Debt vs Startup Equity: Crunching The Numbers

Investing in tokenized debt is a new and exciting opportunity available to investors as an alternative to equity investing. The majority of asset classes have some kind of debt aspect to them, but debt investing is considered to be less risky overall. Take real estate as an example of this –  property investing can be structured as either debt or equity, very similar to how company financing is done today.

 

Put simply, the difference between debt and equity is:

    • In case of default, debt holders get paid back first
    • Equity most often relies on upside at an exit event for profits. For example, if one invests into startup equity, the returns are usually realized when the company is sold or has an IPO. For real estate, equity returns are realized at property sale or refinance

 

This makes equity the riskier investment, because it’s not in the first position of repayment in case of default and because it relies on an exit event. There is, however, one caveat – generally, equity has the promise of greater returns. Here, we will examine an example of a debt vs equity investment scenario.

 

Debt Investing and Tokenization

 

The concept of debt is universal, with many countries issuing their own debt in the form of sovereign bonds.The size of the overall debt market is enormous, with public markets, bonds and the like accounting for a daily total trade volume of over 100 billion USD.

Another benefit for debt investors is increasing applications of tokenization. Tokenized debt can bring forth new options, such as secondary trading.Through tokenization, chunks of debt or notes can be fractionalized and minimum entry requirements lowered for investors.

 

Startup Equity Investing

 

With equity investing, the financial reward comes over a longer term, after the investor’s stocks in the startup has been vested, or the startup in question has launched a public offering, or been acquired. How long are these terms? Well, the general average time for a successful exit in a startup is 8-10 years – this is when the company is either sold or a public offering is made.  But many startups never reach this stage. Out of all the startups created in 2014, only slightly more than half of those companies have survived until 2018 and beyond.

 

If the startup were to exit at a high valuation, any equity in that startup could be transitioned into a big payout for the investor, making the wait more than worth it. If  the startup were to fail however, or manage to hang around but never sell or launch a public offering, the equity might not turn into anything valuable even if the investor has waited for an extended time.

 

An Example Investment Scenario: Debt vs Equity By The Numbers

 

Starting with a seed investment of $10,000 investing into real estate debt, with an average return of 10% per year. This debt investment, if invested for a period of 10 years, compounded monthly, should grow to just over $27,000. On the other hand,  an investor can invest the $10,000 across 10 startups equally for the average exit time of 8-10 years. One of the 10 startups gets a 10x return, earning the investor $10,000. Out of the other 9, four get a 2-3x return yielding a total between $8-12K. The remaining five startups fail.

 

Let’s break this down. For the investor in this scenario, debt is more lucrative, returning $27,000 versus the total of $22,000 earned by investing in 10 different startups. Only 1/10 startups are likely to succeed – but the amount of startups becoming unicorns in the US increased 353.1% between 2013 and 2018.

 

Debt investing offers investors more consistent returns, though the possibility of hitting a unicorn with a huge exist is nullified. . Equity investing, on the other hand, offers financial reward over the long term, but carries a higher degree of risk. The global debt market equates to $270 trillion, roughly 3x the size of the global equities market, but both options carry their own unique advantages and pitfalls for investors.

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