"The Rise of Venture Leasing"
Reprinted from The Monitor, November/December 1998

Over the past decade, venture leasing has grown from a rather small, highly fragmented, niche market into an important growth segment for specialized lessors and skilled lease originators.

By George A. Parker

Exactly what is venture leasing? What has fueled its growth during the 1990's? Why has this segment of leasing become so active? To answer these questions, one must look at several developments during this decade to appreciate the rise of this important niche within the equipment leasing landscape.

The term venture leasing describes the leasing of equipment to pre-profit, early stage companies funded by venture capital investors. These companies, like most growing businesses, need computers, networking equipment, furniture, telephone equipment, and equipment for production and R&D. Venture capital backed startups rely on the continued funding from outside investors to support them until their business models are proven or profitability is achieved. According to Pricewaterhouse Coopers, investment by institutional venture capitalists in startup companies grew from less than $3.0 billion at the beginning of the 1990's to a record annualized rate estimated at over $13.0 billion for 1998. More than 3,000 high growth startup companies in the U.S. will receive venture capital funding this year alone. What is fueling this rapid growth? It's a combination of many factors, including: continued economic expansion, a long running bull market for stocks, abundant entrepreneurial talent, new exciting technologies, and government policies favoring venture capital formation and free enterprise. In this environment, a sizeable pool of venture capital has been formed to launch and support the development of many new technologies and business concepts. Additionally, an elaborate array of support services has developed to promote the growth of startups. CPA firms, banks, attorneys, investment banks, consultants, lessors, and even search firms have committed significant resources to this emerging market segment.

Where does equipment leasing fit into the venture financing mix? The answer lies in the relatively high cost of venture capital versus venture leasing. Financing new ventures is a high risk business. Venture capitalists generally receive a sizeable equity stake in the companies they finance to compensate them for this risk. They typically seek an investment return of at least 35% on their unsecured, non-amortizing equity investments. Their return is achieved via an IPO or other sale of their equity stake within four to seven years. In comparison, venture lessors seek a return in the 15% - 22% range. These transactions amortize in 2 to 4 years and are secured by the underlying equipment. Although the risk to venture lessors is also high, the risk is mitigated by having equipment as security and having an amortizing transaction. Appreciating the obvious cost advantage of venture leasing over venture capital, startup companies have turned to venture leasing as a significant source of funding to support their growth. Additional advantages of venture leasing to new ventures include the traditional leasing strong points --- conservation of cash for working capital, management of cashflow, flexibility, supplement to other credit sources, to name a few. Although actual figures are not available, this writer estimates that well over $500 million in lease financing is provided annually to venture capital backed startups in the U.S. by various lessors and equipment financing sources (including vendors, lessors, finance companies and banks). This figure has the potential to be much higher since many venture capital-backed startups still finance a significant part of their equipment needs with relatively expensive venture capital.

How can newcomers to the venture leasing segment participate successfully? First appreciate the high risk nature of venture leasing and approach this market with caution. Next, determine whether you are physically accessible to an active geographic region for venture capital-backed startups. If so, introductions to these companies can be achieved by networking with local VCs, bankers, CPAs, attorneys, and chambers of commerce. Additionally, many active regions for venture capital-backed startups have associations that promote capital formation and networking. Conferences, seminars and luncheons dealing with emerging technologies, securing venture financing, going public, all typify endeavors of supportive venture organizations in regions active with new ventures. Next, a little self-evaluation of one's skill set and patience is in order. It is imperative that the lease originator becomes familiar with the lessor's basic credit requirements, transaction structures, and pricing for venture lease transactions so that the transactions can be funded successfully. The ability to apply a dash of traditional credit skills with a large splash of qualitative analysis and common sense is deriguer for the venture lease originator. Factors to be evaluated before a deal is closed include: the caliber of the management team, quality and support of the venture capitalists, underlying business concept and market, liquid capital compared to cash burn rate, and the collateral value of the equipment to be leased. Generally, funding sources (primarily venture lessors) that specialize in financing venture lease transactions can help lease originators and brokers evaluate prospective venture lessees in each of these important credit areas, and help structure and price the transaction.

How does a 'good' venture lease transaction look? As mentioned earlier, two of the main ingredients of a successful new venture are the caliber of its management team and the quality of the venture capitalists. In many cases the two groups seem to find one another. A good management team has usually demonstrated prior successes in the field in which the new venture is active. Additionally, experience 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 also have successful track records and direct experience with the type of companies being financed. The best VCs have developed some degree of industry specialization and many have individuals in house with direct operating experience within those industries. The amount of capital funded by the VCs and the amount allocated for future rounds to the startup is important. An otherwise good VC group that has exhausted allocated funding for the venture can be problematic.

