.

Typically high-risk, long-term commitments, VC rounds have the possibility to yield momentaneous results. They are however less flexible in judicial and financial terms than a round of private debt. Most VC opportunities also never get enough traction to come to life.

In the case of a VC round falling, it is always good to have a plan B, and private debt might be exactly what you need. Whether on its own or combined with venture capital, private debt makes for a great alternative to venture capital for scaling up your company.

Let’s dive into the specifics of both before looking into how they complete each other, and how running the two side by side is a terrific way to plan for a round failing or being delayed.

What is Venture Capital

Venture Capital is typically a long-term commitment that can bring great new assets to your company. The pooled funds will be invested in promising, high-growth start-ups like yours.

The way it works is that they will buy equity stakes (shares) of your company and use their pooled funds to scale it up. Since they own shares in your company, their investment returns are dependent on your company’s performance. Which means there are strings attached to their newfound partnership with you.

There are advantages but also inconveniences to a VC deal.

Advantages of Venture Capital: 

1. Capital: You will profit from great capital opportunities with venture capitalism. The cash influx on day one is a real boost to your operations.

2. No Loans: You don’t have to worry about paying back, it’s not a loan. From another perspective, VC does not dilute your equity entirely. Most deals dilute 10-25% of your equity, according to how much cash the fund is willing to invest in you.

3. Non-monetary perks: Venture capitalism is not just a friend with deep pockets either. There are non-monetary reasons to get involved with them. Three come to mind:

1. Consultancy: Venture capitalists are well-versed in managing your company profile. They have trained personnel to assist you in your day-to-day operations and help with the financial side of your business.

2. Signalling: VC funds, and especially the more famous ones like Sequoia Capital or Benchmark, are great at signalling, i.e., they are a great marketing strategy in and of itself for your company. It shows you have a mature business and might attract clients.

3. Networking: Another non-monetary advantage to venture capitalism is the possibility of networking. There will be opportunities for you and your employees to meet other influential and impactful entrepreneurs, and finally give out some of these 500 business cards you ordered online, 2 years ago.

    

Disadvantages of Venture Capital

The VC world is not all fun, cocktail parties, and free money either. Remember about the strings attached we mentioned earlier. Though they hedge their risk by investing relatively little in a lot of different companies (compared to, say, private equity), VC funds are also strict with the way this money has to be used.

1. Pace: While negotiating your deal, you can expect clauses mentioning short and long-term strategies that might differ from your original plans. VC funds like to take things slow and have standard procedures concerning business strategy. They might not align with the distinct demands of the industry in which they operate.

2. Preferential Shares: Another typical clause found in VC deals will need consent to give out preferential shares: In short, it means that you vow to pay dividends to your lenders before anyone else involved in your company. In a recent report published by Mountside Ventures, it was hinted that 80% of VC funds expect getting preferential shares. Most chances are it will be on your Term Sheet.

3. Freedom: VC funds are not know-betters, but they like to implement changes in how you will have to operate, and they can since you have allowed them to cast a vote on the board of directors. From the aforementioned report, 80% of VC Funds expect a board seat, along with a List of Board Reserved Matters. So, in a sense, you are sacrificing two things

1. ) Long-term freedom about your exits. You will need to buy their shares back before thinking of selling your company.

2. ) Short-term freedom, whereby day-to-day operations might not run according to your personal vision. 

Two additional things can also be seen as double-edged swords:

4. Pressure: Firstly, VC funds can put a lot of pressure on your company to meet certain criteria during your partnership. Performance might be valued over morale. You need to evaluate the culture fit between this mentality and that of your company.

5. Due Diligence: Secondly, unlocking VC funds requires going through a painstaking amount of paperwork to complete the due diligence. This helps your lenders evaluate the risk profile, financial health, and legal soundness of your company. You might need to hire a consultant to prepare in advance and accommodate the workstreams in your finance team.

Due diligence always helps in assessing your team’s ability and your business’ strength. And pressure may or may not make diamonds, so take the last two warnings with a grain of salt.

What is Private Debt

Generally overlooked, private debt is a rapidly growing alternative to equity fundraising. You will typically secure cash against an agreed-upon interest rate. Businesses need to have stable revenues to access debt, and usually have done a prior round of VC. And…that’s it !

There’s not as much drama with private debt as with other ways to fund your growth. There are some obvious advantages and some less obvious ones. There are also a couple of drawbacks. Let’s get into it.

Advantages of Debt Financing

1. Pace: It’s easier and quicker to secure private debt than funding with VC.

2. No Strings Attached: You can use the money as you see fit. You know the particular requirements of your industry better than anyone else because you have been competing in it for a long time now.

Whether it is to hit the profitability mark first, prioritise your product; hire sales talents, or widen your client base: with private debt, you’re still “master of your domain.” 

3. Operational Control: You have no other long-term commitment than to repay the loan and the interest. Your exits are immaculate. You do not pay preferential shares, and you have the same operational control as you used to.

4. No Dilution: The most important advantage for some: you do not dilute your equity. Again, that’s control over your exits and your day-to-day operations. It’s also a great multiplier if you decide to pass on the reins to another CEO and keep an annuity as a NED.

5. Fewer Taxes: Private Debt has fiscal advantages. Dividends are taxed as part of your profits, while a loan is part of your expenditures.

6. Vigour: In times when the economy is slowing down, private debt is still readily accessible. Unlike equity funding, which might be more difficult to find then. This is due to VC portfolios symmetrically following the market’s performance.

Disadvantages

1. Debt Accumulation: You have a higher risk profile for future lenders once you start accumulating debts contracted with Private Debt funds. You want to make sure your debt/equity ratio does not tilt too much towards debt. We will go over this later in the article.

2. Interest rates: Interest rates are slightly higher than a bank loan. This is because private debt funds have fewer securities to protect against your business potentially failing. This does not mean they are risk averse. Since primary (or senior) creditors are always paid first during a liquidation, private debt funds don’t fear lending money as much.

Whether you have revenue streams for the duration of the loan is going to be their primary concern.

3. Less non-monetary advantages: There are fewer opportunities for networking or signalling. It might change with Private Debt becoming a more prominent funding means.

Capital Structure & Risk Planning

Capital structure relates to how much debt and equity make for your company’s funding. To access growth, and eventually reach milestones, you will go through rounds of financing, that’s a given.  

How you’ve managed to finance your asset acquisition, how much equity you’ve diluted, and many loans you’ve contracted will design a picture of your company’s borrowing practices for future lenders. Needless to say, it’s important to take capital structure into consideration before initiating any new operations.

It’s possible to appreciate the capital structure of your company with many indicators. The best way to evaluate it is using the debt-to-equity ratio (D/E). The ratio indicates the risk tendency of a company.

Typically, companies relying heavily on debt have a more “aggressive” capital structure and might be considered risky for future investors, as their interests stack up and can hinder profitability.

This risk might be also the very source of the company’s growth. A company relying too much on equity can be seen as not taking enough risk to foster its growth. However, if you are considering funding multiple other rounds in the future, a low D/E ratio is preferable from the lenders' perspective.

Conclusion

Private Debt is still overlooked as a growth instrument. Venture Capitalism retains an aura of heightened value for companies in rounds b and c of funding.

Over-funding with debt has its component of risk, as you have seen. Yet in healthy doses, and in synergy with VC, it’s a cost-effective, hassle-free way to scale up.

With the right balance, it allows you to avoid equity dilution and loss of operational control. You can use this money to make quick growth spurts in areas you know need improvement. It allows you to reach milestones quickly, even in mild economic recessions, and also is a great alternative to a delayed or failing VC round.