The venture capital industry in America has faced more than its fair share of ups and downs.

From early exit by start-up founders to critics slamming the industry, calling it a big Ponzi Scheme.

The entree of venture debt as a primary source of finance has not been an easy one.

A few investment fund managers are making a go of this and are bringing a new lease of life into the space.

Venture capital has become one of the cornerstones of the American economy.

Start-ups now have the bleeding edge and leverage required to scale through the various problems that are a part of the cycle.

With venture debt, all kinds of advantages now exist and this oft-forgotten funding method expands the liquidity options available.

It also allows for a longer growth cycle, improved balance sheets, stronger equity bias and thus increase the odds for innovators who are ready to change the world.

We had a pow-wow with Zack Ellison who is the Managing General Partner at Applied Real Intelligence (A.R.I) LLC, a Venture Investment Firm about venture debt, A.R.I’s DEI council, the impact

of the Venture Capital on the American economy, and the whole nine yards of issues within and outside the venture finance industry.

We believe his insights will pave the way for a greater understanding of the power of venture debt and how the industry will evolve and adapt in the future.

Zack Ellison,MBA,MS,CFA,CAIA Managing General Partner at Applied Real Intelligence LLC (“A.R.I.”), a Venture Debt Investment Firm

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• What is venture debt?

The huge benefit of venture debt for founders is that it helps them keep ownership of the companies they have built.

Venture debt is broadly defined as the issuance of term loans to venture-backed companies.

Unlike traditional bank lending, venture debt is available to companies that do not have positive cash flows or significant assets to use as collateral.

Venture debt typically consists of loans, with an original maturity of less than five years, that are combined with equity warrants valued at 5% to 10% of the notional value of the debt.

Venture debt complements, and rarely substitutes for, funding provided by equity investors.

Loans are customarily made three to nine months following a Series B, Series C, or later equity financing round to companies that have already received institutional funding, typically in excess of $15 million over multiple equity financing rounds.

Startups at this stage have already received four to six rounds (i.e., angel, pre-seed, seed, Series A, Series B, Series C) of funding over the previous five to ten years.

A.R.I. believes that investing in companies that have reached the growth or expansion stage (typical of Series B and Series C companies) provides the most attractive risk-adjusted investment return.

At this stage, companies are generating revenues and free cash flow that are ample to support debt on a standalone basis.

Additionally, sponsor-backed companies have a reduced risk profile attained through the deep vetting and due diligence processes performed by institutional investors over a period of many years.

Benefits confer to both the underlying borrower and the borrower’s existing equity investors – including the VC firms that have previously funded the borrower – principally by offering a minimally-dilutive and cheaper alternative to equity financing.

The founding teams and their early investors are not meaningfully diluted out of their positions.

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• Please, can you tell us about your diversity, equity, inclusion, and investment (DEI) council?

A.R.I.’s mission is to democratize access to capital for all types of early-stage founders, including women, people of color, and other underrepresented groups.

Company founders are not served efficiently or equitably by the existing venture capital ecosystem.

Less than 3% of venture capital funding goes to women and other underrepresented groups, which make up approximately 70% of the U.S. population.

Vast wealth is quickly being created in technology-enabled companies and sectors but only a very small percentage of people are taking part in this boom – the rest are being “boxed out” by the structure of the current ecosystem.

Those who do not take part in this 4th industrial revolution will never be able to catch up economically.

Massive segments of the population, predominantly women and people of color, will be permanently disadvantaged.

Therefore, creating access to capital and wealth creation opportunities must be done now before irrevocable harm occurs and inequality is made permanent.

A.R.I. prioritizes diversity, equity, and inclusion (“DEI”) in our investment mandate and aims to democratize the availability of minimally dilutive capital and “do well while doing good” by unlocking the massive economic potential in underserved segments of the market.

We believe that the best idea should win but that can only occur if every idea is heard. We are committed to making that happen.

A.R.I.’s Diversity, Equity, & Inclusion Investment Council (“DEI Investment Council”) was a natural result of our mission to democratize access to capital.

