Venture-debt financing is not anti-entrepreneur

As I have written here before, it is common for entrepreneurs to offer to their investors preferred stock in their new ventures to raise capital. Preferred stock terms have strong protection for investors and in the end no debt is put on the company.

Venture debt is another form of financing companies. The investors loan money to the company instead of buying an ownership stake.

For example, UTFC Financing Solutions LLC, a Utah firm specializing in venture debt, funds entrepreneurs by extending loans with attached warrants. Usually, the loan must be paid back with terms of 14 percent interest over five years or so, plus UTFC receives the right to purchase a small percentage of the company.

Critics deride such terms as "backward" and anti-entrepreneur. After all, they ask, who would take on debt in the early stages of a company? But in my view there are ample reasons why early-stage debt may be the "preferred" choice — pun intended.

A side-by-side comparison of three rounds in a standard investment scenario shows that the use of venture debt over equity reduces by 10 percent the amount of the company the entrepreneur has to give to investors. In a typical situation that could be $1.5 million just through a round or two. If the company becomes wildly successful the savings could be in the tens of millions of dollars of value that the founders get to keep or share with their employees.

That seems incredibly pro-entrepreneur, doesn't it?

In fact, we should wonder why an investor would do a debt deal if it is so favorable to the entrepreneur. Obviously, blue-blooded venture investors do preferred stock because they get more of the company. Why would venture debt investors give up that percentage? The venture debt investor gets one important thing: reduced risk, expressed mostly through a secured credit position and priority over equity investors.

So, does it really work in the end? Critics say no — especially not for tech companies. I asked several tech entrepreneurs why they took on venture debt in addition to, or instead of, equity investment. I found many tech companies that have been blessed by venture debt.