Venture leasing can give new companies a head start on equipment
Ed Bartlett brought his Harvard Business School training to his new job as president of a start-up company. And he brought eight years of experience with big-company finance. But he didn't bring any illusions. He knew the long list of financing options available to an established company would be quite a bit shorter at Nationwide Remittance Centers Inc. (NRC). He just didn't realize what living with a short list would be like. Talking to one financier, he remembers, "was like dealing with a hit man at the end of the dock."
Few start-ups will escape the "give-up-an-arm-and-a-leg" school of finance. They're just too risky. But lately some have been discovering that the list of alternatives is growing. Bartlett, a 42-year-old convert to small-company life, is using a new, little-known financing technique called venture leasing. Venture lessors rent equipment to brand-new companies in return for a pricey rental rate and a slice of the company's equity.
While those aren't exactly bargain-basement terms, they're better than no terms at all. Banks and traditional leasing companies won't deal with start-ups. Or they require such customers to put down a large cash deposit -- 30% to 70% of the price of the equipment. That, of course, raises the cost of leasing enormously. More important, it ties up capital that is almost always desperately needed someplace else in the business.
In contrast, venture lessors' charges are relatively painless: a buried interest rate at least two percentage points higher than an established, creditworthy company would pay and an equity stake that is usually less than 2% of the company.
There is a catch, though. Most venture lessors will lease only to companies that have already been financed by venture capitalists. That way, they figure, they're more likely to get a customer that is well funded and well managed. But some will make exceptions, and their number may increase as the industry grows.
Back in early 1987, when Bartlett was looking for lease financing, NRC had two venture backers and a business plan, but not much else. Getting some kind of leasing arrangement was critical. First, Bartlett wanted to hold onto the precious $2 million of venture capital cash he had raised. At a total cost of about $500,000, the equipment he needed would chew up a quarter of it.
Second, NRC's entire operation depended in large part on its equipment -- 25 Data General minicomputers. NRC's business is to collect money for companies faster than they can collect it themselves. For example, to help an insurance company gather the premium payments that its customers send in from all over the country, NRC accelerates two processes: the time that a check spends traveling through the mail and the time it takes to clear through the banking system. The minicomputers, to be installed in 25 banks around the country, were essential to the second part of NRC's service. And, of course, the equipment had to be in place before NRC could begin to take on customers.
Initially, Bartlett tried to get Data General to finance the computers. After all, who would be better motivated to make a deal? But no dice. To do its analysis, DG used a Citibank program that evaluates potential lessors on their cash flow. NRC, of course, had none.
Next stop, venture lessors. Of the handful of companies doing venture leasing at the time, Bartlett liked San Francisco-based Dominion Ventures Inc. best. Geoffrey Woolley, managing general partner at Dominion, describes himself as 80% venture capitalist. "You don't take the risk on the leasing side of the business. You take the exact same approach that a venture capitalist does," he says.
Not that the equipment in question doesn't matter. Dominion didn't turn cartwheels over NRC's choice of Data General computers, for example. "Although DG is known as a good hardware company, its reputation is weak when it comes to software and service," Bartlett explains. DG computers are likely to be worth less at the end of NRC's lease. So Dominion forecast a lower "residual value" for the gear, which raised the cost of the lease financing.
NRC's total leasing costs were also higher than they had to be because, eager to get the business started, it had bought the computers before it struck a deal with Dominion. That meant it had to sell the computers to Dominion before it could lease them. This sale/lease-back feature required NRC to pay the sales tax on the computers twice -- a $25,000 expense -- and to take a $78,000 loss on the sale of the equipment to Dominion. It would have been cheaper and less of a paperwork nightmare to let Dominion buy the machines in the first place.
Here's how the deal worked: Dominion offered NRC a $750,000 lease line, which could be drawn on during a four-month period. After four months the $500,000 that NRC used turned into a loan, to be repaid over the course of three years.
And how much did that cost? Here's where things get a bit tricky. In order for the lessors to take advantage of certain tax breaks, they must talk in terms of leases, not loans, and of rental rates, not interest rates. NRC's rental rate is 3.38% per month. Each monthly rental payment includes both interest and principal, like a mortgage payment. To figure out how much it's costing just to borrow the money, you must calculate the lease's implicit interest rate, so called because it's embedded in the set of terms -- rent rate, duration, lease amount -- that govern the lease. NRC's lease, for example, has an implict annual interest rate of 13.22%.
NRC gave up 0.86% in equity, about average for a venture lease. But Dominion didn't get outright ownership. NRC gave it warrants worth 15% of the lease line, or $112,500. Called "warrant coverage," this percentage typically falls between 10% and 30%. To figure out how much of the company those warrants will buy, of course, NRC and Dominion had to set an exercise price and expiration date. In this case, as with most such deals, the price -- $1.50 -- was mostly determined by how venture capitalists valued the stock in the most recent round of capital raising. On the other hand, NRC haggled a bit over the expiration date, finally settling on 1995.
Though Bartlett doesn't consider it cheap, his venture lease has proved to be far more essential than he expected. Because the U.S. Postal Service hasn't moved as quickly as NRC expected in instituting a new mail service, the company hasn't been able to fully implement its own service. That means that after three years and two rounds of venture capital, NRC has just about reached the bottom of the barrel. "We'd be running out of money now if we hadn't done the venture lease," says Bartlett.
Who's who in venture leasing
Venture lessors come from all walks of life. Some emphasize the venture side of the business, others the leasing. Some specialize in one kind of equipment, others are generalists. Fortunately, the industry is still so small that you can talk to all the major players. Here they are:
Comdisco Inc., Rosemont, Ill.; (312) 698-3000. Contact Jim Labe, director. Leases include office furniture and semiconductor, medical, computer, and telecommunications equipment.
Dominion Ventures Inc., San Francisco; (415) 362-4890. Contact Geoffrey Woolley, general partner. Leases include office furniture and electronic-testing, laboratory, and telecommunications equipment.
Equitec Leasing Co., Oakland, Calif.; (415) 430-9900. Contact William Couden, president. Leases include office furniture and manufacturing, electronic-testing, and selected computer equipment.
Fairfax Financial Group, Fairfax, Va.; (703) 876-5560. Contact Greg Eden, president. Leases include laboratory, data-processing, and telecommunications equipment.
John Hancock Leasing Corp., Hayward, Calif.; (415) 886-2556. Contact Richard Lapin, director of venture leasing. Leases include office furniture and computer, software, production, and testing equipment.
Linc Venture Lease Partners, Chicago; (312) 467-5500. Contact Martin Zimmerman, president. Specializes in health-care and high-technology equipment.
Phoenix Venture Inc., San Rafael, Calif; (415) 485-4500. Contact Norman Nelson, senior vice-president. Leases include office furniture, computer and medical equipment.
Technology Funding, San Mateo, Calif.; (415) 345-2200. Contact David Titus, vice-president. Leases all standard equipment.
Western Technology Investment, San Jose, Calif., (408) 436-8577. Contact Ronald Swenson, president. Leases include computers, R&D, testing, and biotechnology equipment.
For everything else you want to know about the industry, consult the new 50-page research report from Venture Economics, "Venture Leasing," by Lloyd Mintz, $495. To order, call (617) 449-2100.