It is a first-of-its-kind initiative that marks a key milestone in reducing the funding gap for startups led by underrepresented founders. The Council is comprised of diverse and experienced industry leaders and founders who are focused on improving access to capital for underrepresented founders, primarily through three pillars:

2. Education:  Providing strategic and tactical fundraising advice and best practices in capital raising to founders through a series of papers, webinars, social media outreach, and in-person events. The fundraising advice and best practices will be developed by listening to and learning directly from industry practitioners who have successfully contributed to funding start-ups in various capacities.
3. Connectivity & Partnerships: Facilitating introductions and building connectivity between founders and resources that will help create access to capital including: high net worth individuals, angel investing networks, family offices, incubators and accelerators, venture capital firms, corporations, industry organizations, colleges and universities, business leaders, startup founders, service providers, government organizations, and more.

3. Commitment of Capital:  A.R.I. is actively seeking to commit capital to diverse founders and encourages our partners and members of the DEI Investment Council to prioritize capital introductions and/or direct capital commitments.

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• How does venture debt differ from other funding methods for startups?

The biggest difference between debt and equity is that debt, unlike equity, does not dilute a founder’s ownership stake.  Historically, startups were financed almost exclusively by selling equity.

In other words, every time a founder needed money to grow their business, they had to sell a stake of their ownership in exchange for this capital.

Thus, there was often an inverse relationship between the success of the company and the size of the founder’s ownership stake.

As a company would grow bigger and bigger, the ownership stake of the founder would become smaller and smaller.

Venture debt has been booming in popularity because it helps founders keep ownership of the companies they have built.

They must pay interest on the loan and repay the principal of course, but this is a small price to pay for maintaining much larger ownership stakes in their companies.

Related: Multicoin Capital Hires Principal in Asia as Crypto VCs Look East

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• What are the benefits of venture debt as opposed to other funding methods?

Venture debt provides benefits to the borrower in that it:

• Minimizes Ownership Dilution of Management
• Accelerates Growth & Expansion
• Extends Cash Runway
• Decreases Cost of Capital
• Faster to Obtain than Equity
• Enhances Credibility with Institutional Investors
• Supportive & Complementary to Venture Equity
• No Valuation Requirements

Benefits of venture debt to the investor include:

• 15% to 20% target annual return (12% to 15% from debt, 3% to 5% from equity upside)
• Loss rates of less than 0.25% per year over the past 20 years
• Quarterly income of 3-4%
• Minimal volatility
• Low correlation to the market

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• Can you tell us about Applied Real Intelligence (A.R.I.) LLC?

A.R.I. is a Los Angeles-based venture debt investment manager focused on providing financing solutions to innovative, high-growth, VC-backed companies operating in recession-resistant sectors and underserved regions throughout North America.

A.R.I. has dual missions of:

(1) democratizing access to capital for all types of early-stage founders, including women, people of color, and other underrepresented groups;

(2) providing the Fund’s investors with unique access to “innovation” as an asset class, superior risk-adjusted returns, security of capital, and strong portfolio diversification benefits.

In 2018 I began conceptualizing what the “perfect” investment fund might look like.

This led me down the long path to founding A.R.I. based upon my following beliefs from that time:

• Forward-looking returns in traditional asset classes, such as public stocks, public bonds, and real estate, will be insufficient to meet the needs of many investors.

• Venture debt offers an opportunity for generating excess risk-adjusted return (i.e., ‘alpha’) within the fixed income markets given that the strategy has produced very strong historical risk-adjusted returns, remains in its infancy, is inefficient, is underserved, and offers tremendous growth potential.

• Alpha is best generated through active investing that relies on applying real (i.e., human) intelligence. Effectively applied real intelligence leads to superior investment outcomes – through better ideas, relationships, and execution capabilities – than can be produced through passive investing and overreliance on automation, algorithms, machine learning, and artificial intelligence.

• Investment ‘edge’ can only be produced and sustained through the combination of a strong underlying business (i.e., infrastructure and operating capabilities) and a highly capable investment team relying on sound strategy and consistently efficient processes. The combination of a sturdy operating business and strong investment strategy facilitates the optimization of ideas, connectivity, execution, and ultimately performance.

