From the ancient belief, building a startup is balanced on the backs of three whales—time, dedication, and money. While the first two are a given, what about financing? Whether you are a crusty startup founder or a newbie, it is rare to build a startup entirely with bootstrapped funds.

So when it comes time to seek outside funding, many founders find themselves at the crossroads between venture capital vs. venture debt. 

Those two are like Twix sticks—look similar, but bite differently:

  • VC topped with equity investment into a startup, getting a share of the future profits in return.
  • Venture debt—is like a loan for startups, where the lender might get company shares later, and startups pay only interest at first, repaying the loan bit by bit later on.

While the financing choice depends on various factors, like the startup stage, industry, and the entrepreneur’s strategic vision—each option has its own pros and cons, making the decision a tricky pick-and-choose game for startups.

Let’s go through a comprehensive analysis to guide your financing choice.

What is venture capital?

Behind every “start” and before every “up” often hides the “bootstrap” of operations —supportive funds from family and friends of the founder, who believe in the company’s success.

But as the business grows, way before making big money, founders need to look for more formal sources of finance, like venture capital.

That is where “wrooms” VC, a popular cash-raising vehicle. 

  • VC funds startups and early-stage emerging companies in exchange for a share of the company or a board seat. 
  • Startups, in turn, get money, a network of partners and experts, and more money later on, if needed. 

It’s like traditional investing but a little bit risky. As betting on ideas, investors wait for the jackpot: a profitable company or a grand exit (sale or IPO).

How does venture capital work?

The process of securing VC funding is like building a strong bridge – from the blueprint of the business model and pitch deck to the final stage of distributing returns. It’s a step-by-step journey, creating a solid connection between investors and the business. Let’s delve into:

  • Pitching: Entrepreneurs present their business ideas, market potential, and growth plans to VCs.
  • Due diligence: VCs conduct thorough due diligence, evaluating the startup’s team, market size, competitive landscape, technology, financials, and growth potential to weigh the risks and rewards before investing.
  • Term sheet negotiation: When VCs are interested in investing, they unfold a term sheet—a roadmap detailing investment essentials like valuation, ownership stakes, board roles, and other key points. That’s where negotiation with the startup begins.
  • Investment and post-investment: Once the term sheet is agreed upon, legal documentation is prepared, and the investment is made. Post-investment, VCs work closely with the startup, providing guidance, strategic advice, and support to maximize the company’s chances of success.
  • Exit: The ultimate goal of a VC investment is to make a profit through an “exit” strategy, which typically occurs in one of two ways:
    IPO (Initial Public Offering): The company goes public, offering its shares for sale on a stock exchange, which usually provides a significant return on investment for the VCs.
    Acquisition: The company is sold to another company. The proceeds from the sale are distributed among the shareholders, including the venture capitalists.
  • Returns Distribution: After a successful exit, the venture capital firm shares the winnings with investors, cutting them a slice based on how much they chipped into the fund, minus a few fees.

Most VCs focus on one or a few industries they have the most experience. For instance, a healthcare-focused VC might have previously worked as a healthcare industry analyst.

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The role of venture capitalists

Generally, founders are experts in their business, but scaling up may require additional support. That’s where VC investors come in. 

Venture capitalists are typically tech-savvy investors who manage funds dedicated to investing in startups. Their primary focus is on very early-stage but promising startups to invest in. VCs typically bring capital, expertise, industry connections, and guidance to the startups they invest in.

According to the PitchBook platform, there are more than 48,000 venture capital firms operating globally.

Advantages of venture capital

Getting venture capital is a game-changer for fast-growing startups. It’s not just about the money – venture capital firms offer valuable advice and connect you with potential future partners. This is how startups can scale up fast with VC:

  • Access to large funds

Substantial funds of VC fuel rapid growth and expansion. So, entrepreneurs could hire more talents, develop products, and invest in marketing and infrastructure.

  • Expertise and mentorship

Venture capitalists bring expertise and connections beyond money. Their mentorship helps startups navigate challenges and make strategic decisions, while industry connections open doors to new partnerships and credibility

  • Networking opportunities

Venture capitalists often have extensive networks that can open doors to partnerships, customers, and other stakeholders, which helps them access new venture debt markets and gain valuable industry insights.

