Vysoká škola ekonomická v Praze University of Economics, Prague
Master Thesis
2008 Anna Štěrbová
University of Economics, Prague Faculty of Business Administration
Major specialization: Business Administration and Management
Venture Leasing
Written by: Anna Štěrbová
Supervisor: doc. Ing. Jiří Hnilica, Ph.D.
D e c l a r a t i o n :
I proclaim that the master thesis “Venture Leasing” was done by my own and I used only the materials that are stated in the literature sources.
In Prague, 18th April 2008
A n n o t a t i o n :
The diploma thesis examines venture leasing as a complement to venture capital;
describing the process of venture leasing, connected risks and major players. The focus lays on assessing the benefits of venture leasing for the parties involved. The position of venture leasing in both, the United States and Europe is being described.
A n o t a c e :
Předmětem této diplomové práce je “venture leasing”, doplňkový zdroj
financování k venture capital investicím. Práce popisuje základní principy, související rizika a klíčové subjekty. Důraz je kladen na zhodnocení přínosů této formy financovaní pro všechny zúčastněné strany a porovnání situace ve Spojených Státech a v Evropě.
A c k n o w l e d g e m e n t :
I would like to thank my supervisor doc. Ing. Jiří Hnilica, Ph.D. for the constructive remarks and competent advice on the topic.
CONTENT
CONTENT ... 7
INTRODUCTION ... 8
1. VENTURE CAPITAL ... 10
1.1 History of venture capital ... 11
1.2 Players in the Venture capital industry... 15
1.3 Focus of Venture CApital investments ... 16
1.4 Venture capital deal ... 18
2. COMPLEMENTS TO VENTURE CAPITAL ... 21
2.1 Mezzanine Financing ... 21
3. VENTURE LEASING ... 24
3.1 History OF venture leasing in the United States ... 26
3.2 Venture leasing versus traditional leasing ... 27
3.3 Venture leasing providers ... 28
3.4 Objects of Venture leasing ... 31
3.5 Advantages of venture leasing ... 32
3.6 Venture leasing deal evaluation ... 34
3.7 Deal components ... 36
3.8 Returns ... 41
3.9 Risks ... 43
3.10 Western Technology Investment ... 45
4. VENTURE LEASING IN EUROPE ... 49
4.1 European Venture Leasing providers ... 50
4.2 Limitations ... 52
4.3 Outlook ... 53
5. IMPROVING RETURNS BY VENTURE LEASING ... 54
5.1 Start-up funding without venture leasing ... 54
5.2 Start-up funding with venture leasing ... 57
6. LEASING OF INTANGIBLE ASSETS ... 62
6.1 Intangible assets and venture leasing ... 62
6.2 Valuation of intangible assets ... 63
6.3 Software leasing ... 64
6.4 Leasing of patents ... 65
CONCLUSION ... 68
BIBLIOGRAPHY ... 70
LIST OF TABLES AND GRAPHS ... 73
LIST OF APPENDIXES ... 74
APPENDIXES ... 75
INTRODUCTION
The building up of operations of an innovative company requires high amounts of capital, while future income streams are difficult to predict. However, each increase of shareholders capital via venture capital financing results in dilution of company founders shares.
Recently, new financing possibilities that enable entrepreneurs to raise additional funds while giving up less equity than in the case of traditional venture capital deals emerged (Mayer- Fiedrich, 2005). For start-up companies, venture leasing, a financial vehicle developed in the 1990’s in the United States, provides one of the options.
The term venture leasing describes equipment financing provided by equipment leasing firms to pre-profit in early stage companies funded by venture capital investors (Neubecher, 2004). As a risk premium, the venture lessor receives stock options in the company and other warrants. Venture leasing adds leverage to the equity investments enabling both shareholders and venture capital investors to increase their returns and lower risks. The most desirable industries for venture leasing include life sciences, software, telecommunications and information services (Glynn, et al., 2003).
Recently, venture leasing became a standard financing vehicle in the United States, where almost two thirds of venture backed companies use venture leasing to receive additional funds. Therefore, most of the relevant literature is based on the American experience. Most of the literature describes venture leasing as such, without any detailed explanation of its benefits and risks. This thesis’ aim is to research and give clear evidence of how venture leasing differs from venture leasing, and where it may be positioned with regard to other options.
In theoretical literature as well as in available case studies, venture leasing is mostly connected with equipment leasing. Recently, the importance of intangible assets on a company’s value has grown significantly, which has opened up a new business area for venture leasing providers. Leasing of intangible assets will be therefore introduced in the end of the thesis.
The main goal of this thesis is to discuss whether venture leasing improves the position of the entrepreneur and what the effects are on the company’s venture capital providers. The primary concerns are changes in returns and in the ownership structure. In order to answer these questions, differences between classical venture capital and venture leasing, major advantages of
venture leasing for entrepreneurs and investors, as well as connected risks will be described in this paper. The theoretical conclusion should be proven by an example, which compares pure venture capital financing and combination of venture capital and venture leasing.
Secondly, this thesis aims to analyze the position of venture leasing in Europe, where venture leasing is known since the end of 1990’s and to discuss the outlook of European venture leasing.
The thesis has the following structure: After researching the venture capital industry, describing the core ideas of the business and exploring the history of venture capital, a frame for assessing financing options will be described. One of the many possibilities entrepreneurs have - the mezzanine capital - will be briefly introduced.
The core of this thesis in venture leasing, the third chapter, concentrates on general aspects of venture leasing. It will present the way venture leasing works and the impacts it has on all the parties involved: entrepreneurs, investors and venture capitalists. Later, the situation in Europe will be discussed, using examples of European venture leasing providers.
Evidence for the described impacts of venture leasing will be shown in a model case in Chapter 5, which compares both financing possibilities and answers the questions as to which option is more beneficial for the entrepreneurs and how venture capitalists returns are affected.
