Venture Debt vs. Venture Capital Returns

One of my favorite investment strategies is the barbell strategy where I invest in lower risk companies or indices to hit singles and doubles while concurrently investing in more speculative companies to hit potential home runs. Ive structured my after-tax investments to be more low-risk through structured notes. and my pre-tax investments in my rollover IRA. SEP IRA, and Solo 401k to be more high risk. Given my pre-tax investments cant be touched until 59.5 without penalty, I find it easier to take more risks with such funds.

My investments are solely a mixture of equity and fixed income  to keep things as simple and straightforward as possible. My main goal is to come up with an appropriate asset allocation for my age and risk-tolerance, and let the investments perform as they may. Spending energy trying to beat the S&P 500 is a fools game. Id much rather be traveling, playing tennis, building my online business, or writing with my spare time.

Ive recently invested into a new investment vehicle Im very excited about. Its called venture debt. For those of you who are accredited investors who like the barbell investment strategy as well, I think you will appreciate learning about venture debt in this article.

WHAT IS VENTURE DEBT?

A startup company can either raise money to fund operations through equity or through debt. Angel investors and venture capitalists are the earliest stage investors followed by private equity investors and then public investors once the company goes IPO on the NYSE, NASDAQ, or AMEX.

Lets say you are the CEO of a startup and youve raised $5 million dollars by selling 20% of your company through a Series A round. You find out that you need $1 million more for working capital a year later, but you dont want to dilute yourself and existing shareholders by raising a Series B round. This is where venture debt comes in.

A nimble venture debt fund will come in and lend short-term money (usually 1-3 years per investment) into private equity sponsor-backed companies at interest rates of perhaps 12-15%. Furthermore, the venture debt fund can sometimes negotiate warrants (a right to buy stock) for further upside potential.

You might be thinking what CEO in their right mind would be willing to pay 12-15% interest a year and offer warrants. All youve got to do is think about the alternatives for a high-risk, money-losing startup.

First of all, large banks dont have the resources, the patience, or the expertise to invest in such startups. Neither do smaller boutique banks or credit unions. A bank like Silicon Valley Bank, which is deeply entrenched in the tech community can provide lines of credit at perhaps a slightly cheaper rate, but they are a retail bank first and foremost, and not a venture debt company.

Second of all, if your company is growing at 10% month over month, paying 15% a year in interest is MUCH cheaper than selling equity that is growing at 200%+ a year. Maybe the equity isnt growing exactly at the same rate as revenue growth, but its certainly growing faster than 15% a year. You want to own as much of your company as possible while ensuring its survival to allow for your equity to be worth something in the future.

Finally, providing warrants to a venture debt company is a way of creating a longer-term partnership and lowering the interest burden. Perhaps if you didnt agree to warrants coverage, then your interest rate might be 18% or more instead of 15%, for example. Meanwhile, its nice to know that after the loan is due, you should have an easier time borrowing money from the venture debt company who still has a vested interest in your companys survival due to the warrants it owns.

Current Yields For Leveraged Loans, High Yield Bonds, and Venture Debt

MANAGING RISK WITH VENTURE DEBT

The word venture is in venture debt for a reason. Venture investing is early stage and highly risky if you are a straight up equity investor. Venture Capitalists will not see returns on most of their investments. But when one hits, it could be a 1,000% return or more as is the case with early investors in Uber, AirBnb, Facebook, Pinterest, and many more.

But if you are a venture lender, the risk parameters are different. Your number one goal as a venture debt investor is to make sure that the company survives long enough to pay out the agreed upon interest and get your principal back. A venture debt investor doesnt need the company to be bought, or go public, or be a runaway success. Given the investment duration is generally 1-3 years, the venture debt investor just needs the company to remain liquid during this investment window.

Venture debt investors must not only analyze the legitimacy of the business model, but perhaps MORE importantly assess the likelihood that the company will be able to continue raising more money through equity fund raising.

Example: Yet Another Dating App Company (YADAC)

YADAC recently raised a Series A round of $2 million for 20% of the company. YADAC is therefore valued at $10 million dollars, but is losing $1 million a year. The CFO doesnt forecast the company to break even for another five years. As a result, management and investors in the Series A round know that another round of fund raising is likely coming due in two years.

The hope is that in two years, YADAC grows tremendously and the Series B round of fund raising will value the company much greater than $10 million. Fast forward two years later, YADAC grows by 10X and is able to sell a much smaller stake for $20 million dollars at a valuation of $100 million. YADAC is now losing $5 million a year as it has scaled up operations to dominate the online world of love.

The CEO realizes he now has a 4-year runway to make something big happen until all the money runs out. Hopefully hell be able to figure out a way to become profitable by then so that he will no longer need to sell more equity in his company. A year after raising $20 million, he realizes the company burn rate is closer to $7 million a year. In other words, YADAC will run out of money in 3 years.

To ensure the viability of his company, and to minimize the chances of raising another equity round, YADAC reaches out to a venture debt company to lend it $5 million at 15% a year over three years. YADAC wants the extra $5 million for working capital and marketing expenses if they need it. The hope is that they never need it, and simply have $75,000 a year in interest expense to pay before they can stand entirely on their own through profitability. The $5 million venture debt allows YADAC to survive for 10 more months worst case scenario.

The venture debt fund manages a 10% warrant coverage on YADAC as well. In other words 10% X $5 million loan = $500,000 worth of warrants the venture debt company can convert in the future with the strike price equal to the valuation at the time of the loan.

In retrospect, the best bet for the venture debt company would have been to lend money at 15% as soon as the Series A round was complete because YADAC raised another $20 million two years later. The venture debt company could have therefore earned 15% a year + warrants over at least 4 years, instead of just two years. If YADAC fails in year 5, the venture debt company still makes its 15% return, but only loses out on its warrants.

