The Business Model of VCs vs. Venture Debt Funds

VC (Equity) Fund

The Pareto principle applies to VC funds — 80% of returns come from 20% of startups.

  1. The Rockstars* that aspire to become a Unicorn — a VC fund will want to invest as much capital as possible in this rare breed,
  2. The Dark Horses where a VC will invest energy, time, and provide access to their network in hopes they are Rockstars, or
  3. The Walking Zombies that never quite figure out their product-market fit or commercial scalability.

Venture Debt Fund

Venture Debt funds, in comparison, are expected to deliver half the returns of a VC fund. A top performing venture debt fund can deliver 1.5x return over a 10-year period.

  1. The ‘failure rate’ is much lower for a Venture Debt fund — 5% or less of invested capital is written-off — due to the pre-screening of investment opportunities through VC funds and, sadly, sometimes the unwillingness of VCs to ‘let go’ of startups that have been funded and ‘drip fed’ resources for far too long.
  2. A Venture Debt fund is a yield instrument. This means that fund income is generated through a steady and frequent stream of future cash expected (In contrast, VC funds provide multiples return through only two cash entry and exit points — when you initially invest in the business and when you sell the investment — with a long holding period in between). The Venture Debt fund returns borrowed capital and generates income through the (i) coupon or interest paid monthly, (ii) closing/transaction and maturity/end of loan fees, (iii) repayment schedule, and (iv) warrants. Warrants are the ‘sweetener’ that allows the debt fund to participate in the upside that a VC fund has by taking options in the business (typically priced at the most recent round’s valuation) later converted into shares on a cashless basis in an exit event. The first three really drive the IRR (i.e. yield) and the last variable impacts the fund return multiple. In most cases, the typical structure of a venture loan assumes initial capital borrowed is returned in the first 15–18 months of a 3-year loan and the remaining capital is then profit to the fund. (I will discuss market terms for European loans and how to best negotiate in a separate post.)
  3. In addition, a Venture Debt fund re-invests capital committed at least once (i.e. ignoring management fees, a $100MM fund can recycle and invest over $200MM of capital to startups). This mechanism is usually quite limited for VC funds.

Bottom Line

There are key differences between the business model of a VC and Venture Debt fund (summarized below).

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Joyce Mackenzie Liu

Joyce Mackenzie Liu

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European Tech 🚀 Founder of Pegafund 🐎 Software Investor 🤖 Writer🖋️ 3rd Cultured 🌍 Foodaholic 🐷 Yogi 🧘🏻‍♀️