Capital Strategy for Startups: Choosing Between Venture Capital & Venture Debt

Introduction

After the COVID-19 pandemic, climbing interest rates, heightened risk aversion among institutional investors, and depressed corporate valuations have caused startups to rethink their financing strategies and pursue sources of capital beyond traditional venture capital (“VC”).^[1] Today, VC, a historically prominent source of financing for startups, is increasingly being supplemented with venture debt (“VD”).^[2] VD is a financing tool that allows founders to raise capital to fund expenses and strategic growth initiatives without diluting their ownership stake in their startup—a requirement of VC financing.^[3] Ultimately, a founder’s decision to pursue VC or VD financing requires them to carefully evaluate their long-term capital structure and legal risks.^[4]

Venture Capital: Diluting Ownership to Fund Growth

VC firms are investment entities funded by institutional and individual investors; they deploy capital into highly scalable companies in exchange for equity (ownership) stakes in those companies.^[5] These firms typically seek to generate outsized returns through liquidity events—transactions in which they can convert their equity stake into cash—often by selling a company to an acquirer or by taking it public through an initial public offering (“IPO”).^[6]

In the quintessential VC transaction, the VC firm purchases preferred shares in a startup in exchange for its capital.^[7]The preferred shares entitle the VC firm to a variety of legal rights and protections relative to the startup’s founders, who are common shareholders.^[8] Crucially, preferred shares are generally convertible into a set number of common shares exercisable at the VC firm’s discretion, which enables it to benefit from price appreciation if the company undergoes an IPO.^[9] Preferred shares also supply the VC firm with downside protection—liquidation preferences—by contractually requiring that the firm receive a predetermined payout in the event of the company’s sale, bankruptcy, or formal dissolution.^[10] Finally, VC investments tend to be contingent upon certain contractual provisions that give the investor influence over the governance of the startup.^[11] Notably, VC firms negotiate veto rights that enable them to protect their investment by blocking certain corporate actions that may be unfavorable, such as selling the startup, issuing new shares, or incurring large debts.^[12]

VC funding offers significant advantages to startups seeking to focus on profitability and expansion while being efficient with their capital.^[13] VC financing enables early-stage startups to receive a capital infusion without needing to have significant cash flow or assets on their balance sheets.^[14] This form of financing presents a “lower risk” pathway to scalability because, unlike VD, equity financing does not need to be repaid, eliminating the pressure of monthly payments or covenants. ^[15] Additionally, startups tend to benefit from VC firms’ vast networks and operational mentorship, which may enable them to secure funding in the future and source talent from exclusive pipelines.^[16] However, this comes at the expense of  complete legal ownership of their companies and autonomy over all operational decisions.^[17]

Venture Debt: A Non-Dilutive Financing Alternative

VD is a form of debt financing in which funds are lent to high growth startups that have already received VC financing and are sufficiently creditworthy.^[18] Accordingly, VD often supplements VC rather than substituting it.^[19] Startups normally choose to raise VD in connection with equity financing rounds to maximize the capital available to them during a given period and preempt unforeseen capital needs without further ownership.^[20]

VD transactions are typically structured as term loans that are paid down by recipients over a contractually-specified period of time.^[21] The loan is non-dilutive, meaning it provides a capital infusion to the startup without reducing the percentage ownership of the founder(s).^[22] In a VD transaction, the lender is given the rights of a secured creditor and is entitled to receive payment before all of the equity shareholders—preferred and common—in the event of the startup’s bankruptcy or insolvency.^[23] However, VD agreements may provide the lender with the right to convert the debt into equity under certain circumstances, so founders must be cognizant of the risk that their ownership stakes could be diluted in the future.^[24]

The core advantage of VD financing is that it precludes dilution of ownership while permitting a startup to deploy capital flexibly to fund growth initiatives.^[25] Additionally, VD financing enables a founder to avoid accepting an unfavorable valuation from a VC financier during a market downturn by simply accepting a loan and achieving higher growth before its next equity (VC) funding round.^[26] However, unlike VC financing, VD must be repaid, and the loan may be accompanied by financial covenants, such as the maintenance of certain balance sheet ratios, that require close compliance.^[27] Moreover, interest rates for loans will vary and be accompanied by up-front and back-end fees imposed by the lender.^[28]

Venture Capital vs. Venture Debt: Which is Optimal?

