The traditional view is that venture capital helps early stage companies with debt funding used once the company is profitable. The argument goes along the lines that
for the investor, the risks of an early stage company are high, hence equity risk is uncapped, whilst debt with warrants is capped. Hence, why bother with debt at the early stages of a company, since they both share similar risks of default? We show this is not the case.
for the founder, equity is permanent capital, that does not need any return for a protracted period of time, whilst debt needs to be repaid, often with fresh equity capital. We argue that this is not the case with innovate UK and R&D loans.
With the help of Carta's publicly disclosed charts from Peter Walker (email here, linkedin page here), we argue that founders are better off complementing their venture capital injections with venture debt and R&D financing at the early stages of their journey.
The case for the founder
Figure 1, below shows the average dilution by equity rounds in Software as a Service companies in the US, according to Carta. On average, a founder could be diluted by 70% by the time his company breaks even (Series C), assuming he only does primary rounds. If the founder has to do bridge rounds, theoretically, the dilution is prohibitive (unless they compensate with option plans).
Source: Carta
The most dilutive capital raising rounds are the early stage ones. In those early stages, we argue that Innovate UK grants, combined with R&D loans can limit the dilution by avoiding the seed/ bridge component of the fund raise, hence saving 13%-40% dilution. Nighthawk and its sister company, Rocking Horse are leaders in this space, as shown in Figure 2 and can provide financing that is equivalent to equity cost of equity, but only for the period of the loan. There is no permanent dilution, as with equity investors.
Up to Series B, lending against Innovate UK and R&D grants is best.
Venture debt, in reality, can only kick in from Series A or more realistically B, as it is a longer duration loan that requires £2mn of revenues and expects larger orders coming over a 12-18 period. These businesses need this boost to break even and hence repay the loan. Otherwise, the repayment can only occur through an equity raise in late series B/ or early series C, which is less dilutive.
At series B, export finance, in the meantime, also fits the Series B/ late Series A stage. It requires established revenues, established international revenues as well, but the repayment of the loan needs the company to be close to break even.
Source: Nighthawk Partners
The case for the investor
We have shown so far that for the right business, R&D financing and venture debt can materially increase the stake the founder has when he exits the business. The majority of investors believe that for early stage investors, equity investment is better than debt. We disagree.
In our view, on a single successful company, owning equity is better than owing the debt. However, most VCs and investors do not simply own company, they invest in a portfolio of companies. When one looks at that portfolio, and considering the high default rates of these companies over a seven year period, the IRR of the portfolio is close to 12%. Figure 3 shows the IRR by vintage year, according to carta.
In R&D lending and venture debt, portfolio returns have averaged 15%+ over the past 5 years, through a combination of the finite period of investment, warrants and the position of capital in case of default. As a result, these forms of debt, at portfolio level, produce better returns than the riskier equity venture capital firms.
Potentially, one could argue that these forms of investment offer better risk/ reward for investors up to Series B, with equity investments made as visibility on the business improves.
Source: Carta
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