The Growing Attraction of Debt –

Soon after raising a $3 million first round of venture capital financing in April from Bessemer Venture Partners and EnerTech Capital Partners, the managers of already were gearing up for their Series B round. But this time, the business-to-consumer Internet retailer traveled beyond equity and seized the opportunity to combine equity with debt financing.

A growing number of start-ups are finding such hybrid financing more attractive, simply because more lenders are willing to extend lines of credit to earlier-stage companies, and that leaves more control of a business in the hands of its managers, thus maximizing their returns.

In the case of, the decision was simple: “We were looking at it as a cheap form of equity,” says Basil Pallone, the company’s director of finance. In the end, raised $17 million in July in its second round, led by Brand EquityVentures, including $5 million in subordinated debt from Comdisco Ventures, which also invested $500,000 for an equity stake.

“We have access now to $5 million in resources at a price less than it would cost us if we did it with equity, so there’s no dilution, actually,” Pallone says. plans to use the capital for marketing and technology improvement.

James Frangos, a partner in the New York law office of Edwards & Angell who works on venture deals, thinks debt financing for start-ups is still very limited because of the risk lenders must take when funding developing companies. There are no hard figures that show a steady rise of debt financing for early-stage companies, and Venture Economics Information Services, a data company affiliated with Venture Capital Journal, does not track such information because of the difficulty of classifying those deals, which typically involve warrants that end up being converted to equity. But venture leasing firms, banks and entrepreneurs say debt now plays a larger role in the capital structure of funding earlier-stage companies, especially those in the Internet, e-commerce, portal, business-to-business, business-to-consumer and telecommunications sectors.

Traditionally reserved for more mature companies with substantial cash flows, debt has become fashionable with younger companies for a variety of reasons: venture fund raising has reached extraordinary heights, with a record $24.34 billion raised in 1998, thus opening the door for more loan opportunities. At the same time, an explosion of very successful high-tech venture-backed start-ups such as Netscape Communications Corp., Yahoo! Inc. and CIENA Corp. has motivated lenders to take on added risk.

“There is no question that there is a growing adoption rate of some form of debt, whether it’s subordinated debt or convertible debt, as a mechanism of really minimizing the diluted impact of raising capital,” says Jan Haas, a senior associate in Comdisco’s Boston office. The firm has provided equity and debt financing to early-stage IT and life sciences companies since 1987.

Haas says this type of creative financing allows entrepreneurs to focus on achieving key milestones, such as releasing a product onto the market or creating a Web site, steps that increase a company’s valuation and its chances for obtaining additional rounds of financing. Such financing also conserves an entrepreneur’s ownership in his company, while equity financing requires surrendering a large percentage of stock to venture capitalists in exchange for equity.

The Level of Risk

Comdisco Ventures, a division of the Fortune 500 technology services company Comdisco Inc., receives all of its funding from its parent company. With $1.5 billion in loans to more than 600 companies, Comdisco is fully aware of potential pitfalls, but Haas says the risk is no greater than that of a venture capitalist. The venture leasing firm conducts its own due diligence, placing a great deal of importance on the track record of a company’s venture backers, the strength of its management team, market opportunities and the potential for success.

In some cases, debt financing could be considered less risky because VCs’ investments are not secured by underlying assets, whereas a venture leasing firm would obtain a Uniform Commercial Code filing that allows the firm to hold title over a company’s equipment and to resell those assets in the event the business were to go belly up, says Michael Hicks, vice president of Dominion Ventures’ Boston office.

On the flip side, however, the returns for lenders are not as high as those for venture capitalists – a VC’s profits from a successful portfolio company could be exponential, Hicks says, while profits for a venture leasing firm such as Dominion are limited to the principal and interest (usually in the low teens) that the loan generates.

Over the years, Comdisco has expanded its services from equipment-based financing to include subordinated debt and convertible debt. Convertible debt is a loan that the lender may transform – convert – into equity at a liquidity event. Subordinated debt financing typically involve warrants that allow the holder to purchase stock at a set price at a certain time.

Obtaining warrants works like this: with a $1 million loan, for example, Comdisco could negotiate 10% warrant coverage, which means the firm has the right to invest as much as $100,000 in a company at a future date. The number of warrants is calculated by dividing the $100,000 by the per share price of the stock at the time of the deal. If the stock is valued at $1 today, for example, then Comdisco would hold 100,000 warrants, which gives the firm the right to buy 100,000 shares of common stock at $1 at a future date. The warrants become more valuable, assuming a company’s valuation increases over time.