When considering VC or VD financing, founders should be especially aware of the financial costs and legal risks associated with each option.^[29] In the case of VC financing, the financial cost may be characterized as equity dilution, and the legal risks are contractually granting VC investors governance powers that accompany their preferred shares.^[30]For VD, the financial costs may be characterized as the interest payments, financial covenants, and collateral that are required to service the debt, and the legal risks are granting lenders secured creditor rights that will be enforced if the startup fails.^[31]

Ultimately, a founder deciding between VC and VD should evaluate their company’s projected cash flows and near-term capital needs.^[32] If revenues and cash flows are sufficiently stable, VD would be preferable and mitigate dilution risks.^[33] Conversely, if the company does not have an established track record and lacks strategic expertise, VC is likely the better option.^[34]

^[1] Zach Ellison, Venture Debt: The Rise of Non-Sponsored Growth Credit Deals, Venture Cap. J. (Apr. 30, 2025), https://www.venturecapitaljournal.com/venture-debt-the-rise-of-non-sponsored-growth-credit-deals/.

^[2] See Mike Devery & Kyle Larrabee, Venture Debt Reaches Record High, Silicon Valley Bank (Dec. 6, 2024), https://www.svb.com/business-growth/access-to-capital/venture-debt-reaches-record-high/.

^[3] See Understanding Venture Debt Financing, Silicon Valley Bank, https://www.svb.com/startup-insights/venture-debt/how-does-venture-debt-work/.

^[4] See id.

^[5] See Bob Zider, How Venture Capital Works, Harvard Bus. Rev. (Nov.-Dec. 1998), https://hbr.org/1998/11/how-venture-capital-works.

^[6] Stages of Venture Capital, Silicon Valley Bank, https://www.svb.com/startup-insights/vc-relations/stages-of-venture-capital/ (last visited Oct. 20, 2025).

^[7] See Zider, supra note 5.

^[8] See id.

^[9] Cees Brouwer, Siew Kam Boon, Kevin R. Burke, Graham Nicholson, and Natasha Newey, Private Equity - Preferred Shares: A Variety of Uses and Terms, Hogan Lovells (June 30, 2025), https://www.hoganlovells.com/en/publications/private-equity-preferred-shares-a-variety-of-uses-and-terms.

^[10] Id.

^[11] See Daniel T. Janis, Venture Capital Shareholder Agreements—More Attention Now, Less Heartache Later, A.B.A. (May 18, 2017), https://www.americanbar.org/groups/business_law/resources/business-law-today/2017-may/venture-capital-shareholder-agreements/.

^[12] See id.

^[13] See What is Venture Capital, J.P. Morgan (Aug. 19, 2024), https://www.jpmorgan.com/insights/business-planning/what-is-venture-capital.

^[14] Id.

^[15] See J.P. Morgan, supra note 13.

^[16] Id.

^[17] See Brouwer et al., supra note 9.

^[18] See Silicon Valley Bank, supra note 3.

^[19] Id.

^[20] See Understanding Venture Debt, J.P. Morgan (Oct. 17, 2024), https://www.jpmorgan.com/insights/banking/commercial-banking/venture-debt-how-venture-debt-financing-works.

^[21] Jamie Eichenbaum & Myriam Bensadoun-Amato, Venture Debt vs. Venture Capital: Legal Considerations for Scaling, Miller Thomson (June 2, 2025), https://www.millerthomson.com/en/insights/ma-in-canada-trends-insights/venture-debt-vs-venture-capital-legal-considerations-for-scaling/.

^[22] See id.

^[23] Id.

^[24] Id.

^[25] J.P. Morgan, supra note 20.

^[26] See id.

^[27] See Eichenbaum & Bensadoun-Amato, supra note 21.

^[28] See When is Venture Debt Right for Your Business? Silicon Valley Bank, https://www.svb.com/startup-insights/venture-debt/when-is-venture-debt-right-for-your-business/.

^[29] See Eichenbaum & Bensadoun-Amato, supra note 21.

^[30] See Brouwer et al., supra note 9.

^[31] See Eichenbaum & Bensadoun-Amato, supra note 21.

^[32] See id.

^[33] See id.

^[34] See id.