Key Differences Between Project and Venture Finance
IN BRIEF: Project finance is a method of leveraging medium- to long-term debt (a loan) alongside any equity using future cash flows generated by the project by itself, while venture finance uses the balance sheet of the company and/or its sponsors, adding shareholder value within the funded entity. Venture capital (VC), especially startup or “seed” money, is typically exposed to much greater risk, while traditional Project Finance is far more risk averse.
Most early-stage venture capitalists are willing to take risks, spread across their portfolio, with only the occasional “home run” covering other losses, project financiers prefer more modest, predictable, “risk adjusted” returns. For example, VC money can be used to commercialize new technology while traditional project finance will not accept any technology risk (In3’s CAP funding is far from traditional) while most other commercial, operational and political risks are controlled or mitigated.
More on Project Development | Project Finance | Why Project Finance | Venture Finance | Impact Capital | All types of funding
With new construction, expansion, refurbishment or retrofits, Project Finance builds new, tangible assets within a defined start/stop construction period. Working capital or “contingency” as well as any initial operating expenses are limited to what is required to complete the asset construction and generate cash flows to become self-sustaining on a standalone basis. Projects are typically held as a “Special Purpose Vehicle” (SPV), a separate legal entity established to own the project’s assets. The SPV has limited or no recourse to any parent company or to the owner’s other holdings.
The owners of the SPV are not permitted to use invested capital to perform any function other than developing, constructing/installing, commissioning and operating the designated project’s assets. Sometimes prior loans or owner “cash” equity can be repaid from new project funding, but more typical would be repay those earlier investments out of operational cashflows. In any case, the “new money” lender/investor is repaid out of the cash flows generated by the commercial operation of the project’s assets.
What does it all mean in practical terms? This article will explain and explore …
- What structural, cultural or organizational differences exist between venture and project funding?
- What are the best options for “greenfield” (new) project finance? Go here
- What are the best options for venture startups? More (definitions)
More options for Early Stage, Greenfield or Growth capital; For Trade Finance, go here; Mergers & Acquisitions (M&A), contact us.
Project Finance is a complex and varied method of raising long-term financial capital, but most project financiers share a set of common qualification conditions (an implicit checklist). In3’s preferred pathway to funding projects, up to 100% of the required capital, greatly streamlines those complexities to expedite funding and make the entire process easier for executives and non-financial managers. The rest of this article distinguishes when to use project finance versus venture finance, and what to expect along the way.
Warning: Even with our innovations, this topic of project versus venture finance is often misunderstood, except by financial service practitioners and bankers, but it is nonetheless worthy of careful inquiry and patient study if this arena is less familiar. Why? There are advantages of knowing these distinctions, efficiencies to be gained (get to closings faster and more effortlessly), and often with better financial terms, thus money to be made alongside impacts to be realized!
Examples of project finance advantages
- Early stage companies can bypass disputes about pre- and post-money valuation — the #1 reason venture capital deals don’t go through. There are different views of risk/reward, and with diverse assumptions about NPV discounts and IRR come divergent opinions about share prices. Early stage venture valuation can be quite subjective. Project finance, especially greenfield (no operating history) can be far less subjective, on average.
- The equity carried interest (equity partnership, subscription or share purchase agreement) applies to project-based assets, set up as Special Purpose Vehicles or HoldCo’s, not the parent company stock. This eliminates concerns about resource or control. But the downside is that unlike venture capital, where perception of risk just increases the investor’s aspiration for control, traditional (uber-conservative) project financiers will simply refuse or “pass” without explanation. This isn’t about being mysterious … they don’t want to get into an argument.
- Most industries can rapidly deploy projects with greater agility than a venture model so you can scale faster and with greater ease, as projects become more standardized and cookie-cutter. With some notable exceptions, the larger the funder, EPC firm/general contractor or bank, the greater the desire to use familiar patterns of success (cookie cutter) and inherent reluctance to innovate. This also applies to larger deals — making a $1B mistake versus a $1M one.