After determining that the caliber of the management team and venture capitalists is high, a look at the business model and market potential is in order. It's unrealistic to expect expert evaluation of the technology, market, business model and competitive climate by lessors and lease originators, especially those new to the venture leasing market. Here is where a little common sense goes a long way. One should presume that good venture capitalists have done a professional job of evaluating these factors in their 'due diligence'. Although most venture lessors rely heavily on the thorough due diligence of a respected VC, there's still room for the credit trained lease originator to undertake an independent evaluation. Does the business plan make sense to you? What is the product/ service, who is the targeted customer, how large is the potential market? How is the product/service priced, what are the projected revenues? What does it costs to be made or produced, what are the projected expenses? Do these projections seem reasonable or overly aggressive? How much cash is on hand, how long will it last according to the projections? When will the next equity round be needed? These, and questions like these, help determine whether the business plan and model are reasonable. It actually helps if one is not very familiar with the industry--- there should be no fear in asking very basic questions that others that are familiar might feel too embarrassed to ask.

The most basic credit question for the lessor/ lease originator is whether there is sufficient liquidity or cash on hand to support the startup through a significant part of the lease term. If no more venture capital is raised and the venture runs out of cash, the lessor is not likely to collect lease payments. If this situation is not quickly resolved, the primary source of repayment is through repossessing and liquidating the equipment--- not a pleasant thought. To mitigate this risk, most experienced venture lessors look for nine months or more of cash or other liquid assets on hand in considering venture lease transactions. In the typical three year venture lease, if 30% or more of the investment is recoverable from cash on hand and another 40% from the collateral, then the risk has been limited to 30% or less. Assuming that the amount of liquid assets relative to the burn rate can be assessed, some effort in evaluating the equipment liquidation value at various points during the lease is in order. It pays to be conservative and realistic concerning asset liquidation values. Most lessors are not skilled retail remarketers of equipment. The quick sale value is more the norm than the exception. There is no one set of credit criteria that's applicable to all venture lease transactions. Though several venture lessors use some rules of thumb, the methodology is what's important.

Assuming a good prospective venture lease transaction has been uncovered, how does one get it funded? Part of the infrastructure supporting venture capital-backed startup companies is a handful of national leasing companies that specialize in venture leasing transactions. These firms are experienced in structuring, pricing and documenting transactions, performing due diligence, and working with startup companies through their ups and downs. The better venture lessors help lease originators respond quickly to lease proposal requests, expedite getting the credit review process completed, and work closely with prospects to get documents executed and the equipment ordered. Most venture lease transactions are set up under lease lines of credit so that the lessee can have multiple takedowns during the year. These lines typically range from as little as $ 200,000 to over $ 5,000,000 depending on the prospects' needs, projected growth and the level of venture capital support. The better venture lease funders also can assist customers, either directly or indirectly, in identifying other resources to support their growth. Help with acquiring equipment at better prices, takeouts of existing equipment, finding additional venture capital funding, working capital credit lines, factoring, temporary CFO's, introductions to potential strategic partners-these are all value-added services the best venture lessors bring to the table.

What's the outlook for venture leasing? Venture leasing has really come into its own during the 1990s. With several billion dollars of venture capital being pumped into startups annually, this market segment has evolved into a significant one for the equipment leasing industry. In the two largest market regions for venture capital-backed startups-- Silicon Valley and Boston-- competition to finance these companies on every level is fierce, including the equipment leasing segment. In other parts of the country, the story is quite different. Smaller upcoming regions like Research Triangle, NC, Phoenix, Atlanta, Austin, TX, Boulder, CO, Northern VA, San Diego, and Silicon Alley, NY are more fragmented and underserved. There are good opportunities in these regions for lease originators who have ready geographic access, good skills, and who are willing to become active in venture leasing. The most attractive industries where venture leasing opportunities seem to abound include software, telecommunications, information services, medical services and devices, biotechnology, and internet.

Will the recent turmoil in the credit markets and IPO market impact venture leasing? If these developments are relatively short lived, the answer is probably not. Although the securitization market has tightened and a few large banks have reacted with caution to the recent turmoil in the credit markets, venture leasing has not been noticeably impacted. What would impact venture leasing, though, is a prolonged downturn in the stock market and/or shunning of venture capital backed companies looking to undertake IPOs. Since the IPO avenue is the exit strategy of choice and the route to the best returns for most VCs, this industry driver plays an important role in the ongoing growth of venture capital-backed companies. Without an active and receptive IPO market, VC returns would shrink making investments by pension funds, large money managers and other investors in VCs less attractive. Fewer startups would get venture capital, and hence, there might be fewer venture leasing opportunities. Fortunately, the intermediate and long term IPO outlook for venture capital-backed companies continues to look promising. Despite the recent turmoil in the credit markets, demand for venture leasing remains strong. If anything, the activity has increased and shows signs of continuing that trend into the foreseeable future.

George Parker is a director and executive vice president of Leasing Technologies International, Inc. located in Wilton, CT. He is responsible for overseeing the company's marketing and financing efforts. One of the co-founders of LTI, Mr. Parker has been involved in equipment leasing for over 18 years. Founded in 1983, LTI is a leasing firm specializing nationally in venture leasing for early stage companies and vendor lease programs for emerging growth companies.