• Company founders are not served efficiently or equitably by the existing venture capital ecosystem. There is the potential to democratize the availability of minimally-dilutive capital for all types of founders, including women and other underrepresented groups, of early-stage companies, and “do well while doing good”.

• There is an actionable opportunity – not being met by others – to build a best-in-class venture debt fund to provide investors with sustainable alpha, protection of capital, and portfolio diversification while also promoting the social good by increasing access to capital for all types of founders.

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• What edge does A.R.I. have as opposed to other investment managers?

The “A.R.I. Advantage” stems from the following:

• Strategy – Venture debt has produced 15-20%+ returns with loss rates of less than 25 bps, along with low volatility and correlation, over the past two decades. A.R.I.’s venture debt strategy is differentiated to provide access to “innovation” as an asset class, superior risk-adjusted returns, security of capital, and strong portfolio diversification benefits. The majority of incumbent funds are oversubscribed and are not taking commitments from new allocators.

• Mission – A.R.I. prioritizes diversity, equity, and inclusion in its investment mandate and aims to democratize the availability of minimally dilutive capital and “do well while doing good” by unlocking the massive economic potential in underserved segments of the market. A.R.I. is the only institutional-quality venture debt manager in the U.S. that credibly supports this mission.

• Team – A.R.I.’s leadership team has significant experience producing stellar results in venture debt, tech banking, and fixed income investing.

• Operations – A.R.I. has partnered with best-in-class service providers across the platform, including legal, fund administration, tax and audit, banking, loan servicing, human resources, compliance, valuation, information technology, cybersecurity, and data analytics.
• Market Timing – A number of factors are coalescing to provide strong tailwinds for A.R.I.’s Venture Debt Opportunities Fund, including market volatility, low yields in other fixed income offerings, high valuations across most asset classes, investors seeking opportunities in technology and innovation, and increasing concerns around inflation (which favors venture debt’s floating-interest rate structures).

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• Congratulations on your recent oversubscribed multi-million dollar raise! What’s next for A.R.I. LLC?

We are currently targeting a nine-figure capital raise for A.R.I.’s Venture Debt Opportunities Fund.

Our offering has been well-received by institutional investors, including pensions, endowments, foundations, registered investment advisors, and family offices.

Originally, we required a very large minimum commitment size to invest in the fund.  However, we realized that having a large minimum went against our mission.

Just as we want to democratize access to capital for founders, we also want to democratize access for investors to the very best investment funds.

After all, why should only the biggest investors have access to the best strategies like ours?

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• How wide is the funding gap for underrepresented founders?

The funding gap is huge in venture capital and there’s no way to rationalize it.

Less than 3% of venture capital funding goes to women, people of color, and other underrepresented groups, which make up approximately 70% of the U.S. population.

This is not only incredibly inequitable, but also incredibly inefficient economically.

Our country would experience significantly greater economic prosperity as a whole if we tapped into the massive number of talented founders that haven’t been included in the innovation economy.

A.R.I. aims to democratize the availability of minimally dilutive capital for all types of founders of early-stage companies, and “do well while doing good” by unlocking the massive economic potential in underserved segments of the market.

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• What are the best exit strategies for early-stage investors in venture debt funding models?

Equity investments have no pre-defined exit and may never be worth anything.

Thus, they carry considerable risk of loss and significant uncertainty around the timing of the monetization of the investment (i.e., the “exit”).

Debt is very different than equity, and in many ways superior, for investors.

There is a legally binding, contractual “exit” with venture debt just as there is with any other type of debt, such as a car loan or home mortgage loan.

The final exit occurs when the loan is repaid, and this repayment date is known at the outset of the loan.

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• What are A.R.I.’s values?

We will invest in the world we want to live in and express our values through the people and companies we invest in.

A.R.I. believes that the effective application of responsible investing and ESG investment principles will lead to better risk-adjusted investment performance, advance sustainable business practices, and generate positive societal impact with consideration for a broad set of stakeholders.

We strive to do the right thing, especially when no one is watching, and enjoy the process of growth even when painful.

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• How has venture debt improved investment options for startups?