Learning and self-reflection on this topic tends to multiply benefits. You might also want to ask yourself this tough question and answer honestly: “Why don’t I already have the required capital in hand”? See also Education Services if you don’t have a defensible answer and want one.
Let’s explore each type of capital, in turn, and then come back to draw some points of comparison:
Venture Capital (itself quite diverse — early-stage angels, angel groups, venture funds, venture-focused family offices focused on innovation and placement of “risk capital” …) Trade Finance, and Corporate Finance (corporate strategic investors, large institutional funds that focus on public equities, etc.) differ sharply from Project Finance in several important ways. A key difference between the two approaches lies in how debt (borrowing money, via one or more loans) and equity are structured. Both project and venture capital often include a debt component (to leverage or preserve owner equity, among other reasons) alongside the equity owned by the principals, partners, and other shareholders. But there are sharp differences:
With Project Finance the project owners borrow against the cash flow generated by the project alone (additionally secured by available assets and loan guarantees), as part of a separate Special Purpose Vehicle (SPV), while venture finance leverages the company balance sheet, not the standalone cash flows from a separate SPV.
Further, the SPV affords a different ownership structure that is separate from the parent company, both in terms of legal recourse (limited or no recourse loans are common in project finance, less so with venture capital) as well as carried interest rights to profits (gain-sharing or profit sharing) between the equity partners. Ventures typically structure dividends to pay equity partners on their shareholdings, while projects typically assign a proportion of overall cashflows derived from operations.
Confused yet? Let’s boil it down to these two keys on project finance:
- The documentation including contractual arrangements must be verifiable and strong enough to ensure the project’s reliable financial performance. Project finance effectively monetizes these contracts, such as through long-term product offtake agreements (e.g., a power purchase agreement, or PPA), or other guarantees of commercial results. Further, a sponsor or loan guarantee (obtained from either a sovereign entity like a national government, or a bank guarantee whether leased or backed by a Letter of Credit) can be used to great advantage.
- The cash flows from the project must be sufficient to service the debt (repay the loan) and provide a substantial upside for the owners on a standalone basis. Thus, careful financial modeling that shows adequate cash flows coming from the project on its own is critically important. This modeling must be done properly, per recognized accounting standards (IFRS or GAAP). How much cash flow is deemed “adequate” depends a bit on the lender, and overall risks, but generally a metric called “debt service coverage ratio” must be in the range of at least 1.0 to 1.25 to qualify. Acceptable profitability also varies by industry, but IRR is the customary measure (more at “Terminology Demystified“).
Financial modeling profitability/efficiency metrics that matter:
- Project finance looks for Internal Rate of Return (IRR) from cash flows, a measure of capital efficiency or some would say productivity. Equity investors care about Equity IRR (eIRR), that is, rate of return on equity leveraged with debt, but there are often assumptions embedded that make eIRR less reliable an indicator compared to IRR.
- Venture finance is more concerned with enterprise value, and net income (Net Operating Profit) often expressed as EBIT, EBITDA or net operating profit margins (as a percentage over time).
As mentioned above, projects often use a “special purpose vehicle” (SPV) — a separate legal entity or holding company, in the host country where the project will operate, or elsewhere, and thus limit legal recourse (see below for definition) to just that entity. Remaining project risks are largely mitigated through a combination of effective planning, the team’s experience (execution skills and track record), choice of partners and suppliers, skillful contracting with customers (such as long-term purchase agreements), credit enhancement such as loan guarantees, and/or risk insurance(s), and using well-proven technology.
