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Venture Leasing - A Smarter Way To Build Enterprise Value
By: George A. Parker
In 2003, venture capitalists and investors dispense over $18 billion to
promising young US companies, according to VentureOne and Ernst & Young
Quarterly Venture Capital Report. Less documented and reported is venture
leasing’s activity and volume. This form of equipment financing contributed
greatly to the growth of US start-ups. Yearly, specialty leasing companies pour
hundreds of millions of dollars into start-ups, permitting savvy entrepreneurs
to achieve the biggest 'bang for their buck' in financing growth. What is
venture leasing and how do sophisticated entrepreneurs maximize enterprise value
with this type of financing? Why is venture leasing a cheaper and smarter way to
finance needed equipment when compared to venture capital? For answers, one must
look closely at this relatively new and expanding form of equipment financing
specifically designed for rapidly growing venture capital-backed start-ups.
The term venture leasing describes the leasing of equipment to pre-profit,
start-ups funded by venture capital investors. These companies usually have
negative cash flow and rely on additional equity rounds to fulfill their
business plans. Venture leasing originated to allow growing start-ups to acquire
needed operating equipment while conserving expensive venture development
capital. Equipment financed by venture leases usually includes essentials such
as computers, laboratory equipment, test equipment, furniture, manufacturing and
production equipment, and other equipment to automate the office.
Using Venture Leasing Is Smart
Venture leasing enjoys many advantages over traditional venture capital and bank
financing. Financing new ventures can be a high risk business. Venture
capitalists generally demand sizeable equity stakes in the companies they
finance to compensate for this risk. They typically seek investment returns of
at least 35% - 50% on their unsecured, non-amortizing equity investments. An IPO
or other sale of their equity position within three to six years of investing
offers them the best avenue to capture this return. Many venture capitalists
require board representation, specific exit time frames and/or investor rights
to force a 'liquidity' event. In comparison, venture leasing – having none of
these drawbacks - specifically helps young companies acquire equipment for
growth. Venture lessors typically seek an annual return in the 14% - 20% range.
These transactions usually amortize monthly in two to four years and are secured
by the underlying assets. Although the risk to the venture lessor is also high,
this risk is mitigated by requiring collateral and an amortizing transaction. By
using venture leasing along with venture capital, the savvy entrepreneur lowers
the venture's overall capital cost, builds enterprise value faster and preserves
ownership.
Venture leasing is also very flexible. By structuring a fair market value
purchase or renewal option at the end of the lease, the start-up can slash
monthly payments. Lower payments result in higher earnings and cash flow. Since
a fair market value option is not an obligation, the lessee has a high degree of
flexibility and control. The resulting reduction in payments and shift of lease
expense beyond the expiry of the transaction can deliver a higher enterprise
value to the savvy entrepreneur during the initial term of the lease. The higher
enterprise value results from the start-up’s ability to achieve higher earnings,
upon which most valuations are based.
Customers benefit more from venture leasing as compared to traditional bank
financing in two ways. First, venture leases are usually only secured by the
underlying equipment. Additionally, there are usually no restrictive financial
covenants. Most banks, if they lend to early stage companies, require blanket
liens on all of the companies' assets. In some cases, they also require
guarantees of the start-ups’ principals. More and more, sophisticated
entrepreneurs recognize the stifling effects of these limitations and their
impact on growth. When start-ups need additional financing and a sole lender has
encumbered all assets or required guarantees, these young companies become less
attractive to other financing sources. Correcting this situation can sap the
entrepreneurs’ time and energy.
How Venture Leasing Works
Generally, a major round of equity capital raised from credible investors or
venture capitalists makes venture leasing viable for the early stage company.
Lessors structure most transactions as master lease lines, permitting the lessee
to draw down on the line as needed throughout the year. Lease lines usually
range in size from as little as $ 200,000 to well over $ 5,000,000, depending on
the lessee's need and credit strength. Terms are typically between twenty four
to forty eight months, payable monthly in advance. The lessee's credit strength,
the quality and useful life of the underlying equipment, and the lessor’s
anticipated ability to re-market the equipment during the lease often dictate
the initial lease term. Although no lessor enters a leasing arrangement
expecting to re-market the equipment prior to lease expiry, should the lessee’s
business fail, the lessor must pursue this avenue of recovery to salvage the
transaction. Most venture leases give lessees flexible end-of-lease options.
These options generally include the ability to buy the equipment, to renew the
lease at fair market value or to return the equipment to the lessor. Many
lessors cap the fair market value, which also benefits the lessee. Most leases
require the lessee to shoulder the important equipment obligations such as
maintenance, insurance and paying required equipment taxes.
