Towards the end of the 1990s, the European venture capital industry had substantial capital in place to support a cycle of dramatic growth in the early stage sector. Funds were plentiful and investors, investment banks, stock markets, corporate advisers and other professionals had formed a solid infrastructure for early stage companies. But the economic downturn saw this ecosystem contract as many investors became disillusioned following the burst of the Internet bubble. And so the main issue for venture today is one of resources. The deals are there and the tech industry in Europe continues to deliver innovative products and technologies, but securing funds is the problem. This is where venture finance can step in. Angela Sormani reports.
Up to 75% of venture-backed companies in the US have used some form of venture debt to drive growth, but the concept is still relatively new in Europe. But will the facility will appeal to European entrepreneurs and investors.
Venture lending offers a low-cost method for venture-backed companies to leverage fixed assets and their enterprise value to get more out of their equity funding. The practice has financial advantages, but it carries some risk. “Perhaps the greatest benefit of venture lending is that it injects money into a business without heavily diluting the equity stake of the entrepreneur or venture capital investors,” says Anurag Chandra of US venture lending firm Lighthouse Capital.
Venture lending fits into two categories; venture leasing and venture loans. Venture leasing is a hybrid of traditional leasing and venture capital addressing a certain market segment: the early stage company that has achieved a first round of venture capital financing has its eye on an eventual IPO and wants to conserve as much of its venture capital funding as it can. This means not using it to pay for equipment and infrastructure, which in turn avoids having further to dilute equity positions by seeking additional venture capital.
In a typical venture leasing transaction, the lender will lease equipment, such as computers, manufacturing equipment, software or other assets, to early stage companies at a certain interest rate for three to four years. The lender then receives a monthly capital repayment with interest and will also receive an equity share linked to the value of the facility, which is in the form of warrants. These warrants are intended to compensate the inherent lender for the risk of lending to a new company, typically one that would otherwise find it diffcult to qualify for conventional bank financing.
Venture loans, on the other hand, may serve a company in a later stage of its development and typically provide operating capital that can assist in product development, product or geographic expansion or acquisition of complementary technologies. The cost of such capital is normally interest, with principal, paid over a fixed period of time (usually 24 to 48 months, depending on the company’s risk profile) and a small pledge of stock warrants. Some providers even structure deals offering a period of interest-only payments to help preserve cash at critical development stages of the company.
Humphrey Nokes, founder of venture lending firm ETV Capital, explains that the US venture finance market has evolved from a venture leasing-type model funding the hardware assets of semi conductor companies, to a venture loan model funding companies where less equipment was needed. He says: “As the VC market evolved into industries with less equipment needs, there was less demand for venture leasing and so the type of debt financing has been forced to evolve to meet the needs of these companies.”
The main driver behind the venture lending industry is the VCs. “Venture finance is complementary to equity finance. And so it is really a question of how well-developed the VC market is, because we don’t exist without the VCs,” says Nokes.
He warns: “Our risk is a different form of risk to equity risk. A VC can survive on one outstanding investment, whereas if
we have too many losses we will never recover. There is a very strong survivorship bias in the track record of venture lenders and it’s very easy to blow yourself up. If you do it properly you can get good returns, but there are a lot of failures in venture finance; as the saying goes, ‘there are old pilots and there are bold pilots but there are no old bold pilots.’ It’s not the easiest business.”
A small universe
The universe for this lending niche is small with a few well-established players who have migrated from the US to promote their business in Europe. In the US there are a handful of significant players including names such as Lighthouse, Pinnacle, Silicon Valley Bank (SVB) and Western Technology Ventures. The European landscape is much smaller, with household names ETV Capital and EVP dominating the scene and more recent entrants to the European market such as Noble Fund Management, whose partner, Mark Taylor, was a founder of Dresdner Kleinwort Wasserstein’s venture finance business, and US veterans, Silicon Valley Bank, which is just setting up in London.
Noble Fund Management raised £45m for its first venture leasing fund, Noble Venture Finance I, earlier this year. The fund focuses on high growth companies that require high levels of investment in assets such as laboratory test equipment, telecoms systems and computers. These are most likely to be in the high tech and life sciences sectors. The fund will provide these companies with financing of between £500,000 and £2.5m in the form of equipment leases, loans or hire purchase agreements in return for a running yield and an equity kicker of between 20% and 25% of the value of the lease.
