Feature: In a Tight Private Equity Market, Debt Can Be Your Friend –

Spurred by venture-backer Bessemer Venture Partners to seek debt financing before dipping back into the private equity market for a Series B deal, WaveSmith Inc. in December closed a $12 million financing expected lengthen its cash runway and boost its valuation going forward.

Like any number of start-ups, WaveSmith was caught in the stranglehold of the tightening private equity markets – gasping to sustain a path to profitability and building out its optical switching solutions, while scrambling for the next round of funding. However, the company adopted an increasingly common practice of venture-backed companies. That $12 million financing came in the form of debt.

“Our Bessemer guy, Managing General Partner Rob Soni, said we should look at subordinated debt as a way of increasing our war chest because the more you have in your war chest, the better you can manage time,” said WaveSmith President and Chief Executive Bob Dalias.

Balancing debt and equity on the balance sheet is not new. In the late 1990s, the high yield debt market was swollen with issuers looking for fast cash to fuel the build-out of major telecommunications networks. In 1998, radio, television, telephone and telecom issuers ate up 26% of the $138.53 billion high yield market, or $35.97 billion. Even in a shrinking market, the number of telecom high yield issuers jumped to 34%, or $32.73 billion of 1999’s $94.51 billion market, according to Thomson Financial Securities Data.

Rhythms Net Connections Inc., an Englewood, Colo.-based DSL provider, accumulated more than $340.5 million of private equity funding and $915 million of high yield notes on its balance sheet before going public in April 1999. Now-defunct wireless carrier NextWave Telecom Inc., based in Hawthorne, N.Y, secured $1.6 billion of private equity financing and a sizable amount in high yield debt before filing for bankruptcy protection after a long tangle with the Federal Communications Commission over the status of its spectrum licenses.

Today’s debt deals are smaller. Most often, they are meant to propel a company through rocky capital markets, lengthening its cash runway long enough to sustain the development of both technology and a viable business plan. For management, a debt financing minimizes dilution and is cheap to maintain. For equity investors, a debt instrument on the balance sheet may minimize risk.

“The question is how risk tolerance has changed. Private equity is just as risky, or riskier, as high yield in normal times,” said David Hamilton, associate analyst with Moody’s Investors Service and editor of the rating agency’s monthly high yield default report.

In WaveSmith’s case, Comdisco Ventures, a Menlo Park, Calif. outfit specializing in alternative capital structures for venture-backed companies, and GATX Ventures, a subsidiary of Lafayette, Calif.’s GATX Capital, each took a $5 million slice of the deal. Silicon Valley Bank outfitted the remaining $2 million.

Although the company collateralized $5 million of the financing with equipment and software, the remainder is to be spent at the company’s discretion. Still, the debt is a medium-term package backed by warrants representing less than a 5% ownership stake in the company. When WaveSmith completed an $11.5 million Series A deal last June, backed by Atlas Ventures, Bessemer and Commonwealth Capital, the company’s founders ceded control of almost 50% of the company.

In terms of dilution, the capital is highly leveraged, Dalias said, which allows WaveSmith to continue its engineering efforts and move into the beta phase, a milestone that may boost its valuation in a Series B round of equity financing.

“For the equipment suppliers, the investment is spent on developing technology, establishing IP, obtaining market share – all of which translate into long-term asset value and not necessarily predictable revenues,” said George Mattathil, president of Silicom Corp., a strategic and technology consulting firm.

Although the cash infusion will speed the development of WaveSmith’s optical switching technologies, without a second round of equity financing, the company’s war chest will run dry before year-end.

Service providers, on the other hand, face different challenges in the capital markets than their equipment and technology-based counterparts.

Late in November, XOR Networks Inc. coupled a two-year $10 million revolving credit facility with a $23.5 million round of venture financing.

While Lexington Partners led the Series B deal alongside new investor Far West Capital Management and existing venture backers Frontenac Co. and Minotaur Capital Management, Silicon Valley Bank underwrote the credit revolver.

XOR Networks provides e-commerce services to middle market and dotcom clients – offering strategy alongside customized software and applications and system management. While much of the Boulder, Colo.-based company’s efforts are concentrated on up front, fee-generating consulting services; its revenue model is based on recurring fees generated by long-term managed service contracts. Thus, it must invest in infrastructure in conjunction with application development to meet its top-line growth projections of 50% to 100% over the next two to three years.

“We’re moving up the time to cash flow positive. There’s a shift to balance between growth at an accelerated pace, but in a way that there’s cost control, efficient, being as tight as you can on the expense side of the equation,” said XOR Networks’ Chief Financial Officer Robert Komin.

The credit revolver, then, increases the company’s fiscal flexibility at little cost. Although the company must pay a nominal annual fee to sustain the credit facility, it is a low-cost backstop that provides financial leverage – and the possibility of a longer lease line – before the company makes its planned return to the venture markets in the next six to 12 months. Between December 1999 and February of last year, the company raised a $25.7 million Series A round.

“For the service provider, all their investment goes into assets that become obsolete very soon after purchase – so the asset base is declining over time in terms of replacement value and discounting all book value calculations,” said Silicom’s Mattathil. “Their financial strength is based on the revenue stream the services generate – generally robust and long-term. This situation lends itself for a financial instrument with scheduled payments terms, like the bond, but would be more difficult to work with equity.”

In mid-December, months after the launch of its online rental applicant screening service, SafeRent Inc. secured a second round of financing from its band of venture backers. This time, however, the equity investors opted for a $4.25 million convertible debt financing – lowering the cost of capital for an upstart headed into black line territory and offering investors upside potential at a reduced price.

“We’re going to positive cash flow in the very near future,” said SafeRent President and Chief Operating Officer Scotte Hudsmith. “Debt is a less costly model than equity, but this type of debt is convertible into equity, which will hopefully have a higher value in the future.”

Although Hudsmith would not reveal the exact terms of the deal, all of the company’s original investors participated in the financing. In May, the company secured its first round of institutional venture funding. At a valuation of $32.7 million, the company raised $7.75 million in a deal led by Boulder Ventures Ltd. Mellon Ventures Inc., Roser Ventures and Hexagon Investments also participated.

The mix of debt and equity is expected to add enough leverage to the company’s balance sheet to bring it to cash flow positive before mid-year. “With our current business plan, this is the last funding we need before we’re self-generating,” Hudsmith said.

Still, before the close of the first quarter, the company will be back in the market for another round of financing. Most likely, the company will target strategic investors, including those in the multi-tenant housing industry and the financial services sector. Whether the funding will take the form of debt or equity will be based not only on the company’s cash requirements going forward, but also on the cost of capital and the different possibilities in structuring a debt deal, said Linda Bush, chief executive with SafeRent.

“As the competition for private equity becomes more fierce, there’s still private equity available, maybe it’s not as cheap as it once was,” XOR Networks’ Komin said. “You just can’t get a business plan funded with something else behind it.

Financial maneuverings and complicated capital structures, however, will not disguise a failing business model. For investors, deficient technology, bad management and less than optimum execution will counter risk-aversion built into the balance sheet.

“In other words, fundamental business deficiencies are difficult, or impossible, to overcome through financial maneuvering,” warned Mattathil.