Other differences between project and venture finance are summarized below, first the high-level fundamentals, then in further detail, comparing the risk/return profiles of early-stage venture finance and early-stage project finance reveals sharp differences, showing this contrast across their respective columns:
Summary of Fundamental Differences | Venture Capital (startup or early stage) | Project Finance (greenfield or expansion) |
Legal / Ownership Structure | Corporate Balance Sheet-based finance; company itself is borrower or issues shares/units or other legal instruments | Special Purpose Vehicle (SPV) or separate holding company owns project assets. Cashflows on a standalone basis for SPV. |
Liability / Recourse | Recourse in the event of bankruptcy depends on terms of shares/unitholding or debt position | Limited recourse to a parent company or owners, also depends on position in the event of default (senior lender before subordinated, for example) |
Time horizon | Could be a long road to profits … might not have a discrete event or predictable milestone date for commercial results such as profitability from operations or dividends to shareholders. | Typically profitable within a relatively short period once construction / commissioning are completed. Always a stated completion milestone to reach Commercial Operation Date (COD). |
Risk | Commercialization of new tech, new models or other solutions quite common. Venture capital is the right tool for this higher risk/high reward activity. | Normally, no technology risk or even commercial risk is tolerated. In3 CAP is an exception (more). See also below discussion about Recourse: how lenders think about risk. |
Asset Class(es) in the capital stack | Equity and/or Debt or “quasi-equity” such as convertible instruments. Sometimes must be entirely equity, without debt, due to lack of tangible assets (most or all is “working capital”). | Equity and Debt; almost always uses long-term debt, secured by collateral (if Senior Debt is used), repaid via SPV’s cashflows. |
Culture & Style | Relies on strength of managers and their track records, experience, and relationship with investors. For equity, the parties must be able to “stand each other” and form a true partnership. Returns are risk-adjusted and vary widely from sector to sector. EBITDA and net operating margins are key. | Relies on documentation, is extremely conservative, looks not just at the average case, but at the worst case scenario and requires written evidence of the business case, feasibility, and reasonable (close to zero) commercial risk to secure funding. Internal Rate of Return (IRR), which also varies widely by industry and market) is key, a measure of capital efficiency. Traditional project financiers consider equity/debt (leverage) and other ratios. |
Continued compare/contrast analysis between venture and project finance, now in greater detail and with more precision:
| Topic | Venture Finance | Project Finance |
| Stage | Startup or “early” stage — usually beyond technical proof-of-concept, but usually not past “commercial proof-of-concept” … revenue but not yet net profit. | Startup or “greenfield” – defined as less than 3 years operating history. Projects with more than 3 years operating history may seek expansion capital, or capital for retrofits, refurbishment or refinancing. |
| Risk/Return Profile | High risk, high potential return-on-investment (ROI measured as Internal Rate of Return) of financial capital. Some impact investors (about 34% of them, as of the last official survey by the GIIN) accept lower financial returns to realize positive social and environmental impacts. | Lower risk, relatively low returns to the lender (repayment of principal plus interest out of cash flows). Project owners usually keep the vast majority of returns, which vary from below-market rates (concessionary or “soft” loans) to significant windfalls. With lower costs and longer useful lives of infrastructure hardware, projects like utility-scale solar, wind and WTE can reach unlevered IRRs at or above 14%. |
| Assets | Part of the company’s balance sheet, and sometimes pledged as collateral (such as for traditional bank loans).* | Normally pledged as collateral via a lien (as part of Senior Debt). Most “no recourse” or “limited recourse” loans rely on a base of assets — liens and guarantees — to securitize the loan. Note that CAP funding does not require a lien. |
| What is “equity“? How is it defined? | Equity refers to an ownership interest or stake in the venture (units, or shares, of company stock). Equity is ownership with various rights such as voting to influence decision-making, among others. Management may authorize multiple classes of equity ownership (common vs. preferred stock) each with different rights or preferences such as voting, liquidation* or anti-dilution. | In traditional project finance, “equity” is committed in order to obtain an enabling loan. Both equity and debt asset classes are used in proportion as part of a “capital stack.” Most lenders expect project owners to take on a meaningful share of the risks, to take some “skin in the game.” Equity commitments can combine various direct investments including cash, subordinated or mezzanine debt, convertible debt, grants, or other forms of “unexpended” (new) funds. |