Chapter 6 deals with leasing of intangible assets and the specifics of their valuation.
Finally, a conclusion about the position of venture leasing and its prospects for the European market will be concluded.
1. VENTURE CAPITAL
Entrepreneurs often come up with product and ideas, whose development requires substantial amounts of capital. Venture capital serves as an important intermediary in financial markets, providing capital for young, innovative companies that possess few tangible assets and operate within fast developing industries (Gompers, et al., 2001).
Venture capital represents financing provided in return for an equity stake in potentially high growth unquoted companies. The term “venture capital” is defined differently in the United States thanin Europe where it covers investments at all stages. (EVCA, July 2006). In accordance with terminology used in the United States, in this paper, the term “venture capital”
refers only to a group of “private equity” investments, targeting only the start-up and expansion stages of a company (see Figure 1).
Venture money is not long-term money financing, the underlying principle is to provide funds and increase a company’s credibility until it reaches sufficient size to be sold.
Usually, more than half of the companies within a venture capital portfolio will either return only the original investment or fail.
The probability that a company will succeed in the long term is quite low. According to Zider (1998) many factors are crucial for a company’s success, and a successfully performing company may have an 80% chance of succeeding in each component. The overall probability is then the multiple of the single probabilities. For example, assuming an 80% probability of fulfilling nine different criteria, the overall success chance is only 17% (How Venture Capital
THE PRIVATE EQUITY INDUSTRY
Venture Capital
Seed & Start-up Capital
Expansion Capital
Private equity
Buyouts Figure 1 Venture capital definition
Source: EVCA
Works, 1998). Only 10-20% of companies need to become winners in order to achieve the targeted return rate. By classical venture capital theory, at least a 35% return of investment over the period of 5 to 10 years is required.
1.1 HISTORY OF VENTURE CAPITAL
In the late 19th and early 20th century rich American families, including the Vanderbilts and Rockefellers searched for high returns investments (Gompers, 1994).
In 1946 MIT President Karl Compton, General Georges F. Deriot and local business leaders established the first true venture capital fund, American Research and Development (ARD). Their aim was to finance applications of technologies that were developed during World War II. The biggest success of ARD, which was structured as a closed fund, was an investment in Digital Equipment Company: this grew in value from $70,000 in 1957 to $355 million by 1974 . Almost half of the money earned by ARD over its 26 years’ of existence was earned by its investment into DEC.
The first venture capital limited partnership was formed in 1958 by Draper, Gaither and Anderson. The partnership followed the template common for the time: its existence was limited to ten years and the parterships were required to return the assets to investors within a set period of time. In the 60’s and 70’s limited partnerships accounted for of the monies of the venture capital companies. Most of them raised money through closed funds or Small Business Investment Companies (SBIC), which were governmentally chartered risk capital pools. Their goal was to provide early stage financing in various industries. By the mid 1960’s more than 700 SBICs controlled the majority of risk capital invested in the United States (Gompers, et al., 2001). The rapid growth of venture capital companies slowed down due to oil price shocks followed by recession in 1973.
The next phase of venture capital development began at the start of the 1980’s because of a decrease in capital gain taxes, attractive aquisition conditions and liberalisation of the pension funds investment possibilites (Neubecher, 2004). Since 1979, the Employee Retirement Security Act enabled pension funds to invest in high-risk assets including venture capital. This
had a huge impact on both the structure (see Graph 1 and Graph 2) and size of venture capital investments, which grew from $216 million in 1978 to $3.0 billion ten years later.
Almost 80% of funds were organized as limited partnerships with a legaly defined ten year lifetime and their number increased from 225 in 1979 to 674 in 1989 (Gompers, 1994).
Nearly 20% of venture capital went into the energy industry. The average fund was around $20 million with two to three partners managing around five investments (How Venture Capital Works, 1998).
As shown in Graph 3, a shift from start-up investments towards late stage and LBO investments occured in the late 80’s. This development reflects the short term returns focus of pension funds managers. Gompers (1994 p. 18) concludes the success of venture capital in the 1980’s was driven by the enormous amount of capital invested during early stage projects in the late 1970’s and early 1980’s. The dramatic decline in early stage investments resulted in fewer opportunities for profitable late-stage investing in the 1990’s.
Pension funds 46%
Insurance 9%
Corporations 11%
Foreign 14%
Endowments 12%
Individuals 8%
Graph 2 Structure of venture capital investments in 1978
Pension funds 15%
Insurance 16%
Corporations 10%
Foreign 18%
Endowments 9%
Individuals 32%
Graph 1 Structure of venture capital investments in 1988
Source: Gompers, P.: The Rise and Fall of Venture Capital, 1994
The above described changes had an impact on the returns of venture capital investments, which were increasing since 1974 and peaked in 1982 by 31%. A decrease in fund performance followed, as by 1989 returns averaged only 8%. The drop of the market was caused by pension funds losing interests in venture capital companies. The stock exchange crash in 1987 and following recession slowed the market down for several years.
Internet and other technological developments (e.g. telecommunications and biotechnologies) contributed the most to an enormous growth (Neubecher, 2004). In 1999 the year on year growth exceeded 300%. Whilst in the past, venture capitalists acted as gatekeepers who only invested in technologies with high potential, in the dot-com era they were willing to put as much money as possible into the business without analyzing the risk. However, the stock market could not sustain the demand for new IPOs and the dot-com company valuation. In April 2000 NASDAQ started to fall and continued declining through the beginning of 2001. Between 1999 and 2001, more than $ 200 billion were raised; by April 2001 NASDAQ was 68% lower than its peak 13 months earlier (Zook, 2005).
