Venture Leasing: Financing for start-ups on the rise
According to Pricewaterhouse Coopers, investment by institutional venture capitalists in startups grew from less than $3.0 billion in the early 1990s to more than $106 billion in 2000. Although the volume of venture capital has shrunk significantly since the economic “bubble” years of the late 1990s, the current volume of about $19 billion per year still represents a substantial growth rate. Venture capitalists will fund more than 2,500 high-growth startups in the US this year.
The growth of venture capital investment has given rise to a relatively new and expanding area of equipment leasing known as “venture leasing.” What exactly is venture leasing and what has fueled its growth since the early 1990s? Why has venture leasing become so attractive to venture capital-backed startups? To find answers, one must look at several important developments that have fueled the growth of this important equipment leasing segment.
The term venture leasing describes equipment financing provided by equipment leasing companies to for-profit early-stage companies financed by venture capital investors. These startups, like most growing businesses, need computers, network equipment, furniture, telephone equipment, and equipment for production and R&D. They rely on the support of outside investors until they prove their business models or achieve profitability. Driving the growth of venture leasing is a combination of several factors, including: renewed economic expansion, improvement in the IPO market, abundant entrepreneurial talent, promising new technologies, and government policies that favor venture capital formation.
In this environment, venture investors have formed a sizeable pool of venture capital to launch and support the development of many new technologies and business concepts. In addition, a variety of services are now available to support the development of new businesses and promote their growth. CPA firms, banks, lawyers, investment banks, consultants, lessors, and even search firms have devoted significant resources to this emerging market segment.
Where does equipment leasing fit into the venture financing mix? The relatively high cost of venture capital versus risk leasing tells the story. Financing startups is a high-risk proposition. To compensate venture capitalists for this risk, they typically require a sizeable equity stake in the companies they finance. They typically seek investment returns of at least 35% on their investments over five to seven years. Your return is achieved through an initial public offering or other sale of your equity interest. By comparison, risky lessors are looking for a return in the 15% – 22% range. These transactions pay for themselves in two to four years and are secured by the underlying equipment.
Although the risk for risky lessors is also high, risky lessors mitigate risk by holding a security interest in the leased equipment and structuring transactions that amortize. Appreciating the obvious cost advantage of venture leasing over venture capital, start-ups have turned to venture leasing as a major source of financing to support their growth. Additional advantages of start-up leasing venture include the strengths of traditional leasing: conserving cash for working capital, cash flow management, flexibility, and serving as a supplement to other available capital.
What makes a risky lease transaction ‘good’? Risk lessors look at several factors. Two of the main ingredients of a successful startup are the caliber of its management team and the quality of its venture capital backers. In many cases, the two groups seem to meet. A good management team usually has demonstrated previous success in the field in which the new company is active. In addition, they must have experience in key business functions: sales, marketing, research and development, production, engineering, and finance. Although there are many venture capitalists who finance startups, there can be a significant difference in their skills, staying power, and resources. The best venture capitalists have successful records and direct experience with the type of companies they finance.
The best VCs have industry specialization, and many have staff with direct operating experience within the industries they fund. The amount of capital that a venture capitalist allocates to the startup for future rounds is also important. A good venture capital group that has exhausted its allotted funding can be problematic.
After determining that the caliber of the management team and venture capitalists is high, a venture lessor analyzes the startup’s business model and market potential. It is unrealistic to expect expert assessment of the technology, market, business model, and competitive climate from equipment leasing companies. Many leasing companies rely on reputable, experienced venture capitalists who have evaluated these factors during their “due diligence” process. However, the lessor has yet to perform a meaningful independent assessment. During this evaluation he considers questions such as: Does the business plan make sense? Is the product/service necessary, who is the target customer and how big is the potential market? How are the products and services priced and what are the projected revenues? What are the production costs and what are the other projected expenses? Do these projections seem reasonable? How much cash is available and how long will the start-up last according to projections? When will the startup need the next round of capital? These, and questions like these, help the landlord determine if the plan and business model are reasonable.
The most basic credit question facing a leasing company considering leasing equipment to a startup is whether there is enough cash on hand to support the startup for a significant portion of the lease term. If more venture capital is not raised and the business runs out of cash, the lessor is unlikely to collect the lease payments. To mitigate this risk, more experienced venture lessors require that the startup have at least nine months or more of cash on hand before proceeding. Typically, venture lessor-approved startups have raised $5 million or more in venture capital and have yet to exhaust a good portion of this amount.
Where do startups turn to finance their leases? Part of the infrastructure supporting venture startups is a handful of national leasing companies that specialize in venture leasing transactions. These firms have experience structuring, pricing and documenting transactions, conducting due diligence, and working with startups through their ups and downs. The best venture landlords respond quickly to requests for lease proposals, expedite the credit review process, and work closely with new businesses to execute documents and order equipment. Most venture landlords provide leases to new businesses under lines of credit so the lessee can schedule multiple teardowns throughout the year. These lease lines typically range from $200,000 to over $5,000,000, depending on the need of the start-up, projected growth, and the level of venture capital support.
The best venture leasing providers also directly or indirectly help clients identify other resources to support their growth. They help the startup acquire equipment at better prices, arrange takeouts of existing equipment, find additional working capital funding, locate temporary CFO’s, and provide introductions to potential strategic partners— these are all value-added services the best venture lessors bring to the table.
What is the outlook for venture leasing? Business leasing has really come into its own since the early 1990s. With venture capitalists pouring tens of billions of dollars into startups annually, this market segment has become an attractive one for the leasing industry. of Equipements. The most attractive industries for business leasing include life sciences, software, telecommunications, information services, medical devices and services, and the Internet. As long as the factors supporting new business formation remain favourable, the outlook for business leasing remains bright.