Venture debt has improved investment options for startups by helping founders keep more of the companies they have built by minimizing the ownership dilution that would occur with equity funding.

In simple terms: debt capital is much cheaper than equity capital.

Venture debt also provides the cash needed to accelerate growth and extend the runway.  It can be obtained more quickly than equity and can be structured to meet the very specific needs of each unique borrower.

Debt transactions can be truly artful in their structure with almost no two deals exactly alike.

Each borrower is unique; therefore, so is each debt transaction.

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• Please can you tell us about your journey into the venture capital world?

My path into venture capital was a long and arduous one, but I wouldn’t change it for the world.

Although my career successes might lead many to believe I’ve traveled a path of little resistance, I have overcome a lot to get to where I am.

I owe the majority of my success to my mother, Lindsay Ellison, who raised me by herself from the age of 19 in Boston.

I have never met, nor received a cent of financial support, from my father.

My mom and I suffered economically due to discrimination she faced at work in the 1980s and 1990s that today would be unacceptable but then was par for the course.

I witnessed the sacrifices my mom made in order to make ends meet for us while she worked as a radio announcer, artist, and community organizer.

She instilled in me the importance of obtaining the best education – the “great equalizer” she called it – and the need to be strategic and resourceful to achieve success.

She led by example and “walked the walk” – I was extremely proud when my mom earned her college degree from UMass-Boston in 2005 (after I had already graduated from Swarthmore College) with a 4.0 GPA and Phi Theta Kappa honors.

We had no safety net, and everything achieved had to be earned. My mom put in the work and inspired me to do the same.

Through my mom’s dedication and a combination of planning, hard work, and good fortune in finding an amazing mentor (Fred Burrill, a bus painter for the MBTA in Boston who was raised in the rough Mission Hill area of Boston), I was able to turn my early achievements in the classroom and on the basketball court into (virtually) free educations at a prestigious private high school and college.

I then parlayed this into a string of jobs, each better than the last…like a line of progressively bigger dominoes being knocked down in sequence.

To succeed I had to be creative at finding opportunities where others saw none and be willing to take intelligent risks.

This later helped me immensely as a banker, bond trader, and fixed income inverstor at leading global firms such as Thomson Reuters, Scotiabank, Deutsche Bank, and Sun Life.

It also built the skills I would later need to be successful as a company builder and to effectively identify other successful startup founders.  “It takes one to know one” as the saying goes.

More importantly, my upbringing led me to develop deep empathy for those who have ambition and determination but lack access and financial resources – a familiar situation for many entrepreneurs – and created a desire to give something back and help create a more equal playing field.

I consider the professional work I’m doing with startups now as a natural extension of sharing what I’ve learned in life from my mom and other great mentors to help founders of all types overcome obstacles and reach their goals.

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• How do you think emerging technologies such as cryptocurrencies, blockchain technology and web3 technologies are going to change the venture capital funding industry?

These technologies will improve access, cut out intermediaries, speed processes, and if used properly, create greater trust.  In sum, society will become much more efficient as the adoption of blockchain and web3 technologies proliferate.

However, I am cautious on the utility of having so many cryptocurrencies.

I’ve talked to hundreds of “experts” and not one has been able to convincingly make the case that there is a real economic need for all of the cryptocurrencies currently in existence.

There’s certainly a use case for some, but not for dozens and certainly not for hundreds.

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• Venture capital critics and skeptics have said that the VC industry is dead and gone? What are your thoughts about this?

We must have a very different definition of “dead and gone”!

The size of the U.S. venture capital market set an all-time record in 2020 with nearly $160 billion of capital invested…and then more than doubled this record in 2021 with over $330 billion of capital invested!

Innovation is at the heart of the 4th industrial revolution that we’re currently in the midst of and the majority of this innovation is being funded with venture capital.

Furthermore, venture debt is growing significantly faster than venture equity, providing additional growth capital to propel society’s advancement.

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• Other critics and skeptics have indicated the startup high failure rate as an indication of “Ponzi-like” activity within the VC industry. What are your thoughts on the issue?

I disagree with this assessment.