Challenges of venture capital

Venture capital is a field filled with many twists and turns. From the risky business of betting on new ventures to the puzzle of finding the perfect exit strategy, venture capital firms’ workflow faces a much broader set of challenges and problems, such as:

  • Equity dilution

Perhaps it is the most significant drawback of VC. As more funding rounds occur, the founders’ share of the company decreases, leading to a potential loss of control.

  • High expectations and pressure

Venture capitalists expect a substantial return on their investment. This pressure can translate into high expectations for growth and profitability, putting added stress on the startup’s management.

  • Loss of control

External investors taking a big share can mean founders lose control. It’s a tricky dance—needing capital but holding onto autonomy.

What is venture debt?

Venture capital debt (or venture capital loan) is like a startup sidekick—it supports early-stage startups and is often used alongside equity financing. Unlike traditional bank loans, it’s there for companies, even if they’re not raising profits or loaded with assets.

While venture debt gives a cash boost, letting companies hold off on raising more money, it comes with a set of risks. Lenders want every cent back, linking their investment to goals, VD comes with strict contracts.

When is venture debt used?

Venture debt is typically employed by startups to complement venture capital equity. It can be used as performance insurance, a lower-cost runway extension, funding for acquisitions or capital expenses and inventory, or a short-term bridge to the next round of equity.

Key players in the venture debt market

Venture debt for startups is a lifeline, blending the best of equity and traditional loans. The field is dotted with standout players, from Silicon Valley Bank’s tech-savvy approach to Kreos Capital’s European flair. These key players are more than just lenders; they’re growth catalysts, powering up-and-coming businesses with the funds and flexibility they need to soar. Among some of the notable players in this space are:

  • Silicon Valley Bank (SVB), a key player in venture debt, crafted specialized loans for tech and life sciences startups, holding a remarkable 50% market share. It doesn’t just play the game; it sets the rules!
  • Horizon Technology Finance is fueling the future, loan by loan. They’re experts in secure loans, driving venture-backed companies in tech, life science, healthcare, and cleantech. With loans in the hundreds of millions, they’re shaping industry leaders and transforming the business landscape!
  • Hercules Capital is a venture debt giant with $11 billion in firepower, specializing in tailor-made debt financing and fueling innovation across life sciences, technology, and green tech. 
  • Trinity Capital has become a top-notch provider of diverse financial solutions, managing over $1 billion in assets.
  • TriplePoint Capital is a major player in venture debt with a global footprint in key regions like Silicon Valley, New York, and Europe. TriplePoint offers venture debt and equity financing to companies in technology, life sciences, and other high-growth sectors.
  • Runway Growth Capital: Focuses on providing long-term growth capital to companies in technology, life sciences, healthcare services, and consumer sectors, with 31 debt and 76 equity investments in tech, life sciences, and consumer sectors, plus $61.7 million in prepayments, they’re dominating their focus industries.

Advantages of venture debt

This type of loan is commonly embraced by entrepreneurs, especially those involved in startups, as it is a practical option for obtaining funds over a relatively brief duration. Further advantages of this loan are detailed below.

  • Minimized equity dilution

Venture debt saves entrepreneurs from losing control of their firms through dilution. Even if banks hesitate, venture debt allows founders to take on short-term debt, repay it, and stay in charge of their company.

  • Flexibility in use

Unlike traditional bank loans, VD is fast and convenient and comes with minimal paperwork. The venture debt terms are less restrictive, making it a preferred choice for entrepreneurs needing a quick cash injection.

  • Shorter commitment duration

Venture debt usually offers a shorter commitment of about 3 to 4 years compared to the longer terms often associated with equity investments. This provides startups with greater financial flexibility and shorter-term debt obligations.

Challenges of venture debt

Although venture debt is quite popular amongst various entrepreneurs, there are also many challenges related to it. Some of them have been listed below:

  • Interest and repayment terms

A startup might be challenged with high rates and tight repayments as investors steer clear of failures in their limited upside game.

