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
  • Not always the first claim on the value or cash-flow of a business
  • Generally participates equally in future value realization of a business

Debt

  • Finite maturity date
  • Often includes intermittent cash-payments, such as interest
  • Has a priority claim on the value or cash-flow of a business, but can be junior to other debt instruments
  • Generally does not participate in future value creation of a business

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:

Equity

  • Upside: Fully “along for the ride” — when an equity holder wins, the founder usually wins too
  • Downside: Fully “along for the ride” — conversely, when a business fails, equity investors usually lose some or all of their investment
  • Term: Fully “along for the ride” — equity investors generally have no ability to influence the timing of an exit (unless they hold significant sway on the board)
  • Value-adding contributions/Operating Assistance: Fully “along for the ride”, value-adding contributions/operating help — because of the reasons listed above, equity investors are generally highly incentivized to contribute to the success of a business throughout its life, to the best of their abilities and bandwidth (large positions matter more than small ones) — they participate directly in any upside they create.

Debt

  • Upside: Not “along for the ride” — when the founder wins, debt investor gets their money back
  • Downside: Not “along for the ride” — when a business fails, a debt investor gets their money back first, if there is anything left for investors to recover
  • Term: Not “along for the ride” — if debt investors don’t get paid off on time, they can force the sale of a business, even if that’s sub-optimal for the other stakeholders (founders, employees, equity investors)
  • Value-adding contributions/Operating Assistance: Not “along for the ride — because of the reasons above, debt investors are not incentivized to add much value to businesses. As long as a debt investor is confident they are “in the money” (they’ll get their money back eventually), theres no need to contribute more to the business, as they will not participate in any additional value created.

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.
  • Preference
  • Board seat(s)
  • Control
  • Time
  • Exit timing

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
  • Advance rate
  • Warrants
  • Term
  • Covenants
  • Time
  • Flexibility

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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