| Technology Risk | Early stage venture funding can tolerate risks when there are commensurate rewards. Some venture funds are risk attractive, focused on taking smart risks in order to realize substantial upsides from innovative new solutions. VC funding is often used for R&D, including the milestones of “technical proof-of-concept,” business feasibility (reaching and sustaining net profitability) and ultimately “commercial proof-of-concept” — a viable and reliable business income stream that proves to be resilient in the face of market fluctuations, generates sustainable value and sustaining profits. Later stage venture money is typically used to recapitalize or buy out existing equity partners (M&A via Private Equity and Hedge Funds). Rarely do venture capitalists cross over into project finance transactions. | With the exception of the “venture capital of project finance” (equity investment or convertible debt in the earliest stage, used for proving out new models, or to demonstrate feasibility at a larger scale), to build the “onramp” to project bankability, most mainstream project finance requires completely proven technology in the hands of developers that have built multiple projects under similar conditions. Such conditions include
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* Note: Some venture equity investors will request liquidation preference rights; that is, in the event of venture failure they get paid back first out of any remaining assets. Lenders call this “senior position.”
Times of Change in Venture Capital Markets
To make matters slightly more confusing, some early stage ventures prefer to use debt or hybrid instruments (convertible debt, revenue contracts such as mentioned above, quasi equity, etc.) rather than pure equity investment (direct sale of interest shares) in an effort to avoid dilution of their ownership interest and/or to retain control. But all capital structures must work for both parties, or there is no point.
To get a successful venture off the ground and funded by venture capital (angels, angel groups, boutique VCs, development finance institutions, etc.), you’ll need key ingredients that go beyond our assessment tool’s (RAIN) scope, like a stellar business concept, a well-developed and tested business model, a high-quality summary business plan, typically a large ($500M+) available market, a well-defined addressable market (total addressable market, or TAM), a defensible and significant competitive advantage, and a highly skilled team. All of these areas are requirements for attracting ventures investors. By contrast, project investors have a rather different agenda.
From a lender’s perspective, low potential reward (repayment of principal plus interest) means lower risk profiles than most, except perhaps for traditional banks, which are not generally lending money in the current economy.
Recourse: how lenders think about risk
Project finance is quite conservative, even lazy. Most project investors look not at the average case but at the worst case. In the event of default, that is, if the project company can no longer repay the loan, the project finance lender wants to establish “recourse” or a guarantee – a backup source of repayment. This helps prevent fraud, but also makes it possible for lenders to make these investments at quite favorable terms (read: cheap money with little or no interest in owning rights to cashflows beyond debt service), thus forming a reasonable expectation of being repaid. Commercial lending is certainly not philanthropy (though some impact investors — roughly 12% in recent surveys — are nearly so, with very modest expectations for returns, reliably delivered).
Insurance companies and pension funds often invest in projects for this reason — modest returns but reliable, repeatable, and at sufficient scale to generate better-than-inflation returns on capital employed.
From a structural perspective, the main difference between a venture and a project seeking finance is how the company would structure debt funding — the money loaned to the company or project company. Projects offer limited recourse, or no recourse funding, but for ventures, recourse is not confined to the operation of a specific project. The company is “on the hook” for repayment, even if the project that was financed utterly fails.
In general, project investments can be more leveraged because most project financiers make relatively modest use of equity (seen as risk capital) and rely more on debt from third party sources (such as banks), which combined with guarantees, free up capital for other purposes.
Summary: there are many advantages to project finance, such as limiting the recourse (protecting the project promoters interest), but also tradeoffs, such as the need to set up a special purpose vehicle (SPV), provide various guarantees and more rigorous financial modeling to show adequate cash flows and lower-than-average risk.
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