Venture Debt: Key Lessons Learned

In part 16 of his series on venture debt, Zack Ellison from Applied Real Intelligence reflects on key investment lessons he has learned.

While anyone with a large checkbook can invest in venture debt, consistently generating returns demands rigorous preparation, disciplined execution, and a commitment to learning from both successes and failures. After 20 years in the investment industry, spanning roles at five publicly traded financial firms, including three with more than $1 trillion in assets, I’ve learned that success in venture debt requires far more than just capital.

During my career, I’ve navigated some very challenging financial environments, including the Global Financial Crisis, where I underwrote telecom, media, and technology loans at Scotia Bank in NYC without incurring a single loss. Even with that foundation, I recognized that excelling in venture debt would require specialized expertise. To prepare, I spent years engaging with more than 3,000 investment professionals, allocators, founders, and legal experts, refining a strategy rooted in sound principles and practical insights. These efforts culminated in some of the key lessons I’m sharing here:

Due Diligence

Know your customer. Loyal, enthusiastic customers are the foundation of early-stage success, providing both credibility and momentum. However, overreliance on a small group of customers is a major red flag. Diversifying revenue streams significantly reduces risk.

Perform operational due diligence. Thorough operational checks such as background investigations, vendor references, technology assessments and onsite visits uncover critical details to assess enterprise risks.

Do third-party verification. Engaging specialists for audits, quality-of-earnings reports, valuation assessments and industry consultations provides granular insights needed for informed decision-making.

Structuring

Use A.R.I.’s “4S” rule. Prioritize small size, seniority, security and short duration. This framework minimizes risk exposure across the most critical factors.

Apply strong covenants. Competitive pressure may tempt some lenders to forgo covenants, but this is shortsighted. Strong deal structures with thoughtfully structured covenants allow early intervention when challenges arise.

Utilize leverage limits. Loans that are excessively large relative to recurring revenue and enterprise value often signal unsustainable growth expectations.

Perfect your liens. Ensure creditor rights with properly perfected UCC (Uniform Commercial Code) filings prior to funding to protect your priority claim and mitigate recovery risks.

Put prepayment protections in place. Prepayment fees or make-whole provisions protect lenders from adverse selection when top-tier borrowers pay off loans early.

People

Study the Incentives. Understand the motivation and incentive structure of everyone involved, from the borrower’s leadership team to equity investors. Incentives drive decision-making and misaligned incentives will often derail deals. As Charlie Munger said, “Show me the incentive and I’ll show you the outcome.”

Collaborate with people you trust. Warren Buffett said it best: “After some other mistakes, I learned to go into business only with people I like, trust and admire.”

Common Pitfalls

Don’t chase hot deals. Hyped deals usually come with fewer risk protections and often underperform. Focus on under-the-radar opportunities with strong fundamentals.

Avoid companies with high cash burn rates. Companies with excessive cash burn rates are inherently risky. Favor borrowers with disciplined cash management. Cash is king and needs to be treated as such.

Don’t overly on sponsors. Good sponsors are certainly beneficial but shouldn’t be viewed as a reliable safety net. Always perform independent diligence and assume the sponsors will abandon their investments during periods of high stress.

Navigating Market Shifts

Recognize market cycles. Economic expansions, contractions and recoveries significantly influence borrower behavior, risk appetite and capital availability. Equally important is understanding investor and market psychology, as sentiment amplifies or dampens these cycles. As Howard Marks outlines in Mastering the Market Cycle, successful investors must recognize where they are in the cycle and adjust their strategies accordingly.

Be forward looking. As Wayne Gretzky said, “Skate to where the puck is going to be, not where it has been.” Similarly, Bill Gates reminds us, “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.” Practically, this means looking beyond traditional metrics and staying ahead of key technology shifts and market trends by incorporating an equity-tilted perspective and leveraging innovative tools.

Portfolio Management

Diversify. Spread investment risk across sectors, geographies, founder type, and other factors to capitalize on varied opportunities. Concentrated positions need to be considered wisely given they can deliver outsized returns but also increase downside risk.

Be flexible and ready to adapt. Flexibility and patience are key to success in working with early-stage companies. Lenders who aren’t patient and accommodating risk damaging their reputation and missing out on future opportunities.

Stick to what you know. Peter Lynch wisely advised, “Invest in what you know.” Stick to your expertise and avoid markets, sectors and business models you don’t understand. Speculative or unproven industries often carry disproportionate risk. While start-ups may thrive on hard pivots, investment managers benefit from discipline, consistency and a deep understanding of their domain.

Don’t be passive. Active portfolio management is crucial with early-stage companies. Engage frequently with borrowers to address early warning signs and ensure consistent alignment.

Learn from others’ mistakes. It’s better to learn from the mistakes of others rather than your own. Analyze case studies of companies and deals that have gone bad. It is better than trial-and-error or learning on your investors’ dime.

These lessons may seem simplistic, but as I’ve learned, great investing doesn’t require reinventing the wheel. As I’ve often heard from top performers, “The team that blocks and tackles the best usually wins.” As we enter a new phase in the venture debt and growth credit markets, sticking to what works while learning from what doesn’t will position investors to navigate challenges and seize opportunities ahead.

Zack Ellison is the founder and managing partner of Applied Real Intelligence and CIO of the A.R.I. Senior Secured Growth Credit Fund. Send comments or questions to zellison@arivc.com and visit A.R.I.’s website at www.arivc.com.

Columns in the Series

Part 1: Venture Debt: A Lucrative Path for Institutional Investors

Part 2: Demystifying Venture Debt Deal Structures

Part 3: How to Structure Venture Debt to Maximize Equity Returns

Part 4: How to Manage Risk in Venture Debt

Part 5: Advanced Risk Reduction Techniques in Venture Debt

Part 6: Exit, Diligence, and Recovery Tactics for Venture Debt

Part 7: Venture Debt: The Critical Role of Operational Due Diligence

Part 8: Venture Debt: Debunking the Top Five Myths

Part 9: Venture Debt: How to Be a PEST When Analyzing Markets and Industries

Part 10: Venture Debt: How to Fundamentally Get It Right

Part 11: Venture Debt: How to Best Evaluate Leadership Teams