Recent history of Venture Capital in the United States
The drop of the market continued through 2001 and bottomed out in 2002, when only $3 billions were invested. The recent development of the market is shown in Table 1 (NVCA,
Graph 3 Venture capital investments by type of financing
0%
20%
40%
60%
80%
1980 1981 1982 1983 1984 1985 1986 1987 1988 Start-up Expansion& Late Stage LBO
Source: Gompers, P.: The Rise and Fall of Venture Capital, 1994
2007). According to Thomson Financial1 and the National Venture Capital Association2 (NVCA) there are significantly higher portfolio diversifications than around 2001, when investments concentrated on only a few industries. Lately, the focus of venture firms lies in capital intensive industries such as life sciences and clean technology, which require the presence of venture firms for a longer period of time.
According to a Global Insight study conducted by NVCA in 2006, venture-backed companies accounted for 10 million jobs and $2.1 trillion in revenues in the United States.
Table 1 Venture capital investments 2001-2007
Number of funds
Venture Capital ($M)
01/2001 318 38 800
2002 179 3 937
2003 152 10 606
2004 208 19 058
2005 228 28 803
2006 229 31 698
2007 235 34 676
Source: NVCA, 2008
Venture capital in Europe
With the exception of the UK, there has been very little venture capital activity outside the United States. In 1996, the U.S. venture capital pool was three times bigger than the investments in other 21 nations (Jeng, et al., 2000). 70% of all venture capital investments in the rest of the world went to four countries only – Israel, Canada, United Kingdom and Netherlands (Gompers, et al., 2001).
Towards the end of 1990’s, venture capital activity started to grow in Europe. After the dot com bubble burst, the European venture capital market managed to recover quicker than in
1 Thomson Financials is a provider of information and technology solutions to the worldwide financial industry (www.thomson.com)
2 The National Venture Capital Association represents around 480 venture capital and private equity firms in the United States
the United States and in 2005 the investments in Europe were 90% higher than in 1998 (compared to only 4% growth in the US). Despite this higher grow, in absolute numbers the level of European investments is still much lower (2005: EUR 12,7 billion) than in the United States, where the investments reached EUR 17,4 billion (Meyer, 2006).
1.2 PLAYERS IN THE VENTURE CAPITAL INDUSTRY
Four main players may be identified within the venture capital industry:
- an entrepreneur who is in need of funding, - investors looking for high returns,
- investment banks that need the companies to sell,
- a venture capitalist, who works as an intermediary for the other sides.
For the entrepreneurs, who possess very little or no cash flow to support debt obligations, venture capital is usually the only possibility on how to raise funds for the business. Often, entrepreneurs are aware of the risk and the fact that they might lack needed managerial and other skills (How Venture Capital Works, 1998).
The equity component of the financial agreement between the entrepreneur and the venture capitalists generally takes the form of convertible preferred stock. Their conversion typically occurs by initial public offering (IPO). In addition to equity, venture capitalists usually receive inside management rights.
Venture capital partnerships
Limited partnerships are the most common form of venture capital investments. The partnership is structured as a closed, private fund. Most venture capital funds have a fixed life of 10 years, with the possibility of a few years’ of extensions to allow for private companies still seeking liquidity. Over the first two to three years, the fund makes investments, which are active for up to five years. The remaining two to three years represent the time, when the profits are harvested.
The partnership consists of General Partners (venture capitalists), whose task is the management of the fund and attracting capital from external investors, and Limited Partners (investors), who do not participate in the operational management of the fund (Dvořák, et al., 1998), but invest the capital.
General Partners usually obtain 2-3% of the total capital as an annual management fee.
The venture capitalist partners agree to repay the investors’ capital before sharing the additional gains, which come from the appreciation of the portfolio. The gains are divided between the investor and the venture capitalists, with the investor getting between 70% and 80% and the general partners sharing the remaining 20% - 30% (How Venture Capital Works, 1998).
1.3 FOCUS OF VENTURE CAPITAL INVESTMENTS
Venture capital investments will occur at various stages of a company's development.
Funds can be raised even before there are real products in development, in which case we speak about “seed” financing. The term “start-up” refers to investing into companies who have a product or service in development in its preliminary stages. In case extra funds are required to help the company move beyond its critical mass, become more successful, and grow, we speak of the “expansion” stage.
Venture capital investment usually implies there are several rounds of investments, and each of them should cover the funds needed for achieving preset milestones. In this way, venture capital investors lower their risk position by splitting the capital requirements into more divisions. Table 2 shows the average duration and capital invested at cash utilization3 at each stage of a company’s life cycle (Gompers, et al., 2006)4.
3 Shows the rate at which is the company using cas between financing rounds
4 The data is based on research conducted by Gompers and Lerner among 764 venture capital firms
Table 2 Investments by stages
Stage
Time to next funding
(years)
Amount of funding
($000s)
Cash utilization ($000s/year)
Seed 1,63 $1,045 $641
Start-up 1,21 $2,709 $2,225
Early stage 1,08 $2,476 $2,292
Expansion 1,26 $2,659 $2,111
Late stage 0,86 $3,159 $3,673
Source: Gompers, et al., The Venture Capitala Cycle, 2006
Shorter investment cycles and higher amounts of funding are typical for later stages, where the risk connected with investments decreases due to more accurate information available to investors.
Venture capital firms may also lower the risk by co-investing with other firms. Usually, two or three groups are involved in all stages, contributing to diversifications of the portfolios and decreasing the workload of VC partners by getting others involved (Glynn, et al., 2003).
Early stage
The early stage venture market is often seen as being critical to the success of later-stage investments. The term “early stage” covers seed investing, start-up investments as well as other early stages investments.
Within a typical start-up deal, the entrepreneur will raise $3 million, giving up 30% of the equity in form of preferred stock options. In return for financing the first two years of companies’ operations, the venture capitalists expect a return of ten times over five years and require substantial stakes equity stakes, which makes venture capital very costly. To achieve the average fund returns above 20% it is necessary for the annual compound interest rate to be around 55%.
Expansion stage
Venture capital money plays an essential role within the adolescent stage of a company’s life cycle, where building infrastructure is required for business growth. As shown in Figure 2, within this period, the financials look similar for companies that will succeed as well as for those who will fail in the end (How Venture Capital Works, 1998).
