Every entrepreneur faces critical decisions about how to fund their venture. The financing path a company chooses has profound implications for its future, determining not just its financial health but also the autonomy of its operation and its ability to realize its founder’s vision.
Through the illustrative journeys of two fictional biotech companies, 4Paws Corporation and 19/39 Inc., we’ll unravel the differences between raising capital through venture equity and venture debt, shedding light on the broader implications of each method.
Important Venture Capital Terms
- Equity: Referred to as shareholders’ equity (or owners’ equity for privately held companies), equity represents the amount of money that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company’s debt was paid off in the case of liquidation. In the case of acquisition, it is the value of company sales minus any liabilities owed by the company not transferred with the sale.
- (Equity) Dilution: Dilution occurs when a company issues new shares that result in a decrease in existing stockholders’ ownership percentage of that company. Stock dilution can also occur when holders of stock options, such as company employees, or holders of other optionable securities exercise their options. When the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.
- Participating/Non-Participating Stock: These are two types of liquidation preferences
- Participating: With this liquidation preference, the preferred stockholders are entitled to receive their initial investment amount back first, and then they also share the remaining proceeds with the common stockholders.
- Non-Participating: In contrast, with a non-participating liquidation preference, preferred stockholders must choose between receiving either their original investment amount or converting their preferred shares into common shares and participating pro-rata in the distribution of remaining proceeds.
- Preferred Stock: A type of equity that offers higher claims on dividends and assets than common stockholders but usually with limited voting rights. Cofounders and employees own common stock (or options to buy common stock) and the investors own preferred stock, which gets paid first in a dissolution, should you be acquired, or in a liquidation (sale of the company’s assets).
- Warrant: A derivative that gives the right, but not the obligation, to buy or sell a security — most commonly an equity — at a certain price before expiration. The price at which the underlying security can be bought or sold is referred to as the exercise price or strike price. An American warrant can be exercised at any time on or before the expiration date, while European warrants can only be exercised on the expiration date. Warrants that give the right to buy a security are known as call warrants; those that give the right to sell a security are known as put warrants.
4Paws and 19/39: 2 Funding Scenarios
Both companies were founded in 2006, aiming to revolutionize veterinary care by harnessing the genetic potential of pets. Joshua Nickerson, founder of 4Paws, and Jens Ley, founder of 19/39, had a friendly rivalry. They had worked together in senior positions at Damascene Sciences, an early, successful (also fictional) biotech in Silicon Valley, where they had been early employees. Both Nickerson and Ley initiated operations in 2006 using their savings, including money made from option grants of Damascene stock, as seed money. Their significant investments allowed them to avoid going the typical “friends and family” route and/or raising initial capital from seed/angel investors.
After brief ramp-up periods where the founders continued to self-fund their companies, both completed their Series A rounds in 2007, with each raising $5 million at a $10 million pre-money valuation, for post-funding valuation figures of $15 million each. In venture speak, pre-money valuation plus new money equals post-money valuation.
So, in the cases of 4Paws and 19/39, the VC investors paid $5 million to own 33.33 percent of each company since $5 million of new money is 33.33 percent of the post-money valuation of $15 million. Nickerson and Ley likewise each owned 33.33 percent of their respective companies. The remaining third of each was allocated or reserved for current and future employees, either directly or through the employee stock option pool.
By 2012, after five years and two more funding rounds (Series B and C), both companies showed promising results with blood analysis for pets. This information was valuable to veterinarians, pet insurers and owners. Consumers spent $50 billion annually on pets, which was expected to grow to $72 billion by 2018, so both companies attracted attention from investors and potential buyers.
In 2013, however, neither company was profitable yet, so both raised Series D funding. 4Paws aimed to monetize its data and explore the use of diet to prevent and treat diseases, hoping to pioneer a food-as-medicine approach to veterinary science.
Knowing When to Sell
By 2015, 4Paws faced profitability challenges, and its expensive tests and reports had yet to convince pet insurers to cover costs. After weighing options, including further VC funding, Nickerson and the board decided to sell 4Paws for $100 million to the (fictitious) Unicorn Pet Food Company. Nickerson, now with an 11 percent stake, received $10 million after fees and expenses.
His negotiation with VC investors to have their investment be in the form of non-participating preferred stock (versus participating preferred stock) resulted in more favorable returns for himself and his employees.
During the same period, 19/39 shifted its focus. In 2012, they began selling “Felin’ Fine” cat food, which, while not clinically proven to reduce human allergic reactions, showed promising results in studies and gained strong anecdotal support from customers. The company narrowed its focus to cats due to promising research and surging sales of Felin’ Fine.
In 2015, Unicorn Pet Food offered $85 million to acquire 19/39. Ley, who wanted to prove the science behind dander-neutralizing cat food, felt this offer undervalued the company. At the recommendation of a VC board member, he explored venture debt to avoid further equity dilution and maintain control.
Ultimately, 19/39 borrowed $30 million from Pioneer Growth Credit Fund at a 10.2 percent interest rate, plus a small amount of equity in warrants known as an equity “kicker.” For 19/39, the warrant coverage was 5 percent, calculated as a $30 million loan at 5 percent, equalling $1.5 million in equity, resulting in a 1.4 percent dilution at a $105 million valuation.
Using Venture Debt for Funding
In contrast (as shown in chart one below), had 19/39 raised $30 million in a Series E round at its 2015 valuation of $85 million, it would have done a down round. This is a funding round where the valuation is lower than the previous round, sending negative signals to investors, employees, and potentially customers and partners. Such a round would’ve caused more than 25 percent dilution for Ley, his management team, employees, and existing shareholders.
Using venture debt at this time provided the necessary funds with less than 1.5 percent dilution, compared to >25 percent with equity.
With the $30 million debt capital, Ley advocated for research to prove Felin’ Fine’s effectiveness, which the board approved. Scientists confirmed Felin’ Fine’s allergen-reducing qualities, leading to a market-ready product by February 2018. The company took on an additional $15 million in venture debt for marketing, with a reduced interest rate and no additional warrants due to their favorable relationship with their existing lender, which can be common among strong-performing portfolio companies. This approach avoided significant dilution. Within six months, 19/39 sold 10 million units of Felin’ Fine, making the company an attractive acquisition target.
In early 2019, 19/39 was sold for $400 million. As chart two, Ley’s 10 percent stake was worth $40 million, far more than the $8 million he would have received in 2015. By using venture debt twice, Ley avoided about 23 percent dilution, saving $90 million for himself, management, employees and investors.
To summarize, while Nickerson sold 4Paws for $10 million in personal profit, he unfortunately saw his vision go unfulfilled as Unicorn Pet Food did not pursue his concept of food-as-medicine. Ley’s decision to use venture debt twice and remain independent allowed him to realize his dream and achieve significant financial success.
Figure Out Your Funding
This story illustrates the impact of financing decisions and the importance of understanding both venture capital and venture debt. Debt, under the right circumstances, can be a powerful option. Remember, however, that companies that raise debt can raise equity but choose not to. In other words, venture debt is advantageous for companies with a strong path to profitability; it is not “rescue financing.”
There’s no one-size-fits-all to raising capital in the later stages, and founders will need to carefully evaluate all the options available to them. I recommend that you take professional legal and financial advice to determine which pathway is best for your particular circumstances. Each method of raising capital has advantages and disadvantages and often eligibility criteria need to be taken into account.