The trend for venture finance started in the US in the 1980s and has since become a proven concept. Industry professionals estimate around two thirds of start-ups in the US employ venture debt, but there are few statistics available. One of the grandfathers of the industry in the US is Silicon Valley Bank (SVB), which was founded in 1983 to provide credit and banking services to Silicon Valley’s growing population of start-up technology companies. The bank started serving the technology and life sciences markets at a time when they were not well understood by the financial services industry. Many of these technology and life science companies had yet to show profits and were not considered creditworthy by local community or regional banks. SVB has banking relationships with over 300 US VCs and hopes to mirror its success in the European market.
As to whether this form of financing will become as prevalent in Europe as it is in the US, Humphrey Nokes, of ETV Capital, says: “Europe is where the US market was a cycle or two back. There is also the complexity of different jurisdictions in Europe, which means it is not as straightforward as in the US.”
Ross Ahlgren, of European Venture Partners (EVP), adds: “In the US, venture finance is a multi-billion dollar a year business. Why is Europe so much less developed in this form of financing? There are several reasons. One is that it is harder to get commitments for a venture debt fund in Europe as the LPs have less experience with the asset class. It’s not the VCs or the entrepreneurs, it really is just the case that it is hard for a venture debt fund to get off the ground. Another reason is that it is harder to create the necessary critical mass when you operate in multiple jurisdictions throughout Europe with multiple regional and local co-investors – it is a challenging task.”
EVP set up in 1998 and is in the process of closing its second fund, EVP II, with a target of over €105m. To date, the group has committed over €155m to some 70 companies in ten countries across Europe. But fund raising has been tough second time round, says Ahlgren. “Many American LPs that have positive experiences investing in the US venture debt market have slowed or even stopped investing in early stage European VC and thus European venture debt. There is a flood of money coming in for the mid-market, buyout and mezzanine funds, but it is completely void in the early stage market.”
Interestingly, he says high net worth individuals understand and are more confident of the product than LPs unfamiliar with the asset class, they understand that you get capital protection with a VC upside from the warrants.
The use of venture leasing or loan facilities provides start-ups with less dilutive and complementary financing alternatives and can be a valuable resource for entrepreneurs as well as sustaining strong returns for investors. The structure of a venture lease also offers a certain amount of flexibility while a bank loan can be more stringent. Bank loans are secured by all the company assets while a venture lease is secured only by the equipment being leased. So, if the entrepreneur defaults on a lease payment, only that piece of equipment is taken away. Banks may also be more reluctant to finance an early stage company, which is normally loss-making and therefore represents a higher risk. Anurag Chandra, of Lighthouse Capital, says: “Venture lending is 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.”
Tim Brown, of VC firm Alta Berkeley, agrees: “In general in Europe, the traditional suppliers of leases or loans are pretty conservative and are going to look carefully at start-up balance sheets and most of these make them feel very unsettled.” Ross Ahlgren adds: “Most banks will not look at what we do as
there is a high risk factor involved and you need to have a good understanding of the needs, risks and upside potential of early stage technology companies. In addition, banks are very credit focused while we would rather keep the company alive if things get tough and work the situation out like any other venture capital investor. If a company goes under water in, say 24 months, we still get 24 monthly payments and we get the assets back.”
The lease agreements made by venture lending firms are designed to compliment the development of a business. Some agreements provide the company with an option to exchange the asset for a different or an upgraded version during the life of the lease. This flexibility is particularly valuable when the firm is unsure of its needs and its technology is evolving rapidly.
Another advantage of venture leasing is as a stepping stone to profitability for a company. Lease payments are generally lower than the expenses incurred by buying an asset (at least in the first few years of an asset’s life.) And so the reported net income for an early stage company may be higher if assets are leased, rather than bought.
The VCs and the venture lenders have a symbiotic relationship. In fact the existence of the venture capital market is crucial to the existence of venture lenders. Ahlgren says: “The first prerequisite for our investments is who the VC is. The good ones add a great deal of value and we ultimately source our deals through our contacts in the VC industry. We are not set up to handle thousands of business plans. If they come to us and we like them, we will sometimes send them onto the VCs.”
He adds that the firm also relies on the VC in the due diligence process. “At the end of the day we put a lot of faith in our VC partners. We like to have diversification by VC, industry type, country and asset class to spread risk.” By asset class Ahlgren means the type of equipment provided. For a biotech company this may be laboratory equipment, for software businesses it may be servers, for electronics businesses it may be production equipment. “You don’t want to find yourself with 90% of your portfolio in PCs,” says Ahlgren. “While they are easy to sell when the company goes under, they lose their value very quickly.”