Venture lessors target lessee prospects that have good promise and that are
likely to fulfill their leases. Since most start-ups rely on future equity
rounds to execute their business plans, lessors devote significant attention to
credit review and due diligence - evaluating the caliber of the investor group,
the efficacy of the business plan and management's background. A superior
management team has usually demonstrated prior successes in the field in which
the new venture is active. Additionally, management’s expertise in the key
business functions -- sales, marketing, R&D, production, engineering, finance
--- is essential. Although there are many professional venture capitalists
financing new ventures, there can be a significant difference in their
abilities, staying power and resources. The better venture capitalists achieve
excellent results and have direct experience with the type of companies being
financed. The best VCs have developed industry specialization and many have
in-house specialists with direct operating experience within the industries
covered. Also important to the venture lessor are the amount of capital VCs
provide the start-up and the amount allocated for future funding rounds.
After determining that the management team and venture capital investors are
qualified, venture lessors evaluate the start-up’s business model and the market
potential of the venture. Since most venture lessors are not technology
specialists – able to assess products, technology, patents, business processes
and the like - they rely greatly on the thorough due diligence of experienced
venture capitalists. But the experienced venture lessor does undertake an
independent evaluation of the business plan and conducts careful due diligence
to understand its content. Here, the lessor generally attempts to understand and
concur with the business model. Questions to be answered include: Is the
business model sensible? How large is the market for the prospect's services or
products? Are the income projections realistic? Is pricing of the product or
service sensible? How much cash is on hand and how long will it last according
to the projections? When is the next equity round needed? Are the key people
needed execute the business plan in place? These and similar questions help
determine whether the business model is reasonable.
Satisfied that the business model is sound, the venture lessor’s greatest
concern is whether the start-up has sufficient liquidity or cash on hand to
support a significant portion of the lease term. If the venture fails to raise
additional capital or runs out of cash, the lessor is not likely to collect
further lease payments. To mitigate this risk, most experienced venture lessors
pursue start-ups with at least nine months of cash or sufficient liquid assets
to service a substantial portion of their leases.
Getting the Best Deal
What determines venture lease pricing and how does a prospective lessee get the
best deal? First, make sure you are comfortable with the leasing company. This
relationship is usually more important than transaction pricing. With the rapid
rise in venture leasing over the past decade, a handful of national leasing
companies now specialize in venture leases. A good venture lessor has a lot of
expertise in this market, is accustom to working with start-ups, and is prepared
to help in difficult cash flow situations should the start-up stray from plan.
Also, the best venture lessors deliver other value-added services - such as
assisting in equipment acquisitions at better prices, trading out existing
equipment, finding additional venture capital sources, working capital lines,
factoring, temporary CFOs, and introductions to potential strategic partners.
Once the start-up finds a capable venture lessor, negotiating a fair and
competitive lease is the next order of business. A number of factors determine
venture lease pricing and terms. Important factors include: 1) the perceived
credit strength of the lessee, 2) equipment quality, 3) market rates, and 4)
competitive factors within the venture leasing market. Since the lease can be
structured with several options, many of which influence the ultimate lease
cost, start-ups should compare competing lease proposals. Lessors typically
structured leases to yield 14% - 20%. By developing end-of-lease options to
better accommodate lessees' needs, lessors can shift some of this pricing to the
lease’s back end in the form of a fair market value or fixed purchase or renewal
option. It is not uncommon to see a three year lease structured to yield 9% -
11% annually during the initial lease term. Thereafter, the lessee can choose to
return the equipment, purchase the equipment for 10% - 15% of equipment cost or
to renew the lease for an additional year. If the lease is renewed, the lessor
recovers an additional 10% - 15% of equipment cost. If the equipment is returned
to the lessor, the start-up reduces its cost and limits the amount paid under
the lease. The lessor will then remarket the equipment to achieve its 14% - 20%
yield target.
Another way that leasing companies can justify slashing lease payments is to
incorporate warrants to purchase stock into the transaction. Warrants give the
lessor the right to buy an agreed upon quantity of ownership shares at a share
price predetermined by the parties. Under a venture lease with warrant pricing,
the lessor typically prices that lease several percentage points below a similar
lease without warrants. The number of warrants the start-up proffers is arrived
at by dividing a portion of the lease line - usually 3% to 15% of the line - by
the warrant strike price. The strike price is typically the share price of the
most recently completed equity round. Including a warrant option often
encourages venture lessors to enter transactions with companies that are very
early in development or where the equipment to be leased is of questionable
quality or re-marketability.
Building a young company into an industry leader is in many ways similar to
building a state-of-the art airplane or bridge. You need the right people,
partners, ideas, materials and tools. Venture leasing is a useful tool for the
savvy entrepreneur. When used properly, this financing tool can help early stage
companies accelerate growth, squeeze the most out of their venture capital and
increase enterprise value between equity rounds. Why not preserve ownership for
those really doing the heavy lifting?
About the Author:
George Parker is a Director and Executive Vice President of Leasing Technologies
International, Inc. (“LTI”). Headquartered in Wilton, CT, LTI is a leasing firm
specializing nationally in equipment financing programs for emerging growth and
later-stage, venture capital backed companies. More information about LTI is
available at: www.ltileasing.com. |