When it comes to investing in high-profile start-ups, most investors probably think these deals are reserved for venture capital and private equity. However, the capital markets present some unique ways for retail investors to gain exposure to young tech companies with the potential to make it big. Business development companies (BDCs), in particular, are unique investment structures that allow investors to invest in vehicles that provide capital to high-growth businesses that may still be closely held.
One of the best-performing BDCs on the market is Hercules Capital (HTGC 0.63%), which specializes in venture debt and growth capital for technology and life sciences businesses. Let's take a look at what exactly Hercules does and why the stock may be appealing to dividend investors.
What is a business development company?
BDCs act as capital providers for companies seeking different ways to augment the balance sheet. For example, during the early days of a start-up, the company may raise several rounds of funding from venture capital or private-equity investors. However, over time, the founders and employees may not want to raise money from these investors due to equity dilution. Therefore, the start-up may look at an alternative, such as raising debt.
If the start-up chooses to explore debt providers, two common options are going to a traditional bank or looking at a BDC. BDCs often have higher risk profiles than traditional banks and are more willing to lend larger amounts. Depending on the capital needs of the business, this can be a major differentiating factor.
BDCs like Hercules may be willing to write a sizable check, but there's a price. Hercules specializes in a vehicle known as venture debt. In essence, these are high-yield loans that are much more expensive than rates offered by traditional banks -- assuming they'd even approve a loan, which gives BDCs an opening.
While the thought of debt might scare some businesses, the caliber of Hercules' portfolio speaks for itself, suggesting the company's value proposition is strong. For example, some companies Hercules has partnered with include Ancestry.com, Box, DocuSign, and FanDuel.
Image source: Getty Images.
How does Hercules stack up against the competition?
While it might seem like Hercules competes against venture capital funds, this often isn't the case. A number of BDCs focus specifically on the technology and life sciences sector, including TriplePoint Venture Growth, Trinity Capital, Barings, and Horizon Technology Finance Corporation.
Data source: YCharts.
The chart above illustrates the total return of Hercules stock benchmarked against the cohorts I outlined. Investors can see that Hercules stock has significantly outperformed the competition and has been a terrific company to own for several years.
Should you invest in Hercules stock?
One of the best reasons to invest in BDCs is the passive income they provide in the form of dividends.
Data source: YCharts.
The chart above shows that Hercules has increased its dividend by 45% over the past five years. The company currently has a dividend yield of 11.9%. This means that a position of just $1,000 should return approximately $120 in annual dividends at the current yield. Taking this a step further, a $10,000 position would provide you with more than $1,000 of passive income each year, provided the company continues to pay a generous dividend. Depending on how much dry powder (cash) you may have on the sidelines, Hercules stock might look tempting.
Hercules stock currently trades at about $16 per share. For investors looking for proven market leaders without investing in the volatility of high-flying growth stocks, Hercules may fit the bill.
More importantly, the company is well positioned to take advantage of the rising interest rate environment. To me, Hercules represents a best-in-class investment opportunity uniquely equipped to succeed during times of more pronounced economic volatility. Now looks like a great time to open a position in this dividend generator and hold for the long term.