According to EVCA, the majority of European venture capital firms invest into the expansion stage – 56% of deals (81% of funds) went into the expansion segment in 2005.
1.4 VENTURE CAPITAL DEAL
A typical venture capital investment deal will include rights and protections that are designed to allow the venture capitalists to gain liquidity and maximize the return for their investors. The equity component of the financing arrangement between venture capitalists and entrepreneurs generally takes the form of convertible preferred stock, mostly with dividend and liquidation preferences. The preferred stock will often be connected with a fixed dividend rate
Time
Sales
Whole industry
“Winner”
“Loser“
Start-up Adolescence
Maturity and shakeout
Venture Capital Investment Period
Figure 2 Sales development in different stages of a company
Source: Zider, B.: How Venture Capital Works, 1998
that, due to the cash constraints of early stage companies, is not payable currently but is cumulative and becomes part of the liquidation preference upon a sale or liquidation of the company (How Venture Capital Works, 1998).
The liquidation preference is generally equal to the purchase price of the stocks, plus accrued and unpaid dividends. The aim of this is to ensure that in case of failure, the venture capital partnerships are given priority claims to all of the company’s assets and technology - up to 100% of the investment. Most venture capitalists also insist on participation rights so they share in an equal basis with the holders of the common stock on any proceeds that remain after the payment of their liquidation preference (BANCE, 2006). These liquidation rights and the right to convert the preferred stock into common stock allow the venture capital partnerships to share in the upside in case of a successful IPO.
One of the major factors for decisions of venture capitalists is the percentage of the company that they own. This percentage is a function of the pre-money valuation of the company upon which the venture capital investors and the company agree. In determining the pre-money valuation, venture capitalists analyze the projected value of the company and the percentage of this value that will provide them with their required rate of return (Gladstone, 1988). This analysis takes into account the risks to the company and the future dilution to the initial investors from anticipated follow-on investments.
To protect existing shareholders from reduced earnings, anti-dilution rights are incorporated in the agreements. Dilution occurs when earnings have to be spread among an increased number of shares. One dilution protection measure adjusts the conversion ratio used to calculate the value of convertible securities if a stock dividend is paid. Another dilution protection technique is a “full-ratchet provision”, which automatically increases the equity percentage held by the original investors if subsequent investment rounds decrease a company’s value.
Most investment structures have a provision that allow the venture capitalists to participate in management of the company. Typical protective provisions give the venture capitalists the right to approve future issuances of stock, the declaration and payment of dividends, increases in the company’s stock option pool, expenditures exceeding the approved budgets, and the sale of the company (Gladstone, 1988).
As long as the company is achieving its business goals and not violating any of the protective provisions, most venture capitalists permit management to operate the business without substantial investor participation except at the board level. According to Zider (How Venture Capital Works, 1998), venture capitalists spend little time on the best as well the worst performing companies. “Instead, the venture capitalist allocates a significant amount of time to those middle portfolio companies, determining whether and how the investment can be turned around and whether continued participation is advisable” (How Venture Capital Works, 1998 p.
136).
Venture capitalists must achieve liquidity in order to provide the requisite rate of return to their investors. The primary liquidity events for venture capitalists are the sale of the company, the IPO of the company’s stock, or the redemption or repurchase of their stock by the company.
Generally, venture capitalists do not have a contractual right to force the company to be sold. However, the sale of the company will be subject to the approval of the venture capitalists, and depending upon the composition of the board of directors, they may be in a position to influence the sale efforts.
Very often venture capitalists insist on redemption rights to achieve liquidity event in the cases when a sale or IPO will not occur. This gives the investors the right to require the company to repurchase their stock after a period of generally 4 to 7 years. The purchase price for the VC’s stock may be based upon the liquidation preference (for example the purchase price, plus accrued and unpaid dividends), the fair market value of the stock as determined by an appraiser, or the value of the stock based upon a multiple of the company’s earnings.
An early stage company may not be able to finance the buyout of an investor and the redemption right may not be a practical way to gain liquidity. However, this right gives the venture capitalists the option to compel the management to deal with their need for an exit strategy and can result in a forced sale of the company.
2. COMPLEMENTS TO VENTURE CAPITAL
Apart from pure venture capital as described above, there are various alternative financing possibilities for entrepreneurs. The aim of this chapter paper is to identify these opportunities, which help entrepreneurs to raise additional funds without giving up as much equity as the classical approach. As shown in Figure 3 there are different financial vehicles fulfilling these criteria. When raising funds via venture capital, entrepreneurs typically give up between 20% and 40% of equity. The other presented options are connected with much lower equity stakes – usually less than 5%.
The focus of this thesislies on venture leasing, which provides further funds for seed and start-up companies. Venture lending represents a form of venture leasing and will be discussed within the next chapter5.
2.1 MEZZANINE FINANCING
Mezzanine financing is a suitable financial vehicle for venture capital backed companies that are in their expansion stage and need additional funds to support their growth and prepare for an IPO. Many of these middle market companies do not have enough collateral to receive
5 Comparison of presented financial vehicles is shown in APPENDIX 1
Figure 3 Comparison of financing options
LOW HIGH
Level of given up equity
Venture Capital
VENTURE LEASING Mezzanine
capital
Seed/ Start-upExpansion
VENTURE LENDING
Source: Author
bank loans. Further injections of venture capital may not be an option neither, since the owners may not wish to give up as much equity as required by venture capitalists in this stage (Sprink, 2003).
Mezzanine (or bridge) financing provides subordinate debt financing with greater returns than traditional bank debt. The vehicle is connected with an intermediary level of risk.
Originally, the term was used by venture capitalists for financing companies between the time they received the early stage capital and their first IPO (Torpey& Viscione, 1987). Nowadays, the definition is more general, describing private placements of middle-risk capital. Among the leading mezzanine lenders are companies such as Merrill Lynch, Morgan Stanley, Lehman Brothers, JP Morgan and GMAC.