Venture Debt Sources Of Return. 30% IRR Blue-Sky Target Example

VENTURE IN WITH BLUE-CHIP EQUITY INVESTORS

Lets say you find a great startup that is backed by Sequoia Capital, Accel Partners, and Draper Fisher Jurvetson. These are the guys behind Whatsapp, Facebook, and Hotmail among many more. You likely want to lend the startup as much money as possible during their Series A, B, C, D funding etc. because chances are high Sequoia, Accel, DFJ and other venture capital firms will throw money at the startup in future rounds, thereby ensuring youll get paid back.

This is very similar to the greater fool approach to investing. Its just that such fools are worth hundreds of millions of dollars each. Sure, such investors do their tremendous due diligence for you with tons of money and connections behind to support a company. When liquidity is flowing, valuations dont matter as much, and the risk of default goes way down for venture debt investors. But as we all know, the good times dont last forever! Otherwise, wed all be mega millionaires.

The venture debt investor must therefore properly ascertain market conditions, the companys business model, the quality of investors behind the startup, and the likelihood that more funding will take place.

The two main problems for venture debt funds is that it might be too small to be significant and the startup might be too in demand to accept the venture debt funds money. Creating term sheets and going through the legal process takes a lot of work. Some companies wont even bother if you cant lend them at least $5 million dollars, for example.

OTHER BENEFITS TO VENTURE DEBT

Here are other benefits of investing in venture debt.

1) First lien on all assets – senior secured, full sets of protections.

2) Restrictive covenants including limitation on dividends and other requirements.

3) Senior position in the capital structure with participation in equity upside presents superior risk-adjusted return profile.

In other words, if the company is faltering or on the verge of going bankrupt, the venture debt investors have a better chance of getting their money out before the investment turns to zero. The restrictive covenants are great for venture debt investors to ensure that the companies reach specific milestones before borrowing more money or executing another strategy. Borrowers obviously would prefer less covenants.

BEFORE YOU INVEST IN A VENTURE DEBT FUND

Every single presentation you will receive as a perspective client will make the venture debt fund look amazing. Ive sat in numerous fund raising pitches before when I was in banking and in my personal private equity investments. Every single presentation makes me want to dump my entire life savings into the company or fund!

The reality is that not every company or fund is successful. Heres what I look for:

1) Quality management

2) Disciplined management

3) Hungry management

4) Investment strategy

5) Cost structure

If Im putting money into a fund for someone else to manage, then Im mainly focused on the people running my money. I want them to have the best return profiles, have the most experience, and be the hungriest go-getters around. At the same time, I want to know they will be sticking true to their funds mission of investing in at least 60 companies with a 18% IRR target and a 2-3 year investment window or whatever the funds strategy is. I dont want to wake up one day and find out they went all-in on some coal company in China when they are supposed to be investing in tech and internet startups.

The cost structure is very typical to a hedge fund cost structure of 2% of assets under management and 20% of the profits. Although many funds have lowered their cost structure to 1%/10% to attract more capital. The fund Ive invested in allows me to participate in the venture capital and private equity space in a lower risk way with a target 20%+ expected return profile per annum and a blue-sky target of 30%+. The minimum preferred return is 8% per annum, which is just fine by me given that is 3X the 10-year yield (my constant return bogey).

If I can achieve a 8% annual return with relatively low risk, I am allocating as much capital as possible to such an investment given our low interest rate environment. Anything over 8% is gravy to me. Im really striving to invest in 5-10 year chunks. Peer-to-peer lending is another great way to try and achieve an 8% yield with lower risk if the portfolio is diversified. The minimum to lend can be as low as $1,000.

Another potential positive is that I have the optionality of investing directly into the startups the venture debt fund is investing into when the startups raise more funds through equity.

HOW DO I INVEST IN VENTURE DEBT?

As far as I know, becoming a limited partner in a venture debt fund is largely through invitation or connections. There are no publicly listed venture debt only companies to invest in on the stock exchange or any exchange for that matter. You need to know someone who is already an LP or a Managing Partner to invest.

The fund I invested in is still raising money if you are interested in an introduction. But their minimum is in the multiple six figures. I definitely do not recommend allocating a majority of your investments in venture debt or venture capital, although thats how many people have achieved enormous wealth over the past several decades.

My venture debt investment consists of all new money Ive saved over the past year and a half and represents roughly 15% of all equity and fixed income investments and 3% of my overall net worth. In other words, if my venture debt fund blows up, Ill still be able to afford Rhino, my snazzy Honda Fit!

ALTERNATIVE TO VENTURE DEBT

Sliced Investing :  If you dont have several hundred thousand dollars to invest in a venture debt fund, one of the most innovative ideas to come out of Silicon Valley is democratizing access to hedge funds for regular accredited investors those who make $200,000 or more or have a net worth of $1 million or more. A lot of hedge funds have minimums of $1 million to just get in. As an accredited investor myself, I dont have that type of money to invest in just one fund $50,000 $150,000 yes, but not a million. Sliced Investing has created a fund of funds that allows individuals to invest $20,000 $200,000 in a Sliced Investing hedge fund of funds.

Each fund invests in three different hedge funds that are closed to the public or that require large minimums to get in. Sliced Investing smartly pools investors money and invests the pool into each fund to gain access. The Sliced Investing investment committee conduct due diligence on each fund to ensure the best fund managers possible. If youre interested in investing in a hedge fund to make money or protect your principal, take a look at Sliced Investing. Ive met with the founders here in San Francisco and they are backed by Y Combinator and Khosla Ventures, one of the premier Venture Capitalists in the country.