Venture
Leasing: The Other Venture Capital
By
Jay Hollander
Jay Hollander, Esq. is the principal of Hollander and Company LLC, www.hollanderco.com, a New York City law firm concentrating its efforts in the protection and development of property interests relating to real property, intellectual property and commercial interests, as well as related litigation.
The content of this article is intended to provide general information relating to its subject matter. Providing it does not establish any attorney-client relationship and does not constitute legal advice. Personal advice in the context of a mutually agreed attorney-client relationship should be sought about your specific circumstances. Summary: "Venture
leasing" is a creative vehicle that allows start-up companies
to finance certain infrastructure and equipment needs.
The practice has financial advantages, but it also carries
some risks. This article explains what venture leasing
is and how it works.
Introduction
It's
no secret that the lifeblood of any early stage company is
venture-capital financing. Without it, there is no cash to
burn and no financial muscle to grow a company to profit or
IPO.
Historically
less well-known, however, has been an additional vehicle
for financing certain infrastructure and equipment needs
that has allowed venture-stage companies to simultaneously
cut down on their cash burn rates, focus their equity capital
on their core business needs and often increase their valuations
for IPO purposes.
This
vehicle, known as venture leasing, is a financing device
for early stage companies that had been used relatively
rarely in years past, but has picked up considerable popularity
in the last couple of years, coinciding with the explosion
in IPOs in the late '90s.
Still,
as we shall see, the use of this device is not for everyone.
There are requirements that companies contemplating this
type of financing should be prepared to meet and there
are decisions to be made concerning the terms of such financing
that early stage companies need to be aware of before electing
to use it.
What
Exactly is Venture Leasing?
So,
what exactly is venture leasing? Simply, it is a hybrid
of traditional leasing and venture capital meant specifically
to address a certain market segment: the early stage company
that has gotten a first round of venture capital financing,
has its eye on an eventual IPO and wants to conserve as
much equity-based venture capital as it can without diverting
it to costs for equipment and infrastructure and without
having to further dilute equity positions by seeking additional
venture capital.
In
a typical venture-leasing transaction, the lessor will
lease equipment such as computers and software to early
stage companies at a certain interest rate for three to
four years. The lessors will also customarily seek warrants
for stock in addition to the lease payments, a back-end
compensation intended to compensate the lessor for the
additional risk in lending to a new company that would
otherwise find it impossible to qualify for conventional
bank or leasing firm financing.
For
the early stage company, there are many benefits to such
an arrangement. First, as noted above, if the lease is
properly structured, there is a substantial savings in
cash that the company might otherwise have to spend to
purchase the leased assets. This helps in several ways.
Not only does it allow the company to use previously obtained
venture-capital money for core purposes such as research
and development, sales and marketing, it also can prevent
company founders from having to give up substantially more
equity if further resort to venture capital would otherwise
be required to fund these purchases.
Second,
venture leasing provides a source of financing when a company
doesn't qualify for bank or traditional leasing financing
or when additional venture capital may either be unavailable
or trigger unwanted penalties in the original venture-capital
agreement.
Third,
venture leases typically only require the leased asset
as the sole or primary collateral for the lease, as opposed
to a commitment of all of a company's assets.
Another
benefit of venture leasing is in flexibility, if the entrepreneur
chooses wisely. In negotiations with a venture lessor,
the giving of company warrants with a suitable exercise
price as part of the compensation for the lease can result
not only in a lower interest rate overall but also lower
payments at the outset, when cash might be shortest.
For
early stage companies that have already acquired assets
and are looking to obtain some more cash without going
back for more venture capital rounds, venture leasing can
also accommodate "sale/leaseback" arrangements, giving
a start-up a way of drawing working capital out of assets
it already owns by selling them in exchange for a cash
infusion and a lease of the same assets.
"Off
the Balance Sheet"
Perhaps
most importantly, if properly structured, the entire venture
lease obligation can be done "off the balance sheet," an
accounting technique in which lease obligations to acquire
assets do not show up as assets or liabilities on a firm's
balance sheet.
This
method of structuring venture leases can be a very valuable
tool for companies, especially those contemplating an IPO.
The simple reason is that, for financial reporting purposes,
off-balance-sheet financing does not require the company
getting the equipment to list the equipment as an asset
or to list payment obligations to the lessor as liabilities
on the company balance sheet. This avoids dilution of a
company's key financial ratios such as the often-consulted
debt-to-equity and return-on-equity ratios.
Especially
in today's more stringent market for IPOs , a company's
valuation will largely be based on the strength of its
balance sheet. In this analysis, higher multiples are given
to companies whose balance sheets show significant free
cash, unencumbered by corresponding liabilities.
Care
must be taken here, however, since accounting regulations
have limited this off-balance-sheet structure to certain
types of cases where the lease can be structured to meet
the accounting requirements for an "operating lease," considered
a long-term rental as opposed to a method of financing
the purchase of the assets.