  • Security and covenants

When startups borrow money, lenders may request collateral and set rules (venture debt covenants). Startups must assess how these terms might limit their operational flexibility and ability to adapt to changing market conditions. It’s a delicate balance between securing funds and maintaining control.

  • Risk of debt accumulation

Venture debt reduces equity dilution but brings debt risk. Handling this debt is crucial, especially during tough times or if the startup takes longer to turn a profit.

Factors to consider when choosing between venture capital & venture debt

While angel and venture capital investments are familiar routes, many founders are turning to debt solutions for sustainability. However, the application processes for VC funding and debt financing vary significantly. In this part, we will outline key distinctions and offer guidance on what to anticipate during each journey.

1. Eligibility

  • Venture capital investors typically cover all company stages, from pre-revenue to later-stage companies.
  • However, not all businesses are suitable for venture debt. Typically, lenders require traction, revenue, or strong financial statements, e.g., with $2-$20 million in ARR.

2. Application processes

  • VC investors focus on growth potential, market opportunity, and management team capability.
  • VC applications include a pitch deck, executive summary, business plan, financial projections, and a cap table.
  • Debt providers emphasize financial health, creditworthiness, and loan repayment.
  • Debt financing applications require extensive financial documentation, including historical financial statements, detailed projections, budgets, and existing debt information.

Founder tip:

When pitching a VC investor, founders should be confident and optimistic about growth. But for debt providers, better keep it real. They want facts from the last year, your plans, and other info to see if you can deliver on your promises.

3. Deal structures

  • VC involves selling equity stakes, often with preferential rights like liquidation preferences and anti-dilution provisions.
  • Debt is a loan with terms such as interest rates, repayment schedules, and maturity dates. 

4. Dilution

  • VC can dilute ownership and control through preferred shares, board seats, and governance rights.
  • Debt maintains control and ownership, with possible dilution through venture debt warrants.

5. Use of funds

  • VC funds long-term growth, key hires, and new products or services.
  • Debt is used for short-term needs like sales and marketing, equipment financing, or bridging financing round gaps.

6. Cost of capital and exit expectations

  • VC has a higher cost of capital due to the expected high ROI, targeting around 40% per year.
  • VC investment may pressure startups for specific strategic directions and exits within certain timeframes.
  • Debt has lower costs and does not directly influence exit strategy if repaid on time, making it attractive for startups to prioritize control over strategic direction.

The “hierarchy of growth capital” advises founders to maximize recurring revenue, explore non-dilutive sources, and revisit non-dilutive options for additional financing.

The future of venture financing

Tech’s rapid evolution opens doors to endless possibilities. Discover the top 5 predictions and emerging trends, poised for substantial VC funding, each set to redefine industries and transform our daily lives. Get ready for the tech revolution!

Predictions and emerging trends

Down-rounds, recaps, and difficult decisions
In 2023, companies tried to avoid down-rounds by cutting costs and raising convertible notes, but the funding scene stayed tough. Venture debt lenders hesitated to refinance without more equity. Investors now decide which companies to fund, shut down, or sell at a loss.
In 2024, down-rounds and recapitalizations will likely continue.

Capital in hand, ready to adapt
After raising capital in 2021 and 2022, some companies are changing plans, potentially leading to disagreements with investors. This could result in the formation of new companies or spinouts. Investors must decide whether to support the pivot or retrieve capital for other investments.

AI an exception
With a $21.4 billion raise in 2023, AI startups, including OpenAI’s notable $10 billion round in Q1, are poised for continued growth in 2024 with increased focus on AIML.

Governance in the spotlight
VC-backed companies face scrutiny for governance issues. Unconventional structures, like full founder control, spark debates. OpenAI’s CEO ouster and return highlight governance concerns. Founders and investors weigh growth models vs. “public benefit.” Corporate governance remains a hot topic in startups.

IPO momentum in 2024
Late-stage startups are gearing up for potential IPOs amid a better economic outlook. Unicorns and survivors may step into the spotlight after a two-year chill. With M&A uncertainty following canceled deals, IPOs are the cool choice now. 2024 is totally IPO time!

