Which Is The Better Option For Growth Funding: Venture Debt or Venture Capital?
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Which is the better option for growth funding: venture debt or venture capital?
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I have been speaking with multiple founders from the early stage to the growth stage. While raising the fund at their growth stage or wanting a fund to achieve growth milestones, they always got confused about whether to go for venture debt or venture capital. And they always wonder which one is a good option considering the risk & benefits.
If you are one of them getting confused about which option is better to go for your growth stage startup, then this is the write-up for you. We will understand this with a simple example.
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Consider a founder who is looking to raise $2M to achieve his next growth milestones and he is wondering whether to go for $2M Venture Capital or $2M Venture Debt. Let’s decode this and see which one is the best option for fundraising.
Option One: Venture Capital
Let considers some terms about the company.
- Pre-money Valuation of the Company= $12M
- Venture Capital Raised= $2M
- Post-money Valuation= $14M (Pre Money + Investment Amount)
- Equity Dilution = $2M/$14M = 14.28%
- Company Valuation at Exit= $50M (You can get this through financial modelling)
- Venture Capital Gain= $50M*14.28%= $7.14M (till exit the vc firm able to maintain the equity)
Second Option: Venture Debt
Venture Debt is typically structured as a Term Loan with Interest Payments and WARRANTS.
If you are not aware of the Warrant term - let me explain to you in simple terms - “Warrants are a security that gives the holder the right (but not the obligation) to purchase company stock at a specified price within a specific period of time.”
- Pre-money Valuation of the Company= $12M
- Venture Debt Raised= $2M
- Pre-Money Valuation= Post-Money Valuation ( for ease of calculation subscription of shares from Venture Debt has been considered as a Capital Increase at a Marginal Value)
- Venture Debt Annual Interest Rate= 12% (monthly 1%)
- Tenure= 36 months
- Facility Fees= 1%
- Legal Fees= 1%
- Warrant Coverage= 20%
- Warrant Coverage= $2M (Venture Debt)*20%= $400K
- Dilution= $400K/ $12M (Post-money Valuation)= 3.33% (remember for Venture Capital Financing it was 14.28%)
- Facility Fees= $2M*1%= $20K
- Legal Fees= $2M*1%= $20K
Next will calculate the Monthly Interest and Principal Payment:
- Used PMT function on an Excel sheet
- It will look like this = -PMT(monthly interest rate, total number of payments for the loan, present value of the debt, future value, type)
- Monthly Interest+ Principal Payment=-PMT(1%, 36, $2M, 0, 0)= $66,429
- Total Payments in 36 Months= $66,429*36= $2.39M
- Total Interest Payment= $2.39M- $2M= $.39M
- Total Interest Payment+ Facility Fees+ Legal Fees= $.39M+ $20K+ $20K= $.43M
- Now Company Valuation at Exit= $50M
- Cost of Warrants= $50M*3.33%= $1.66M
- Total Interest Payments+ Facility Fees+ Legal Fees+ Cost of Warrants= $.43M+ $1.66M= $2.09M
- Venture Debt= $2M
- Total Payment to Venture Debt Lender= $2M+ $2.09M= $4.09M
- IRR Calculation: $2M (1+R)^3= $4.09M, R= 27.01%
Finally,
- Venture Capital Gain= $7.14M
- Venture Debt Gain= $4.09M
- Overall gain to the Founder if he considers Venture Debt option= $7.14M- $4.09= $3.05M
I hope this will give an idea of how Venture Debt is cheaper than Venture Capital.
If you want to download the Excel sheet with an example that is used here - Download it Here.
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