Interested in venture debt investing? I’ve been diving into this world since 2015 as a way to diversify my investment portfolio. In this post, I’ll break down what venture debt is and how it could potentially offer higher yields with less risk compared to other investment types.
I use what’s known as the barbell strategy for my investments. This approach mixes low-risk investments, like bonds or index funds, with high-risk opportunities to balance potential gains with a solid safety net. For my safer bets, I use after-tax investments in bonds and index funds. My riskier bets are placed in pre-tax accounts like SEP IRAs and Solo 401ks, where I can afford to gamble a bit more since I won’t be touching this money until I’m nearly 60.
Venture Debt versus Venture Capital
Venture debt is an appealing alternative to traditional venture capital. Here’s how it works: imagine you’re a startup CEO who’s already raised $5 million by selling 20% of your company. When you need an additional $1 million for working capital, instead of diluting further by issuing more equity, you might consider venture debt. This is where a venture debt fund steps in, offering short-term loans at interest rates of around 12-15%, sometimes with added warrants that allow the lender to buy equity at a later date.
Why would a CEO agree to such high rates and potential equity loss? The alternative could be worse—dilution of their stake in a growing business or stalling growth due to lack of funds.
The Role of Banks
Banks, especially large ones, typically shy away from high-risk investments in startups due to a lack of resources, patience, or the specific expertise required. Banks like Silicon Valley Bank that did engage deeply in tech startups faced severe repercussions, as seen with their recent mismanagement and shutdown.
Venture Debt’s Appeal
For a company growing rapidly, venture debt can be more cost-effective than new equity, particularly when equity values increase faster than the cost of debt. It allows company founders to retain more ownership and control while extending the runway to profitability.
The Long-Term Role of Venture Debt Funds
By issuing warrants along with debt, venture debt funds often position themselves as long-term partners to startups, aligning their interests by reducing the interest burden and maintaining a stake in the company’s future.
Venture Debt vs. Market Volatility
Venture debt is particularly attractive because it’s senior to equity during a financial squeeze, meaning debt lenders get paid before equity investors if the company folds. This positioning makes venture debt a relatively safer proposition in the high-stakes world of startup investing.
A Real-World Example
Consider a hypothetical company, “Yet Another Dating App” (YADAC), that’s raised significant funds but continues to operate at a loss while scaling aggressively. Venture debt here would provide the necessary capital to navigate through growth phases without further diluting equity at potentially unfavorable terms.
Why Consider Venture Debt?
1. It provides a senior claim on assets and returns in the event of bankruptcy.
2. It includes restrictive covenants that help ensure the company meets certain operational milestones.
3. It’s a good way to leverage the expertise of seasoned venture capitalists indirectly through structured debt deals.
Investing in Venture Debt
Investing in venture debt typically requires connections in the finance world, as these opportunities aren’t usually available through public markets. The entry point can be steep, often requiring a substantial minimum investment.
Diversification through Venture Debt
While venture debt can be a lucrative investment, it’s essential to diversify. Real estate crowdfunding platforms and private growth company funds are other avenues to consider for balancing your investment portfolio.
Venture debt is just one part of a strategic investment approach aimed at maximizing returns while managing risk effectively. Whether you’re a seasoned investor or exploring new territories, understanding and leveraging different investment strategies can help stabilize and grow your financial portfolio.
