Key Differences Between Project Finance and Venture Finance

IN BRIEF:  Project finance is a method of raising medium- to long-term debt (a loan) based on cash flow generated by the project, while venture finance uses the balance sheet of the company and/or its sponsors. Projects typically do not have technology risk; most risks are controlled or mitigated.  

What does that mean in practice?  What other structural differences exist and what are the best options for startups?  (For questions about trade finance, go here.)

Project Finance is a notoriously complex and varied method of raising long-term financial capital.  This article distills those complexities into explanations geared toward executives and non-financial managers, clarifying when to use project finance versus venture capital, and what to expect along the way.

Warning:  this remains a complex topic that is mostly misunderstood, except by practitioners, but worthy of careful inquiry and patient study.  Why?  There are advantages, efficiencies, and money to be made!  See also Education Services (ask yourself this tough question and answer honestly:  “Why don’t you already have the required capital in hand”?).

Venture Capital (itself quite diverse — angels, angel groups, funds, family offices, etc.) or Corporate Finance different 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) is 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, sponsors, and other shareholders.

But with Project Finance the project owners borrow against the cash flow generated by the project alone (additionally secured by available assets and loan guarantees), while venture finance leverages the company balance sheet, not the cash flows.

Two keys on project finance:  

  1. The contractual arrangements must be verifiable and strong enough to ensure the project’s reliable performance.  Project finance effectively monetizes these contracts, such as through long-term product offtake agreements (e.g., a power purchase agreement), or other guarantees of commercial results.  
  2. The cash flows from the project must be sufficient to service the debt (repay the loan).  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.  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.

Projects often use a “special purpose vehicle” (SPV) in the host country where the project will operate, 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).

Other differences between project and venture finance are summarized below.  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:

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) 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 keep the vast majority of returns, which vary from below-market rates to significant windfalls, sometimes called “soft” loans.
Assets Part of the company’s balance sheet, and sometimes pledged as collateral (such as for traditional bank loans).* Always pledged as collateral — even “no recourse” or “limited recourse” loans rely on a base of assets to securitize the loan. 
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 project finance, “equity” is committed in order to obtain an enabling loan.  Both asset classes are used in proportion as part of a “capital stack.”  Lenders expect project owners to take on a meaningful share of the risks, … 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 funds.  
Technology Risk Early stage venture venture funding can tolerate risks when there are commensurate rewards.  VC funding is often used for R&D, including the milestones of “technical proof-of-concept,” business feasibility (net profitability) and ultimately “commercial proof-of-concept.” With the exception of the “venture capital” of project finance (equity investment or convertible debt), building the “onramp” to bankability, most project finance requires completely proven technology in the hands of developers that have build multiple projects under similar conditions.  

* 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.”

Notes on the Role of Debt

Type of debt: construction (short-term) loans, senior debt (long-term as 3 or more years), mezzanine (aka sub-debt or convertible debt, quasi-equity, etc.), working capital lines of credit (more common in trade finance)

Both ventures and projects usually rely on debt capital, but projects typically rely on it more, as there are physical assets with every traditional type of project that can be leveraged and secured.  Startup venture funding, also known as venture capital, takes on more risks with the potential for proportionately higher returns.  There is overlap in some cases — very open-minded project funding sources that are actually less risk averse than certain types of (mostly later-stage) VCs.

Debt capital is particularly popular in the current economy with affordable interest rates and favorable terms available to qualified borrowers.  Not every venture relies on debt, but commercial credit and related instruments (such as revenue-sharing notes, or topline revenue contracts, for example) are important tools in forming adequate financial capital for reaching development targets.

Startup ventures typically rely more on equity investment, at least to start, and repay investors by building long-term enterprise value (based on increasing the company’s share price), and sometimes by offering dividends, but the goal is often to position the company to be acquired or to make a public offering, or in some cases, for shares to be “redeemed” or repurchased from investors.  These “exits” are what venture investors use to gain liquidity (earn back their investment).  Otherwise, there is generally no market for early stage (private) equity.

Times of Change in 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

In the event of default, that is, if the project company can no longer repay the loan, the project finance lender has “recourse” – or 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 a reasonable expectation of being repaid. Commercial lending is not philanthropy (though some impact investors — roughly 12% in recent surveys — are nearly so, with very low expectations for returns).

From a structural perspective, the main different 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. Project offer limited or no recourse, but for ventures, recourse is not confined to the operation of a specific project.

In general, project investments can be more leveraged, keep capital more less or at least less encumbered, because most project finance investment make relatively modest use of equity (seen as risk capital) and rely more on debt from third party sources, thus freeing up capital for other purposes.

In summary, there are many advantages to project finance, such as limiting the recourse, but also tradeoffs, such as the need to set up a special purpose vehicle, provide various guarantees and more rigorous financial modeling to show adequate cash flows.

We’d like your feedback on this article.  Please post a comment!