As Canada's innovation ecosystem continues to grow, more entrepreneurs are looking to ways to finance the next stage of their company's growth without giving up equity. The solution often lies in understanding the legal trade-offs between two popular funding options:
- venture capital,and
- venture debt.
While both can provide critical growth capital, they come with very different implications for ownership, control, and legal risk. This article explores how these financing tools work, and the legal considerations that a founder should weigh before signing a term sheet and closing a raise.
Understanding the two funding models
Venture Capital (VC)
VC involves the sale of a portion of a company's equity to an investor in exchange for capital. This typically results in the creation of preferred shares and the implementation or amending of a shareholders' agreement, giving the investor certain rights, typically board seats, vetoes, and exit rights.
Venture Debt
Venture Debt, by contrast, is a loan, usually provided by a specialized lender to start-ups that already have VC backing. While the lender does not receive equity upfront, the loan often comes with warrants (rights to purchase equity at a set price in the future) and includes contractual restrictions on how the business can operate.
In short and on a high-level, VC changes the ownership of your company, while venture debt changes how your company operates.
Key legal differences between venture debt and VC
1. Restrictive covenants and operating constraints
One of the most important legal features of venture debt is the inclusion of restrictive covenants, or clauses that limit your freedom to operate. These may:
- Restrict taking on additional debt or issuing dividends
- Impose financial ratios that must be met on a regular basis (monthly, quarterly etc.)
- Require prior lender approval for certain business decisions (e.g., M&A activity)
While VC also involves some oversight, typically via board participation and/or veto rights, the operational constraints tend to be less rigid in the short-term.
2. Conversion rights and equity exposure
Although venture debt is marketed as "non-dilutive," many venture debt agreements include warrants, and some may include rights to convert debt into equity under certain scenarios.
For business owners, this means potential future dilution, especially if the valuation at conversion is lower than anticipated. VC, on the other hand, involvesknown dilution from day one, often accompanied by a carefully negotiated shareholders' agreement.
3. Priority in insolvency scenarios
From a legal standpoint, venture debt gives the lender the rights of a secured creditor. In the event of insolvency or restructuring, the lender is entitled to repayment before shareholders. This may include rights over intellectual property or other business assets, depending on the collateral agreements.
VC investors, by contrast, are equity holders, last in line in the event of liquidation but often with special protections, such as liquidation preferences.
Legal advantages of venture debt
From a legal and strategic perspective, venture debt can offer several advantages for founders who wish to retain control over their company's equity, including:
- Minimal immediate dilution: Founders preserve more ownership early on.
- Speed of execution: Venture debt documents are often faster to negotiate than equity rounds.
- Bridging tool: Venture debt can extend the company's runway between equity rounds, allowing time to achieve better terms later.
However, the trade-off lies in higher legal risk in default scenarios, and less flexibility to pivot without lender consent.
When is venture debt a good fit?
Venture debt is best suited for companies that:
- Have predictable revenue or cash flow
- Are already backed by reputable VCs
- Are close to profitability or a major milestone
- Require funding to extend runway without triggering a down round
That said, legal due diligence is critical. Founders must fully understand the implications of loan covenants, the triggers for default, and the scope of any equity-linked provisions.
Key takeaways
- VCgives immediate cash in exchange for equity—and long-term alignment with investors.
- Venture debt provides flexible capital without upfront dilution, but often includes strict covenants and potential for future equity conversion.
- Legal review of loan terms, warrants, and security arrangements is essential to avoid unintended risks.
- Founders should model different scenarios (e.g., default, liquidity events) to fully understand financial and legal implications of both instruments.
- Founders should consider and negotiate either option carefully to protect control and maximize strategic options.
Conclusion: Aligning funding with your growth vision
Choosing between VC and venture debt is more than a financial decision, it's a strategic and legal inflection point. Both instruments have their place in a company's growth journey, but they must be aligned with the company's vision, risk profile, and exit strategy.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