The VC industry doesn’t appear “Ponzi-like” to me.

The market is very efficient at picking winners and losers.

However, there are certainly many Ponzi-like schemes that are running rampant in the market.

One could argue that meme stocks and many crypto “currencies” are the epitome of Ponzi assets given they have market prices that are not supported by any intrinsic value.

Speculators, not investors, buy these assets and hope to profit quickly, with early buyers of these assets profiting only by inflows of money by later investors.

This is the very definition of a Ponzi scheme.

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• How is the VC industry gearing up for the inclusion of Gen Z into startups?

Gen Z represents people aged 10 to 25.

While they are an important demographic, there are a lot of other generations with the majority of purchasing power that need to be tended to right now.

That said, the world is going to look a lot different in 10 years than it does today.

Exponential growth has replaced linear growth and we are seemingly moving towards a world with unbounded opportunities.

Because we have entered the “exponential age”, it is more important now than ever to foster equal opportunity so that current inequities do not grow exponentially as well.

The venture capital industry has been terrible in this regard for its entire history and doesn’t seem to be changing fast enough.

My hope is that Gen Z is a catalyst for greater equality going forward.

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• How has startup culture influenced daily life within the United States?

The proliferation of startup culture has created a sense of freedom and optimism for many.

It has also misled some into thinking that anyone can build a great company or be a successful investor, without having the requisite skills and experience.

Unfortunately, survivorship bias is rampant in the startup world.

The media reports only the big successes, and this becomes the representative sample that we see – but we rarely hear of the companies that have gone bust.

And the failures represent the majority.

It’s very similar to the lottery, where we hear only of the few big winners but not of the hundreds of millions who failed to win.

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• What is the impact of the VC industry on the US economy? Please, can you give us numbers regarding this?

To date, the impact of the VC industry on the US economy has been substantial and it is a near certainty that the VC industry will make an even larger impact going forward.

In a 2021 working paper titled “The Economic Impact of Venture Capital: Evidence from Public Companies” by Will Gornall (Sauder School of Business, University of British Columbia) and Ilya A. Strebulaev (Graduate School of Business, Stanford University and National Bureau of Economic Research), the authors found that:

“Venture capital-backed companies account for 41% of total US market capitalization and 62% of US public companies’ R&D spending. Among public companies founded within the last fifty years, VC-backed companies account for half in number, three quarters by value, and more than 92% of R&D spending and patent value. The US did not spawn top public companies at a higher rate than other large, developed countries prior to the 1970s ERISA reforms, but produced twice as many after it. Using those reforms as a natural experiment suggests that the US VC industry is causally responsible for the rise of one-fifth of the current largest 300 US public companies and that three-quarters of the largest US VC-backed companies would not have existed or achieved their current scale without an active VC industry.”

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• As the world shifts towards digital business models, what role do you think the VC industry will play in sustaining exponential digital growth and advancement?

This depends on how one defines the “VC industry”.

What is certain is that innovation will be the driving force in value creation for everyone on our planet.  How this innovation is funded is changing significantly.

Already we are seeing a move away from traditional VC equity funding towards a much greater utilization of venture debt financing.

The sources of capital are also changing rapidly.

Many large corporations, asset managers, and family offices are now providing sizable funding to startups.

This creates an existential threat to many traditional VCs given the aforementioned groups have nearly limitless capital whereas the pool of venture capital is very small in the grand scheme.

For context, when I was a bond trader at Deutsche Bank, we had $2.8 trillion in assets compared to the $330 billion that was invested in all of venture capital in the U.S. last year.

Another of my former employers, Sun Life, has over $1.4 trillion in assets under management.

A “big” VC fund is the size of a rounding error for the large banks and asset managers and it is inevitable that more funding to startups will be coming from these institutions.

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• What role do you think A.R.I. LLC will play in helping to shape the knowledge economy?

We intend to play a large role in creating equitable access to capital within the knowledge economy while helping founders keep more ownership in the companies they have built.

There is a need for leadership – both in thought and action – that is not currently being met by others.  We will fill this gap and provide venture debt to founders to fund the future that we want to live in.

 

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