Mezzanine financing is suitable mainly for companies in the following situations (Torpey& Viscione, 1987):
- Too high interest rates or collateral requirements connected with raising senior debt;
- Senior debt is only offered with a floating interest rate, which is unacceptable for the management;
- The growth is insufficient to attract venture capital;
- Company owners don’t want to dilute their equity position
Pros and Cons of Mezzanine capital
Mezzanine financing is a suitable vehicle for companies that operate at profit and possess a significant market share. The companies should operate in high growth industries and offer the investors exit possibilities within a few years. The following table summarizes the key advantages and disadvantages of using mezzanine capital:
Table 3 Mezzanine Capital – advantages and disadvantages
Advantages Disadvantages
No or little equity dilution Minimum volumes of transactions
High flexibility Limited in time
Lower financing costs than for venture capital funds
Higher financing costs than for conventional debt capital
Equity equivalence Diverging interests
Easy to combine with other finance products
Source: IKB Deutsche Industriebank
The Transaction
The scope of mezzanine financing transactions usually ranges between $5-100 million for a single company. The deal is connected with a fixed interest rate, typically 2 to 4 points above the prime rate lasting over 5-7 years (Sprink, 2003).
The debt comes with equity warrants or preferred stocks. The equity requirements vary widely from venture capital, since in most cases mezzanine capital providers require equity stakes around 5%. After the company goes public, the lender gets back principal, interest and any capital gains resulting from exercising the warrants.
Because of the connected risks, are the required returns higher than by traditional senior debt transactions. The expected returns in mezzanine financed businesses are between 20% and 30%, significantly lower than venture capital companies assume.
3. VENTURE LEASING
Glynn defines venture leasing as an asset backed venture capital for early stage, pre profit companies funded by venture capital (Glynn, et al., 2003). Venture leasing combines traditional venture capital with equipment leasing. The aim is to address the fixed assets financial needs of early stage, high growth, technology companies.
Such companies require huge amounts of capital to start their operations and enter the market; however, in the early stages, they lack any sources of income and their future profits are rather unsure. Since the companies are young and do not possess any saleable product or service, these innovative companies are not credit worthy enough to turn to a bank for equipment loans. Because of the low credit-worthiness investments into these companies are very risky, resulting in limited possibilities of debt financing.
Venture leasing represents a lower risk alternative to an additional increase of venture capital for companies that are willing to obtain further funds without giving up as much equity. Such first round financing would then combine with venture capital covering the working capital, and venture lease providing fixed assets. Figure 4 shows an example split between venture capital and venture leasing in the first financing round (D'Souza, 2003). In exchange for the lease financing, the venture lessor receives monthly lease repayments and equity warrants in the company.
EQUIPMENT
$1 million
WORKING CAPITAL
$4 million
VENTURE LEASING
VENTURE CAPITAL
Figure 4 First round financing with venture leasing
Source: Deutsche Bank
This leverage not only allows the entrepreneurs to stretch their equity through the critical early stages of the life cycle, but also enables the investors to commit fewer funds at the early stage of the company’s lifecycle (EVP to raise €105 millions, 2004). In addition, using venture leasing increases the returns for both the investors and shareholders of the company. Venture lessors view the company in the same way as venture capitalists do, focusing on the growth potential of the company.
There are two main forms of venture leasing. Firstly, leasing in the traditional sense, in which case certain assets are leased and their title belongs to the lessor. In this case, the venture lessor receives monthly lease repayments and equity warrants in the company. Secondly, the venture leasing may occur in the form of a loan, which is backed up by a loan on all the company’s assets - this form is also known as venture lending (Glynn, et al., 2003). This thesis focuses primarily on the first form and its implications for start-up companies.
Venture lending
While venture leasing focuses primarily on early stage businesses, venture lending is suitable for large companies, which need to raise funds shortly before an IPO and do not want to give up large equity stakes. The funds are usually used for staff growth or to support further technology developments.
In comparison to venture leasing, the rates used in venture lending are usually much lower; however, the company has to secure the loan with their own collateral. Since young companies often posses only a very limited amount of fixed assets, venture lenders very often take receivables or intellectual property, which is an uncommon technique for traditional loan providers. Another advantage is that the loan may be for almost any kind of operating expense (Worrell, 2003).
Leading venture lenders include RBC Centura, Comerica and Sillicon Valley Bank (which is co-operating with more than 300 venture capital providers in the United States).
3.1 HISTORY OF VENTURE LEASING IN THE UNITED STATES
The origins of venture leasing go back to the late 1960s as a reaction to the slowdown in the venture capital industry. Venture capitalists, who were seeking for new opportunities to expand their businesses, sensed the opportunity to lease equipment to young companies in addition to providing funds. Entrepreneurs, on the other hand, looked for alternatives to the high-cost venture capital. Debt financing was in many cases unmanageable, since both banks and traditional leasing providers required significant amounts of cash up front.
There were three parties involved in the early venture leasing transactions – the lessee, the venture capitalist (served as the lessor), and another venture capital fund. In the beginning, the active partnership with the main venture capital provider was necessary, since only a limited number of firms offered venture leasing. Besides, these were usually small companies that needed referrals of other venture capitalists for deals. Similarly to a traditional lease, the lessor kept the ownership title to the equipment; however, the venture lessor and the main venture capitalist received warrants for their referral.
Even though a few deals occurred in the 1970’s, start-up companies were rather skeptical towards this innovative vehicle. Their major concern was that venture leasing would increase the control of venture capitalists over their own companies (Lerner, 2001).
The rebirth of venture leasing industry in the U.S.A took place in the late 1980s. As a reaction to increased demand for the enormously expensive chip fabrication equipment needed by chip manufacturers, the Equitec Financial Group established a new subsidiary: Equitec Leasing Company. Within the next five years, Equitec raised 11 limited partnerships, each to the value of around $30 million to provide equipment leasing for high risk business.
