Why equity and debt investors think differently
Funding is the lifeblood of businesses, and it can come in one of two forms: equity or debt capital. Before we get into the differences between equity and debt technology, we'll quickly recap the differences between equity and debt investments and investors.
An equity investment is when an investor buys a stake in a business. Over the past ten years, the inflow of hundreds of billions of dollars of venture capital into the startup ecosystem has dominated the funding zeitgeist, so for the purposes of this article, we'll use venture capital as a stand-in for equity investment.
When venture capitalists invest in a startup, they hope that that startup can become the next Amazon or Google. Investors know that most of their investments won't generate massive returns, so they look for companies that could dominate large markets, if all goes well. Equity investors often seek asymmetric upside: bets where the maximum possible upside (a 100x return, for example) far outweighs the maximum possible downside (the loss of the capital invested).
That's why, when venture capital firms evaluate prospective investments, they are likely to conduct analysis on the potential total addressable market (TAM) of that company, as well as adjacent business areas into which the company could expand. Why? Because each of a venture capital firm's portfolio companies must have the potential to be a home run, or "return the fund." That can only happen in large markets.
A debt investment is when an investor lends capital to a company for a mutually agreed upon period of time, after which the borrower pays back the principal and interest of the loan. Loans are familiar, conceptually, to most people, so we won't go into detail about how loans work. However, it is worth pointing out that debt investors only win if most—if not all—of their loans are repaid. That's why debt investors look for stable, predictable investments.
When debt investors evaluate potential investment opportunities, they are focused on protecting themselves from downside risk. It doesn't necessarily matter what the TAM of an investment opportunity is. It's more important to think about all the things that could go wrong, and to evaluate those risks one by one.
Equity investors need to be right just one time; debt investors can't afford to make big mistakes.
How equity and debt investment processes and technology are similar
Regardless of the structural and philosophical differences between debt and equity investments, described above, the investment processes for equity and debt investors are similar and happen in four stages: sourcing, due diligence and analysis, contract negotiation and execution, and ongoing communication and monitoring.
In this section, we'll walk through the capital raise processes for venture capital firms and debt capital providers (focusing on the processes typically seen in middle-market debt), as well as some of the technology offerings available for each phase.
Sourcing is when an investment firm meets with companies it might invest in. This article on venture capital deal flow provides a great overview of all the meetings that VCs must take in order to secure a single investment. It's not so different on the debt side: the number of introductory meetings and potential investments vastly outnumber the number of deals that actually get done. Technology in this space seeks to match investors and possible investments based on what both sides are looking for (e.g., investment size, investment vertical, etc.)
Due diligence and analysis happen before an investment. This is when investors conduct thorough investigations into companies to make sure that they understand the company's financial reports, team, market, and customers. We covered debt capital due diligence in a previous post. In that article, we broke down diligence into four parts: Company Overview Information, Financial Information, Customer or Policy Information, and Historical Data. These categories are similar for both equity and debt, though, as mentioned above, equity investors tend to focus on maximizing upside, while debt investors focus on downside protection.
Contract negotiation and execution happen after investors and companies have decided, in principle, to make a deal. This process starts with the issuance of a term sheet, which investors and companies subsequently negotiate, and results in an executed investment contract. In debt capital, the signed credit agreement is called a credit agreement.
Ongoing communication and monitoring happen after a deal. This is when investors receive regular updates from the companies they've invested in, and offer operating assistance or advice as necessary. These updates are often unstructured or ad hoc, for venture capital investments, and placed into an Excel template, for debt capital investments.
Why equity and debt technology diverged
Although the sequence of debt and equity investment sourcing and completion is similar, much more attention and funding have gone to equity technology, leading to far more innovation in equity investing. Even though venture capital and private credit are roughly the same in size, at about $700 billion, venture capital has taken the lion's share of software within capital markets (likely because of venture capital's traditional proximity to software).
For example, AngelList enables fund managers to create and administer rolling funds so that they can regularly accept new capital. The launch of CartaX, a "private stock market" for shares of private technology companies, also underscores the ways in which equity technology companies have been able to move from providing compliance and workflow functionality into marketplace functionality.
By contrast, there is still a lack of consolidation or innovation in the debt capital markets; none of the capabilities above exist for debt capital. Even resources for founders and operators raising debt capital, a "table stakes" requirement for entrepreneurs seeking to innovate within the space, are few and far between. And market leaders for integrating, analyzing, and sharing debt data are often legacy software players that are not cloud-based, which means that the conditions have not been present for a "debt capital ecosystem" to emerge.
(It should be noted that despite a broad divergence in the evolution of equity and debt technology, due diligence and negotiation for both investment types still happen almost entirely in Microsoft Word and Microsoft Excel—a process inefficiency we've addressed previously.)
Now that equity software has paved the way, there is a clear roadmap for capital markets innovation in debt capital.
Moving forward, we expect debt technology to catch up to equity technology: more data and benchmarks are available for debt investments than for equity investments, and the urgency of tracking each individual portfolio company's performance is higher. Each technological capability that has been developed in equity investment—more accurate and comprehensive benchmarking, novel fund structures and marketplaces, better tools for analyzing investment performance—will make an appearance in debt investment in the next several years.
Want to learn more?
Finley is private credit management software that helps companies with asset-backed loans save time and money by automating routine debt capital management tasks like borrowing base reporting, verification, and alerting. Today, Finley manages over $2 billion in debt capital for customers like Ramp, Parafin, and Arc. If you're interested in learning more about software that can help you streamline your debt capital raise and management, just schedule a demo or take a self-guided product tour. We'd love to chat!