Capital Structure Curriculum for Founders: Principals of Debt and Equity

Debt and Equity are often viewed as black-and-white instruments — that they are symmetrically opposed and binary. Many financing instruments actually sit along a continuum, where they may have characteristics of both debt and equity. However, there are certain defining characteristics that generally distinguish debt and equity for purposes of characterization.

Common Characteristics:

Equity

  • No finite maturity date

Debt

  • Finite maturity date

Its important to try to avoid viewing the above characteristics in isolation — because of these features, holders of debt and equity have different economic incentives. Accordingly, the behavior of debt and equity investors should be expected to be different.

Incentives:

“Show me the incentives and I’ll show you the outcome” — Charlie Munger

Equity

  • Upside: Fully “along for the ride” — when an equity holder wins, the founder usually wins too

Debt

  • Upside: Not “along for the ride” — when the founder wins, debt investor gets their money back

Costs and Term:

Debt and equity are often times compared based on their superficial costs — either dilution percentage or interest rate. These are very important to consider. However, there are a number of other more subtle costs to both instruments that are worth adding to the equation.

As mentioned earlier, the below are generalizations for debt and equity, but don’t necessarily describe all circumstances. Generally speaking, most VC equity follows the standard format below.

Equity

  • Dilution — incoming investors will own a piece of the business forever, and their piece will decrease your ownership.

Similarly, most Venture Debt (SVB, WTI, TriplePoint) follows the standard format described below. However, there are a few firms that will construct more bespoke structures. We’re one of them.

Debt

  • Interest rate

This covers the basics. Of course there are many exceptions to everything described here, this is general information that is intended to get you up the learning curve. In the next section, we’ll share and walk through more detailed descriptions of various structures

Rennick Palley, Founder and Chief Investment Officer of Stratos Technologies - stratoslp.com

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