Stuart Evans, director and CEO of UK-based plastic electronics technology company Plastic Logic, which has secured venture finance from both EVP and ETV Capital, explains the merits of venture finance from an entrepreneur’s perspective. “Venture finance is halfway between conventional bank debt and equity finance. The relationship works because the finance guys depend on the VCs for due diligence. For them what is really important is that they can rely on the VCs to do that research. They follow the VCs.” But he explains: “If you are an entrepreneur there’s no point in thinking about venture finance unless you’ve got good VCs on board.”
Plastic Logic has secured around £11m venture capital funding from VC firms such as Cambridge-based Amadeus Capital Partners and Munich-based Polytechnos. It has also received funding from Bank of America and Yasuda in Japan. Corporate shareholders in the business include Dow Chemical, Seiko Epson and the University of Cambridge. The three main characteristics of Plastic Logic that stand out for a venture leasing firm, says Evans, are first, a strong, high potential business model; second, a high intellectual property position and thirdly, high profile venture capital investors.
EVP provided a £300,000 loan in December 2001 and ETV Capital has just provided £1.2m financing. Evans stresses: “You’ve got to see that in the context that we have already raised £11m. The security that our assets represent is rather modest. But what our IP represents is massive. It’s a pity that there aren’t more people doing [venture finance] in the UK. But at the moment it’s still a niche. The players are mainly teams that are experienced in the US, infiltrating the European market.”
He adds: “A combination of both debt and equity can serve a company well. The main issue is how much the money will cost in equity, interest and management time and will it materially increase a company’s options.”
VCs want venture lenders to be predictable and consistent, quick and efficient; to provide the capital the company needs, when it needs it. ETV Capital works with around 20 to 25 VCs in Europe. Humphrey Nokes says of the European market: “Some European VCs are very conservative. But the product is to a certain extent self-selecting. If investors can’t figure out why they should have it, then it’s risky giving it to them.” He adds that you have to tread carefully with those unfamiliar with the product. “VCs are very sensitive as to how you behave when things go wrong. The banks can’t do it; they’re not structured in the right way and they panic at the wrong time, which worries the VCs. Because the ETV team not only all come from technology and entrepreneurial backgrounds, but also ETV Capital is structured like a VC fund, our incentives are aligned with the VCs and this makes sure we co-operate with whatever the VCs need to do to build value in their companies.”
Tim Brown of Alta Berkeley, a VC firm familiar with the product, says: “Venture leasing makes sense in deals where there is a large amount of capex required. But in a software deal, for example, it doesn’t make sense because the company does not have many hard assets.” Alta Berkeley portfolio company, Inside Contactless, secured venture leasing facilities from EVP to fund the various production and testing equipment the company needed to execute its business plan. EVP had warrants worth 20% of the amount they were leasing. The only other alternative would have been to raise 100% of the amount required as equity; a significant dilution to shareholders.
Brown sees venture loans filling the working capital funding gap that currently exists in the European VC market. “There’s obviously still an education process needed in Europe and a recognition that this is the right instrument for your type of business. There is a real gap in funding working capital at the moment as the balance sheet of many of these businesses is not strong enough for a bank to extend a loan to.”
Martin McNair, of Advent Venture Partners, says the firm is increasingly seeing companies interested in using venture leases/venture loans. “Venture leasing went through a period of popularity during the dot.com telecoms bubble. But with the bursting of the bubble, the willingness to provide this facility dried up and now there is a gap in the market for this type of financing. The facility is a helpful way for a sound, well-funded business to complement that funding to acquire technical assets and make better use of existing cash resources for financing growth.
Technology investor, MTI Partners, has used venture leasing in many of its companies in the last five years and Ernie Richardson views the tool as a useful addition to financial resources. He says: “Where we can deploy it, we will do. It is a useful tool where you’re looking for substantial asset financing and where equity finance is not appropriate or efficient. Young companies typically find asset financing difficult to source through banks. Venture finance helps us to provide leverage to the companies we are investing in. Clearly it doesn’t come cheap, but given that early stage companies find it difficult to secure alternative asset financing, it’s a useful supplement.”
He concludes: “I think there’s a genuine role for it. It’s a tool that has application in growing markets. Where you’ve got expansion going on, it’s a great tool to use in those circumstances.”