To
qualify as an operating lease under the pertinent Financial
Accounting Standards Board (FASB) rules, the transaction
must avoid meeting any of the following tests:
-
Automatic
transfer of ownership at lease end A guaranteed/fixed
price option for asset purchase A term greater than or
equal to 75% of the unit's useful life
-
The
present value of the minimum lease payments are greater
than or equal to 90% of the asset's fair market value
The
Prime Candidates for Venture Leasing
Obviously,
there are substantial benefits to venture leasing. Still,
it's not for everybody and companies interested in the
possibility of using this vehicle should think about it
when they first sit down with their lawyers, even before
seeking out venture capitalists for their first round of
financing.
The
reason for this has to do with how venture-leasing companies
evaluate the risks of early stage companies with whom they
consider doing business. Since, by definition, the clients
for such leasing deals are risky start-up companies, venture-leasing
firms also do their due diligence, just like venture capital
firms. Understandably, venture-leasing firms want to have
some comfort that the company will have secure cash flow
for most of the lease term and that the company has a decent
shot at profitability and/or an IPO.
Nevertheless,
such leasing firms are not in a position to undertake the
costs of a full-blown due-diligence procedure, so they
normally also look at the strength of the venture-capital
firm that first funded the company. Specifically, they'll
be interested in the venture-capital firm's reputation,
its financial commitment to follow-on financing of the
start-up company, as well as the valuations it placed on
the company, whose warrants will likely make up part of
the leasing compensation.
Like
traditional venture capitalists, venture leasing firms
will also carefully evaluate the start-up company's management
team and available cash, to give them confidence in the
prospects of success of the venture.
So,
prime candidates for venture leasing are start-ups with
strong management teams, substantial cash on hand from
a completed first round of venture capital, with either
commitments or good prospects for follow-on financing,
and a reasonable path to profitability and/or an IPO.
The
Basic Terms and Conditions
Since
venture leasing is a flexible creature, the specific terms
of the deal will vary from case to case, in terms of the
length of the lease, the structuring of the lease payments,
the amount of warrants to be given and whether the transaction
will be on or off the balance sheet.
There
are, however, certain basics.
Generally,
title to the assets will remain in the lessor with significant
buy-out cost at the end to avoid accounting interpretations
of the transaction as a purchase to be amortized, rather
than an operating lease allowing payments to be treated
as an expense.
As
a result, depreciation of the equipment will remain with
the lessor, a tax benefit to the lessor that would not
be as valuable to the presumably unprofitable start-up,
and a benefit that can be shared with the lessee through
reduced interest rate on the lease.
The
lessee should expect that the lease obligations will be
fully or primarily collateralized by the equipment, as
opposed to all of the company's assets.
Depending
upon payment schedule and other terms, warrants equal to
10 percent to 20 percent of the lease amount may be negotiated.
Here, care must be taken with respect to valuation of the
company so that warrants can be priced appropriately, and
consultation with legal counsel and venture capital advisors
is important.
The
term for such leases may vary but will typically be for
three to four years on average, with warrants exercisable
once the stock is valued above a pre-defined exercise price.
Often,
such leases are structured to be taken as operating leases,
which do not obligate the lessee to purchase the equipment
at lease end and which work to minimize the monthly payments
to the lessee, freeing up more cash for other purposes
or to remain with the company as a means of increasing
its ultimate valuation.
The
Risks
Of
course, nothing's perfect, and venture leases are no exception.
The
first and most important risk is cash flow. If some unanticipated
event or condition causes the company to rupture cash that
it cannot replace, it runs the risk of defaulting on its
lease payments and having the equipment taken back, something
which would not happen if the assets were purchased outright
in the first place.
Then
there is the risk of dilution of existing percentage equity
ownership based upon the number of warrants given in exchange
for the lease. While this is a valid concern, in reality,
the value of warrants given -- typically equal to five
or 10 percent of the original cost of the equipment being
leased -- will often not materially affect percentage ownership
overall.
Also,
if the transaction does not qualify for off-balance-sheet
treatment, then the assets and corresponding liability
will affect the company's valuations going forward until
the transaction is completed.
Care
should also be taken to ensure that the issuance of warrants
does not violate any provisions of any pre-existing venture-capital
agreements. Nevertheless, it's worth noting that, in the
main, venture capitalists strongly favor venture-leasing
arrangements because of the economic advantages they give
the start-up company.
There
is also a risk of how widely available these leases will
continue to be under current stock-market conditions. Since
warrants for stock in anticipated IPOs play an important
role in venture-leasing transactions, there has been much
concern about the continued availability of the venture-leasing
method since the value and frequency of IPOs has diminished
so severely with the fall in the stock market. Unfortunately,
the probability and extent of this risk is one that only
time will tell. If venture capital deals continue to increase
from their recent nadir, and IPOs gain in frequency and
success in coming months, then the odds are that venture
leasing will come back right along with it. Of course,
the opposite is also true. Copyright © Jay Hollander, 2007. All Rights Reserved.
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