“The bottom line is that debt is less expensive than equity,” Hicks says. “Whereas, with the type of financing that we provide, you pay us back with warrants, and our ownership in the company pales in comparison to the 10% to 60% given to a venture firm, depending on the company.”, a Web site that provides products, services and content to small businesses, opted for a debt and equity combo in its latest round of financing, which closed in September. The deal totaled $11 million: $7 million in subordinated debt and $4 million in a fixed-asset financing from Comdisco, Dominion Ventures and commercial bank Meier Mitchell & Co.

“The purpose of obtaining debt at that point was that it was a very cost- effective form of capital to fuel the expansion of the company,” says Mark Calvert, the company’s chief financial officer, adding that the start-up viewed debt as a way to stretch its $11.5 million first round of venture financing in February from Mohr, Davidow Ventures, Internet Capital Group and angel investors.

Calvert says Onvia’s valuation had risen 400% by the time of its second round, and the company thought it made better financial sense to take out a 20% interest loan. In late September, the company closed another round of equity financing on $25 million, led by GE Equity.

Other Players

Silicon Valley Bank, a Federal Deposit Insurance Corp.-insured lender to high-tech and life sciences companies across the United States, has been securing loans for start-ups since 1983. Unlike venture leasing firms, financial institutions are less aggressive in underwriting loans, and their deals typically are smaller, with average lines of credit falling in the $1.5 million range, says Harry Kellogg, Silicon Valley Bank’s vice chairman.

The bank, which has some 4,500 portfolio clients, lends only to companies backed by reputable venture capital firms and that have experienced management teams and solid business plans, Kellogg says. One example was Covad Communications Inc., a DSL telecommunications company that went public this year.

Silicon Valley Bank and Los Angeles-based Imperial Bank are major institutional lenders that have migrated to earlier-stage companies in recent years, and the list of competitors keeps growing, Kellogg says. “We’re seeing a lot more growing entrants either on the bank side or the venture leasing side because they’ve seen the enormous upside that can be made if you have warrants,” he says, citing the sheer volume of new start-ups, coupled with a huge pool of venture dollars, a strong stock market and wildly successful venture-backed IPOs and M&A all as contributing factors.

Working Together

To be sure, venture leasing firms don’t consider themselves competitors of traditional venture firms such as Kleiner Perkins Caufield & Byers, Mayfield Fund or Charles River Ventures, all of which provide equity financing.

“What we do is supplemental or complementary to the equity investments” that VC-backed companies receive, Hicks says. “[Debt] allows young companies to preserve their equity capital and to spend more time developing their technologies, so that when they go out for subsequent rounds of equity financing, they have demonstrated further progress and can command a higher valuation, which is less dilutive to the company.”

With about $400 million under management, Dominion is in the midst of raising Dominion Fund V, targeted at $150 million. Dominion raises its capital from pensions, endowments and insurance companies, Hicks says, and provides $1.5 million to $3 million in subordinated debt and expansion financing to early-stage IT and life science companies.

The firm also provides $3 million to $10 million in equity financing over the development of a company’s life, but Dominion is precluded from providing equity to early-stage companies still developing their technologies. Among its successes are CIENA Corp., a telecommunications company that held a very successful IPO two years ago. Most recently, Dominion provided $3 million in debt to on-line supermarket Webvan Group Inc., which launched its site in June and is valued at $4 billion (VCJ, September, page 37).

A majority of companies seeking debt financing are in the IT sector – Comdisco devotes 70% of its dollars to IT and 30% to life sciences. Life science deals are structured in the same manner – loans range from $500,000 to $5 million – but warrants tend to have a longer life span because of the length of time it takes biotech companies to bring their products to market, Haas says. Such companies also tend to have a higher “risk profile,” so Comdisco tries to make its loans more secure by, for example, taking a lien on a company’s intellectual property rights. Comdisco has provided debt financing since 1996 to Ontogeny Inc, an early-stage biotech company that develops therapies to combat disorders associated with the loss of cell function.

“We’re in it to make money just like everybody else,” Haas says. “Our bet is that these companies are going to succeed and … hence the equity portion that we hold in the form of warrants or convertible options is inherently going to become more valuable over time when there is a liquidity event in an IPO or the sale of the company.”

A Sample of Providers of Debt Financing

Aberlyn Holding Co. Inc. Meier Mitchell & Co.

New York Orinda, Calif.

Comdisco Ventures Phoenix Growth Capital Corp.

Rosemont, Ill. San Rafael, Calif.

Comvest L.L.C. Silicon Valley Bank

Wellesley, Mass. Santa Clara, Calif.

Dominion Ventures Inc. Third Coast Capital

San Francisco Chicago

Imperial Bank TransAmerica Technology Finance

Los Angeles Farmington, Conn.

LINC Capital Inc. Western Technology Investment

Chicago San Jose, Calif.

LTI Ventures Leasing

Wilton, Conn.

Source: VCJ