Editor’s note: This article originally appeared on CFO.com.

Private equity and venture capital have a lot in common. Both involve acquiring or investing in promising companies, helping to create value, and then exiting on predetermined timelines. Yet a key difference between these strategies is that while venture deals have historically been funded with equity, private equity transactions typically utilize material amounts of debt in the funding stack. 

In part, that’s because the two strategies invest in different types of companies. Private equity buyers, for example, tend to look for mature companies with significant assets and operating cash flows. Those businesses can support servicing large amounts of debt so that the buyers can fund the bulk of the purchase price, thereby maximizing their equity returns.

Conversely, many venture-backed companies are unsuitable for traditional leverage. Instead of generating cash that can be used to pay down debt, they consume cash to drive growth. Plus, they have few or no tangible assets, which rules out traditional loans as a funding strategy and leaves equity as VCs’ default source of capitalization.

But is that really the best option for them? Could borrowers and VC investors be better served by capital structures that more closely mimic the ones that private equity professionals use? And, more specifically, what could they gain from using debt in their capital structures?

Why private equity uses debt

Debt is cheaper than equity. First, its claim on a company’s cash flows is senior to equity holders, making it less risky than an equity investment. That lower risk means that a borrower doesn’t have to pay as much for senior funding as it does for equity capital. On top of that, most tax codes favor debt servicing costs relative to equity since interest payments are generally tax-deductible, whereas dividends are from after-tax earnings.  

Because debt is a senior, contractual obligation, while equity is a residual claim on cash flows, under normal circumstances, the cost and value of a given debt instrument are fixed. In other words, regardless of whether the value of the business rises or falls, the value of the debt is constant.

That means that if you were to fund 80 percent of a $100 million business with debt, and the value of that business doubled, you’d still only have to pay back $80 million. Meanwhile, your $20 million equity investment would now be worth $120 million, a six-fold return. Even after adjusting for interest and other costs, the increase in the value of your owned equity would have gone up dramatically.

Of course, if you’d funded the entire cost of that purchase with equity, you would still have made a substantial nominal profit. It’s just that the change in the value of the company would have to be shared with all the other shareholders who contributed capital to the business. If your business is 100 percent equity-financed, then doubling the value of the business doubles the value of your equity. And while that’s pretty good, it’s certainly not as good as the levered investment described above.

How much does venture equity cost?

The technical way to calculate the cost of equity is to combine a number of inputs, including the risk-free borrowing rate, the risk premium for equity, and the correlation between the stock in question and the broader market. Those aren’t easily obtained for private companies, but we can use the returns to the buyer as a proxy for the cost of equity to the seller.

As a starting point, venture capital firms typically target annual returns of 25 percent, for a fund with a 10-year term. But the cost to the issuer is much higher than that because of the dynamics of venture capital fund management. 

First, a significant percentage of a VC’s available funds don’t actually get invested. Instead, they’re used to pay a variety of expenses, such as audit and legal fees, which can add up to 15 percent of a fund’s assets. That 25 percent return on each dollar of assets therefore has to be earned off the 85 cents of each dollar in the fund that are actually invested in portfolio companies. That implies that each dollar an entrepreneur receives has to triple in value over a decade to meet the VC’s target.

Of course, nobody expects to earn uniform returns across a portfolio, and a venture portfolio will generate a particularly wide range of outcomes. Knowing that some percentage of their portfolio will produce a total loss, venture investors look for outsized returns on those investments that do work. 

Since VCs have no way of knowing which investments will be winners in advance, they prefer to invest on terms that leverage their initial commitments if a thesis develops positively, while minimizing their commitment if it doesn’t. Attaching warrants to an equity round is an example of this approach. But, in general, VCs will try to structure each investment so that they can capture an outsized return from it if it works, while overcoming the drag on the portfolio from the investments that inevitably fail.  

The bottom line is that venture capitalists can’t invest 100 cents of each dollar that their investors give them, and some of the dollars that they do invest will be completely lost. That suggests that they need very high returns on their successful investments, which in turn implies that the cost of those investments for the shareholders selling them is very high. It could be as much as 100 percent per year, and certainly well in excess of the 10 to 15 percent that venture debt might cost.

Historical barriers to using debt have eroded 

Historically, young businesses haven’t been able to borrow. Companies with negative EBITDA and negligible assets weren’t very attractive to potential lenders. Plus, since the business risks in startups are so high, few founders wanted to compound them by adding financial risk in the form of debt, even if they’d been able to obtain it.

But once a company has proved that it can meet a real market need, and is experiencing rapid growth — even if it’s not yet profitable — then its business risk reduces materially. And, as the business risk recedes, the relative costs of capital should be a larger consideration for the company, meaning that it can consider adding debt as a permanent part of its capital structure.   

Today’s specialist lenders understand that business risk isn’t just a function of how long a company has been operating, or how old its chief executive is. That understanding has allowed venture lenders to engineer new tools that let young, rapidly growing businesses borrow.  

For example, the advent of the SaaS business model has spurred recognition of the value of having an installed client base, even if that value doesn’t show up on a prospective borrower’s balance sheet. Practitioners have also developed analytical metrics to understand the risks and qualities of companies they might lend to. Meanwhile, sector specialists cultivate and forge deep relationships with founders and managers that yield a qualitative overlay to their numerical analyses.

As debt has become more widely available, so too has its benefits become more widely understood. Venture debt can serve as a tool to fund working capital and M&A, to add resources to R&D, and to bridge to better terms for equity raises. As noted above, it can also be a far cheaper way than equity to fund these kinds of initiatives and investments. 

The case for debt 

While equity should always be the primary instrument for funding early stage companies, many of the reasons why private equity managers use debt in their investments are also relevant in venture capital. 

Debt was formerly either impractical or impossible for many early stage companies to access. However, venture lenders’ understanding of growth dynamics has changed tremendously in the recent past. Alongside that, the cadence of corporate development for many young companies has accelerated. That means that debt is a realistic alternative for many growth ventures at a much earlier stage than ever before.   

Debt offers a cost-effective way for those companies to fund their growth, and provides managers and shareholders with a valuable alternative to equity. Besides being cheaper than equity in many cases, debt also solves for a number of other issues that can arise in terms of equity financing, such as having to give up board seats and managerial flexibility. 

Private equity partners have benefited from these dynamics over a long period. Now that the option is open to them, perhaps more VCs and entrepreneurs will look at the lessons they could learn from their peers in private equity.