In establishing a VC fund at USC, my partners and I are constantly asked about how we want to invest. Inevitably, we are asked about debt. I suspect it is even more frequent for us because “socially conscious” startups are often non-profits, which cannot be financed through equity. Admittedly, I’m quite biased because I’ve always thought equity is “sexier” than “boring” debt. But I am convinced that equity logically makes much more sense.
Let’s start with a few basic definitions:
Debt: A method of investing where the investor has a contractural right to pre-determined payments (e.g. bank loan).
Equity: A method of investing where the investor is a partial owner of the company and is compensated as a percentage (e.g. stocks).
Obviously, this is an over-simplification, but from an investing perspective, these definitions capture the core differences.
Generally, people ask us about debt because it is considered “less risky.” After all, you are guaranteed payments, whereas equity is subject to market randomness. For startups, however, this simple comparison isn’t appropriate. Instead, let’s look at outcomes in terms of upside and downside potential.
|Equity||Very Exposed||Very Exposed|
|Debt||Some Exposure||Not Exposed|
As a debt investor, you might think you are not exposed to downside risk at all, since you have a legal guarantee of payment. However, in reality, a worst-case scenario is rough for debt investors too. If a company goes to 0 and defaults on their debt, no one gets paid anyway. Moreover, in a rough patch, a company often negotiates with its debtors to reduce payments. Things are not quite as “guaranteed” as they seem.
Notably, being early-stage changes the game a little. Since these companies are “do or die” compared to large corporations, the risk of default is much higher. Thus, the downside risk profile of debt and equity is actually quite similar. At the end of the day, if the company flops, everyone is in trouble.
If the company does well, you want to hold equity. Why? The upside of debt investors is capped; the most you can make has already been negotiated through your interest payments. For equity investors, however, the sky is the limit – you get your percentage regardless of whether the company is valued at $100 or $100mm.
Interest Payments as a Disadvantage of Debt
There is one final reason equity is superior to debt for our fund. At the most basic level, debt imposes interest payments on a company that probably has no revenue, let alone cash flows. For a high-growth company, that money would be best spent reinvesting in the company. Why would you pull cash out of a company that you just invested in?
At a deeper level, equity more easily matches a startup’s needs. Typically, debt requires regular interest payments regardless of how the company is doing, whereas equity allows the company to retain capital until some future exit. The trajectory of an early-stage company is not predictable, and through equity, entrepreneurs and investors can continually make decisions that offer capital for the startup and returns for the investor when appropriate.
I hope this provides a compelling rationale for using equity-only investments for the fund. Equity offers maximum upside potential with comparable downside potential, while also better aligning with the entrepreneur’s interests.
Of course, all of this is me theorizing, so I would love feedback – especially cases of debt or equity investments that went south.
EDIT: In venture capital, liquidation preferences definitely change the nature of this upside/downside analysis. Going into detail about liquidation preferences might be a little too technical for this blog, but for anyone really interested in VC, it’s definitely worth learning about. Here’s a video with some information about liquidation preferences… can’t remember where exactly, but the whole video is a good primer on VC.