In the Internet age, it seems like the hottest companies are more often than not also among the youngest. Many, by traditional definitions, are still in their startup phase.
It can be frustrating as an investor to watch the news and see these companies making so much money for their early investors. For all but the elite few, investing directly in these startups is simply impossible.
But for every problem there is a solution, and I have an indirect and low-risk way for you to add startup exposure to your portfolio -- you can invest in a venture bank.
The average investor's two problems with investing in startups
Realistically, to successfully and sustainably invest in startups, you need to be quite rich. That's because you need to be an accredited investor, which means you'll need either $200,000 a year in income or a $1 million net worth excluding your home.
If you do qualify as accredited, you'll probably need more money than the bare minimum requirements so you can spread around your dollars to several promising startups if you want to make any real money. Most startups fail, so you have to invest in enough to absorb the losers but stay in the game for that one investment that takes off.
If you aren't that rich, which is the case for almost everyone, you'll need to know someone. Maybe your niece or nephew will grow up to be an entrepreneur and approach you for some seed money to launch a venture. Or maybe you live in Silicon Valley and your next-door neighbor is a successful serial entrepreneur. That may get your foot in the door as well. Of course, the odds are fairly large against you in both cases. I suppose it's better to be lucky than good in this case.
Solving these problems are easier than you think
We can solve both the money and luck problems by investing in a venture bank.
These banks make money by funding loans to venture capital-backed startups. The loans are typically for working-capital needs, such as building inventory, hiring employees, or financing rapid growth. The loans almost always come with collateral, and some will even include a guarantee from the venture-capital firm to pay the debt off if the startup fails.
Investing in a venture bank also diversifies your investment across several thousand different startups in multiple industries and at multiple stages of the business life cycle.
Overall, it's clearly a much lower-risk proposition than giving your nephew a check for seed money.
And even better yet, you can invest in these banks on the public markets. You need not be super affluent or well connected. All that's required is a brokerage account and the cash for at least one share.
Two venture banks to consider
The leader in this space is SVB Financial Group (NASDAQ:SIVB), commonly known as the Silicon Valley Bank. The bank has a focus in the technology, life-science, and healthcare industries.
As of June 30, SVB reported $14.4 billion in gross loans on its books. It returned 11.4% on shareholder equity and 0.88% on assets for the same quarter. Venture banks typically have a very high ratio of non-interest deposits to loans; that balance-sheet structure lowers their return-on-asset figure compared with traditionally structured banks. A full 75% of SVB's liabilities are, in fact, non-interest-bearing deposit accounts. Another 21% come from other deposit accounts that pay interest.
SVB currently trades at a valuation of 2.4 times its tangible book value.
Another, smaller venture bank to consider is Square 1 Bank (NASDAQ:SQBK), which this past March agreed to be acquired by PacWest Bancorp (NASDAQ:PACW). That transaction is expected to close in the fourth quarter. The acquisition was driven by PacWest's desire to gain access to Square 1's large non-interest-bearing deposit base, a characteristic the bank shares with SVB.
In the meantime, Square 1 remains publicly traded, currently valued at 2.5 times its tangible book value. The bank has $3.5 billion in total assets and is growing quickly. Average loans increased 35% year over year in the second quarter, supported by average deposits increasing 34% over the same period.
Square 1 reported return on equity of 12.2% and an impressive return on assets of 1.14% for the June 30 quarter.
The only potential drawback to this strategy.
Investing in publicly traded venture banks will not propel you to overnight billions in the same way that an equity investment in the next big startup could.
These companies are operate relatively straightforward banks, even if their clientele consists of high-flying venture capitalists and red-hot startups.
However, even if the upside isn't as great, an investment in a venture bank is a smart alternative for most retail investors simply because of the ease of investment and reduced risk. And don't forget, for most investors it's going to be next to impossible to even qualify to invest directly in these startups. This strategy is prudent, and it's also in the realm of possibility.
If it's overnight billions you're after, then this obviously won't work
If you are dead set on quickly making a billion dollars, then you should probably focus on being the entrepreneur, not the investor.
But if you think there's money to be made in the current startup economy in Silicon Valley or elsewhere, then the easiest way to invest in that market is probably by buying shares in a venture bank such as SVB Financial or Square 1 Bank.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.