The dot com bubble attracted many new players into the industry – mainly regional banks and boutique funds. The returns grew rapidly, and venture lessors earned hundreds of percents on warrant options. However, when the bubble burst, the venture lessors suffered. One of the biggest cases was Comdisco, a large publically traded player that filed for bankruptcy as its portfolio of loans followed the same fate as many start-ups.
The industry started to recover again after 2003, after the renaissance of venture capital as such. Nowadays, around two thirds of venture-backed start-up or early-stage companies in the United States uses venture leasing (Western Technology Investment, 2006). The major players in the United States include companies with a long history such as Western Technology Investments, Lighthouse Capital or Dominion Partners and many new entrants, such as Gold Hill Venture Lending Partners and Horizon Technology Finance.
Recently the American market witnessed a shift from venture leasing towards venture lending. This development resulted from the orientation of venture capitalists, whose focus shifted into industries with less equipment needs (Venture finance: enhancing growth, 2004).
3.2 VENTURE LEASING VERSUS TRADITIONAL LEASING
Despite the same underlying idea, venture leasing and conventional leasing differ in several aspects, which will be discussed further. Table 4 summarizes the key differences between the financing options.
Table 4 Differences between venture leasing and traditional leasing
Venture Leasing Traditional Leasing Type of company Seed, Start-up Established
Basis for analysis Growth potential Stability
Deposit Typically none Often for non-investment grade
Performance covenants Typically none Generally yes for non- investment grade
Equity required Warrants None
Defaults/write offs Higher Lower
Source: Kleinman, R.T. The Statistics of Venture Lease Financing. 2003
The major difference lay in the relevant target group. Traditional leasing offers solutions for companies, which are already established in the market and generate profits. The target customers for venture leasing are young innovative companies with unsure cash flow streams.
While stability is important for conventional lessors when evaluating the deal, venture lessors view the company similarly as venture capitalists, concentrating on the growth potential of the
entrepreneur. In the case of the company going public, this potential is capitalized via exercising warrant options that are incorporated in the venture lease agreement.
To minimize risk and avoid defaults in payments, traditional lessors often call for security deposits from non-investment grade lessees. Additionally performance covenants, such as a certain debt to equity ratio, or limitations of further borrowing possibilities, may be required from the lessors’ side. Venture leasing providers, on the other hand, require neither security deposits nor any other specific covenants. The higher risk of venture leasing is also visible at default and write-off rates, which are significantly lower for traditional lessors than for venture leasing providers (Kleinman, Spring 2001).
3.3 VENTURE LEASING PROVIDERS
Venture leasing partnerships
Only a limited number of venture lessors possess enough capital to invest in ventures; in most cases venture leasing partnerships are created. Syndicated partnerships with a number of limited partners as well as individual investors contribute to this pool of money.
The structure of venture leasing partnerships is similar to classical venture capital partnerships. Venture lessors have the role of general partners; they charge the fund a management fee. The management fee may be calculated in two different ways: Either as a percentage of the capital committed by the fund (in which case it ranges between 1% and 3%), or as a percentage from the partnership’s gross revenue - reaching up to 5% (Lerner, 2001).
Besides, general partners also receive a so-called “carried interest”, a percentage of the profits ranging between 15% and 30% - the most common value is 20%. Lerner emphasizes that
“these funds are usually only received after the limited partners receive their annual investment back. It has become common to also provide for a minimum annual rate of return to the limited partners before the general partners begin receiving distributions” (2001 p. 3). The partnership structure is connected with high flexibility, since the small number of general partners may decide quickly and without bureaucracy. The main goal of the partnerships is to achieve sustainable returns over a long time.
There are two aspects in which venture capital partnerships and venture leasing partnerships differ: cash flow streams and the nature of investors. After providing capital for the entrepreneur, venture capital funds usually have to wait for a few years before realizing returns through an IPO or acquisition. Venture leasing funds, on the other hand, receive monthly income payments almost immediately after closing the deal. The payout structure of the partnership is therefore adjusted to distribute returns from the first year of operations.
Distributions are usually paid on a quarterly basis.
Venture leasing partnerships attract different investors than venture capital funds.
Limited partners in venture leasing are primarily individuals, in many cases former partners or chief executives of venture capital funds, who have experience in the relevant industries, and a few institutional investors, who invest substantially higher amounts (representing up to 80% of the funds’ sources). While individuals usually contribute to the fund by investing between
$250,000 and $5 million, institutional investors typically commit between $5 and $20 million (Western Technology Investment, 2006). Investors are attracted to venture leasing mainly by returns, which, even though lower than by venture capital, exceed the typical S&P 500 returns.
Another advantage of investments into venture leasing funds is a regular income stream from lease repayments. Venture leasing funds generate returns even when venture capitalists can’t exit deals due to weak public markets performance (Glynn, et al., 2003)
Most of the venture leasing providers have close links to a selected number of venture capitalists, and cooperation with venture leasing firms enables their companies to raise additional funds while the equity stake of the venture capitalist remains almost unchanged.
“Venture lessors, on the other hand, rely on the lead venture capitalists to monitor management through his role on the board and to provide them with accurate information about the firm’s prospects” (Lerner, 2001 p. 4).
The major venture leasing providers in the United States are6: - Dominion Ventures,
- Western Technology Investment, - Lighthouse,
- GATX,
- Sillicon Valley Bank.
6 See APPENDIX 2 for further details
Corporate leasing companies (Glynn, et al., 2003)
Within the leasing industries, independent leasing companies are well established players. Because of their tradition, they possess strong connections to capital markets plus fully equipped back offices. In order to expand their businesses many venture leasing companies entered the venture leasing industry, forming their own venture leasing divisions.
Bank loans, issuance of securities and the securitization of lease receivables are sources of corporate leasing companies’ capital. Via securitization, future financial receivables are grouped and sold onto investors.