The role of technology and innovation

In recent years, technology has been a game-changer, solving real-world problems with strategic investments. There’s promise in addressing humanity’s challenges, especially with the potential of AI and quantum computing. Looking ahead to 2024, technology and innovation, shaped by VC investments, will be dynamic and groundbreaking.

Here are 10 technologies that promise innovation, significantly impacting society and the global economy.

  • Artificial Intelligence: The frontier of innovation
    AI is the top pick for VC funding with its endless possibilities in machine learning, language processing, and computer vision.
  • Cybersecurity: Safeguarding the digital world
    Cybersecurity is a hotbed for venture capital, reflecting the urgency to combat digital threats. Recent investments show this trend vividly: in just Q3, cybersecurity startups secured $1.9 billion in funding through 153 different deals.
  • Fintech: Revolutionizing financial services
    With over 60% of people worldwide embracing banking in the future, fintech continues its rapid expansion. From digital banking to accessible financial tools, VCs are keen on funding ventures that push the boundaries of convenience and efficiency.
  • Healthcare: Innovating for better outcomes
    Healthcare profits are set to soar at 15% CAGR, hitting $821.4 billion by 2032. Battling aging populations and rising costs, tech-driven healing is the game. Investors are backing ventures transforming healthcare for better outcomes and affordability.
  • Climate Tech: Pioneering sustainable solutions
    Climate tech claims 10% of global tech deals, up from 1.5% in the past decade. Focused on a greener future, the urgency of the climate crisis is driving investments in clean energy.
  • Edtech: Shaping the future of education
    Learning is redefined, and technology transforms education, making learning more personalized and engaging. Edtech ventures are drawing significant VC interest as they redefine educational paradigms.
  • Robotics: Advancing automation
    Venture capitalists are interested in innovative robotics companies as profits are expected to grow at 11.40% CAGR, reaching $16.8 billion by 2032. Robotics is becoming crucial across industries, from manufacturing to healthcare.
  • Blockchain: The foundation of disruption
    Rewriting the digital rulebook, blockchain remains in its infancy but holds vast potential. According to Gartner​, Blockchain is expected to generate over $3.1 trillion in business value by 2030.
  • Quantum computing: Unleashing unprecedented power
    Quantum computing, a revolutionary force solving the unsolvable, is expected to see investments grow at a CAGR of 11.5% from 2023-2027, reaching nearly $16.4 billion by 2027.
  • Space technology: Reaching new frontiers
    Led by SpaceX and Blue Origin, the space industry is booming. VCs are investing in ventures that make space more accessible. Global investments in space startups hit $4.6 billion in Q4 2023, marking a 31% increase and a yearly total of $17.9 billion. Confidence in the space industry is soaring.

FAQ

What do venture capitalists usually require in return for a loan?

Venture capitalists typically invest in startups in exchange for equity, meaning they become partial company owners. This equity stake allows them to share in the company’s success and potential profits.

Can a startup use both venture capital and venture debt?

Yes, many startups adopt a hybrid approach, combining venture capital and venture debt to strike a balance between equity and debt financing.

What role does due diligence play in securing venture debt?

Due diligence plays a vital role in securing venture debt. Before financing debt, lenders thoroughly evaluate a startup’s financial health, growth potential, and risk factors.

Are there alternative financing options for startups?

Yes, startups can explore various alternative financing options, including crowdfunding, angel investors, government grants, and strategic partnerships.

What is the definition of “runway” in finance?

In finance, “runway” refers to the amount of time a startup or business has before it exhausts its available capital. Considering its current burn rate and expenses, it represents a company’s duration without additional funding.

What is the typical range of venture debt interest rates?

Venture debt interest rates can vary, but they often fall within the range of 8% to 15%. The specific rate depends on the startup’s risk profile and the prevailing market conditions.

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Jenny

CONTENT WRITER

Hey there! I'm Jenny, and I write for Waveup. I've spent the last three years getting to know the ins and outs of different startups. Here at Waveup, I get to work with some really smart folks and together, we turn all that cool know-how into stories and tips we share with you.