The major disadvantage of corporate leasing companies over limited venture partnerships lies in their dependence on parental companies, which limits the flexibility.
Because of bureaucracy and unfamiliarity of general lawyers with the venture leasing industry, the venture lease process extends by several months. Additionally, the venture leasing divisions have to follow the overall corporate goals, which may change quite frequently. This may negatively influence the timing of venture leasing deals. Kanarowski emphasizes the importance of incentive systems in corporate leasing companies, arguing that this system “must avoid compensating sales personnel for short-term results” (2003 p. 5).
An example of a company that underestimated connected risks and concentrated only on potential profits is Comdisco, the most aggressive investor of technology start-ups in the 1990’s.
Because of their insufficient portfolio diversification in the venture leasing division Comdisco Ventures, and no due diligence before conducting investments, the company faced bankruptcy (The Wrong Move?, 2001).
Banks
Banks that have been involved with the venture capital backed companies and larger institutional banks take part in venture leasing transactions. Since they are very often establishing relationships with the entrepreneurs since the very beginning of their business
activity, banks are well positioned to offer additional services and support by further fund raising activities.
Banks are the least flexible providers of venture leasing since their lending practices are connected with strict and very complex approval procedures, mainly by larger sums. Start-ups are usually required to have a banking history by the bank, where they apply for venture leasing.
Besides, different provisions, such as a minimum balance in the account or allowances to sweep the company’s account in case of delay in payments, would be incorporated in the agreement.
Anurag Chandra from Lighthouse Capital comments on the attitude of banks in the venture leasing business: “Venture leasing is a territory that most banks are wary to enter because early stage companies just represent too much risk for traditional banks; such companies have no tangible assets against which to lend” (Venture finance: enhancing growth, 2004 p. 54).
3.4 OBJECTS OF VENTURE LEASING
Assets that are typically acquired through venture leasing include R&D equipment, building networks or production lines. Apart from tangible assets, patents, trade secrets or trademarks may be subjects of venture leasing, since they represent a resalable value.
In some cases venture leasing providers may possess older used equipment, which was captured from operations in classical leasing business. Instead of selling these assets on the market, the venture leasing provider may offer them to the start-up company as part of the venture lease. Acquiring used equipment saves a lot of costs to the young entrepreneur.
According to Mayer-Friedrich old equipment may represent up to 30% of the lease line. The remaining 70% would be purchased by the venture leasing provider. After the lease expires the company buys the equipment for 10-15% of the original costs (Mayer-Fiedrich, 2005).
Assets evaluation
Assets, that are subjects of the lease, have to be evaluated so that the extent, to which the assets may be resold in the future, is proven. While equipment valuation is based on technical
obsolescence and mobility of the assets, valuating intangible assets proves to be more challenging. Very often, subjective predictions of future profits from the patent have to be estimated. The intellectual property has to be evaluated alongside this. For example, the value of single patents is minimal compared to the evaluation of all the patents possessed by the company.
Sal Gutierrez, an investment partner of Western Technology Investments commented on how important collaterals are for the business. “The collateral usually determines the structure of the deal. For example, if a company needs growth capital and it does not have enough collateral in equipment or other hard assets, Westech may decide to shorten the term of the lease and ask for more warrants. We can also ask for all the intellectual property of the firm collateral” (Western Technology Investment, 2006 p. 6).
3.5 ADVANTAGES OF VENTURE LEASING
Venture leasing has numerous advantages for all the parties involved. The aim of this section is to summarize main advantages venture leasing brings for the lessee, the venture lessors and the lead venture capitalist, who provided the first round financing .
Advantages for the entrepreneur:
- access to additional funds without giving up large equity stakes,
- fund may be raised even when traditional debt financing isn’t accessible, - funds raised via venture capital may be used for developing the core activities, - the leased asset required as the only collateral,
- possibility to move the obligations “off the balance sheet”.
“Off the balance sheet” financing is an accounting technique in which lease obligations do not show as assets or liabilities in the balance sheet of the company. The possibility to move the transaction off the balance sheet depends on if the lease is considered financial or operating7.
7 An operating lease is usually a shorter-term lease under which the lessor is responsible for insurance, taxes, and upkeep. The lease may be cancelable by the lessee on short notice. A financial lease, on the other hand, is typically a longer-term, fully amortized lease under which the lessee is responsible for maintenance, taxes, and insurance.
Usually, a financial lease is not cancelable by the lessee without penalty. The accountants often call financial leases capital leases (Ross, 2003)
In order to move the transaction off the balance sheet, the lease must be classified as an operating lease according to both IFRS and US GAAP. Financial leases are capitalized and show on the balance sheet. There are several conditions that have to be fulfilled in order to keep the transaction off the balance sheet. The Financial Accounting Standards Board (FASB) in the United State defines financial leases as those that meet any of the following requirements (Brealey et al., 2003):
- The lease agreement transfers ownership to the lessee before the lease expires.
- The lessee can purchase the asset for a bargain price when the lease expires.
- The lease lasts for at least 75 percent of the asset’s estimated economic life.
- The present value of the lease payments is at least 90 percent of the asset’s value.
All other leases are operating leases as far as the accountants are concerned and may be moved off the balance sheet. When using the off balance financing, the company does not have to show the leased equipment as an asset or list the payments to the lessor as liabilities, which prevents dilution of key financial ratios such as the debt to equity ratio and the return on equity ratio. These financial ratios are essential when evaluating the company prior to an IPO, which is largely based on the strength of company’s balance sheet. Therefore, structuring the venture lease as an operating lease is an advantage mainly for companies that are contemplating for an IPO.
Advantages for the venture lessors:
- the lease is fully repaid in two to four years only and is secured by the underlying equipment;
- above average returns.
Advantages for the lead venture capitalists:
- committing less capital without an impact on the company’s development plans, - provided capital used on core activities and not on assets that quickly lose on value, - additional funds for the company without dilution of the equity stake owned by the
venture capitalist,
- generating higher returns8.
8 sSee chapter “Venture Leasing versus Venture Capital“ for details
3.6 VENTURE LEASING DEAL EVALUATION
When evaluating the attractiveness of a venture leasing deal, a venture lessor looks at three main criteria:
- venture capital provider, - management team,
- business plan including cash flow projections.
The quality of the venture partner is the most important criteria when evaluating the deal.
The level of VC investor’s commitment is strongly connected with the amount of funds invested by the start-up. Since a venture lease usually relies on future funding to cover the ongoing payments, the investor should be strong enough to continue supporting the company at later stages (Glynn, et al., 2003).
In a way, the providers of venture capital gain also from transactions of venture leasing.
The company may invest all of the funds raised into developing a product or service and innovate instead of using said funds on equipment, which quickly loses value.
Another important factor is the management team. The main criteria to assess a good management team is its prior experience in the relevant industry, where the company is operating. Western Technology Investments, one of the major venture leasing providers in the United States, makes exceptions to this rule only in cases where “a reputable venture capital investor is expected to hire a CEO and CFO to run the company”, which is a sufficient guarantee of the management quality (Western Technology Investment, 2006 p. 5).
The third aspect of deal evaluation is the business plan. The venture lessor examines the business model of the company and its market potential. Even though strong and reputable venture capitalists, who conducted the due diligence of the venture, serve as a certain guarantee for the venture lessor, independent evaluations are necessary. The due diligence process which starts after the general conditions are agreed upon usually takes around 8 weeks (ETV Capital).
Many venture lessors use the start-up’s projected cash consumption rate to measure connected risks. It determines how long the start-up can last before a new round of equity is required. The lessor views a transaction as less risky if the start-up can make full payments
during a significant portion of the lease term without raising additional equity. Most lessors look for a ratio that supports at least 9 to 12 months of the start-up’s operation (Parker, 2004).
Besides these three general factors, each venture leasing company has its own additional criteria for deal assessment. The European leading venture lessor - Kreos Capital (formerly known as European Venture Partners) uses three additional criteria. Maurizio Petit Bon, general partner of Kreos Capital, explains that the company would “act as a co-financer only with venture capital groups, never as a sole source of funding; it will only provide leases for general purpose, rather than customized, equipment; and its venture leases cannot be used for
‘leasehold’ improvements, such as alterations to a building’s fabric” (UK Venture Capital Journal, 1999).
Aberlyn Capital Management, an American venture leasing provider, developed its own way of measuring connected risks (Aberlyn Capital Management: July 1993, 1997). It only invested in companies that have already received two rounds of venture capital financing,.
Besides, potential lessees were evaluated on a five-level scale, which reflected the likelihood of default payments and helped diversifying the portfolio9. Graph 3 shows the participation of each class on the overall portfolio, Class 1 being the riskiest and Class 5 containing the least risky companies. Aberlyn also required observation rights in the companies, to lower risks after the contract was signed.
9 See APPENDIX 3 for the diversification criteria details
Class 1 10%
Class 2 35%
Class 3 35%
Class 4 15%
Class 5 10%
Graph 3 Structure of Aberlyn’s portfolio
Source: Aberlyn Capital Management, Harvard Business Review
3.7 DEAL COMPONENTS
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. Figure 5 shows five components that have to be defined within a venture lease agreement.
Lease duration
The duration of the lease agreement refers to the length of the commitment. In most cases, the lease term is between 24 and 48 months. The longer the agreement, the higher the risk for the venture lessor, because of missing cash flow guarantees. According to Kleinman, the most common lease term is 38 months (representing 49% of the deals) and the average lease term was 40,4 months (Kleinman, Spring 2001). The length of the lease is also dependent upon the industry where the company operates. For example, typical leases in the biotech or life sciences industries, where the business development takes longer time, often extend beyond 48 months (Glynn, et al., 2003 p. 8).
Commitment amount
The second important component is the maximum amount a company can lease. The sum may be used either at once, or the company gets a yearly limit for equipment leasing. In
Commitement amount
Duration
Warrant coverage Monthly
payments Ballon payment
Figure 5 Venture lease components
Source: Author
case the firm does not use all the funds provided by the venture lessor, the interests and monthly payment will be adjusted accordingly. However, no changes are made to the warrants coverage.
The size of the loan provided by venture lessors is dependent on the size of venture capital raised by the entrepreneur thus far. Venture leasing providers are generally willing to lend between 20% and 40% of the venture capital investments (Worrell, 2003).
With the development of venture leasing, the size of the deals is growing - enabling current start-up companies to raise more funds than in the past. In his research from 2001, Kleinman identifes 45 venture leases ranging between $100,000 and $1,5 million (Kleinman, Spring 2001). Recently the scope of deals has increased, enabling companies to lease equipment to around $10 million (Parker, 2004), should they fulfill all the criteria. Still, some companies may have to look for more venture-leasing firms to meet all their needs. For example, two or three lessors might be needed to cover a $15 million equipment lease.
Monthly repayments
Fixed monthly payments represent the third important factor. The payments do include both the principal payment and an interest rate, which is commonly based upon a spread above the prime rate. The spread reflects the riskiness of the investment perceived by the venture lessor as well as competitive alternatives available to the customer. The most common interest rate is between 3-8% above the prime rate (Lerner, 2001). The deal is structured in a way that at the start, the payments consist mainly of interest payment, while the equipment is repaid rather in later stages of the process (see Figure 6; p. 38).
A monthly lease payment is determined by a lease rate factor. A lease rate factor is the lease payment as a percent of the total cost of the leased equipment or software. Stated in another way, when multiplying the lease rate factor by the cost of the leased equipment or software, the result equals the periodic lease payment. Typically, the lease rate factor lays between 2,5% and 3,5%.
