From the July 2003 issue of Entrepreneur

Silicon Semiconductor Corp. knows how to make a good thing last. The Durham, North Carolina, company makes tiny, high-efficiency power management semiconductors for use in battery-powered electronics like laptops. Late last year, the company's ability to stretch the life of a battery attracted a $10 million venture investment from the granddaddy of silicon, Fairchild Semiconductor.

That might have been enough for some companies. But Silicon Semiconductor knows that, like a battery, venture capital dollars need to last as long as possible. The company had an aggressive rollout schedule for its new technology and needed to maximize its cash available to accomplish that goal.

With the Fairchild money in the bank, Silicon Semiconductor CEO Glenn Kline went looking for even more cash. What he found was an additional $3.2 million-part loan and part lease. The package came from the venture lending arm of RBC Centura bank, in Raleigh, North Carolina. "The trick is to find lenders who have a real venture equity perspective," says Kline, 40, "not just a traditional banker."

What Is It?
Venture debt is simply a loan that earns the lender a small pledge of stock warrants. Venture lenders are willing to work with risky, early-stage companies because that small "equity kicker" gives them a potentially large upside.

This is territory where mainstream banks fear to tread. Not only are banks scared off by the risk inherent in early-stage companies, but the law also restricts them from straying too far into equity transactions with their clients. Venture lenders, however, have the experience and manpower to evaluate and manage the risks associated with early-stage loans.

Venture debt typically follows close on the heels of a larger VC round. This helps lenders protect their downside risk: VCs have been known to help their portfolio companies make good on venture debt obligations. This kind of loan comes in two flavors: venture lending and venture leasing. If you need to grow head count, develop technology or pay rent, you're looking for operating capital from a venture lender. If, on the other hand, you need to purchase computers, real estate, heavy machinery or other assets, you may be able to get by with venture leasing.

Venture leasing typically carries a high interest rate, but the equipment you purchase becomes the loan collateral. Firms that specialize in this kind of leasing include GATX, GE Capital, Oxford Venture Finance, Pentech and Transamerica.

In contrast, venture lending typically has a very low interest rate, but you'll need to come up with your own collateral. Since young companies often have very few assets to pledge, venture lenders may take a blanket lien on receivables and intellectual property-tactics an average bank would scoff at. On the plus side, lenders may allow you to use the loan for nearly any kind of operating expense. Leading venture lenders include RBC Centura, Comerica and Silicon Valley Bank.

Cheaper in the Long Run
Companies typically turn to venture debt soon after scoring venture capital and well before they would qualify for a standard loan. Why not simply go for more VC money? Selling company stock to a VC turns out to be one of the most expensive ways to raise capital. "The cost of equity can approach or exceed 80 percent for a successful company," says Chris Julich, manager of venture lending at RBC Centura.

Because the interest rate of venture debt is measured in single digits, many entrepreneurs choose to mix some VC dollars and some venture debt. This gives them the total capital they need at an overall price they can afford.

But don't forget that equity kicker. Remember, venture lenders are willing to manage the extra risk because they also participate in the upside gain through warrants for company stock. A $1 million venture loan, for example, can earn the lender an additional 7 percent-or $70,000-in options for stock. According to Julich, taking both the interest rate and the value of the warrants into account, the cost of venture debt comes out somewhere between 8 percent and 15 percent.

Follow the Money
Venture debt may replace a future round of equity fundraising, or you may find that it simply helps top off an equity round that fell a little short. In either case, it is almost always a fast and economical way to stretch your VC cash a little further.

How much further? "For the early-stage venture-backed company, we'll lend about 30 cents on the VC dollar," says Chris Woolley, managing director of Comerica's Technology and Life Sciences division in San Diego. Other lenders say they can add 20 to 40 percent.

If you don't have a recent VC round of cash, you probably won't qualify for the extra boost, since lenders minimize risk by lending only to highly liquid clients. Julich says RBC Centura often looks for cash deposits equivalent to more than nine months of operating expenses. Cash like that constitutes a "long runway" in venture parlance. The hope, of course, is that the business is off and flying before the money runs out.

Back at Silicon Semiconductor, CEO Kline says that thanks to venture debt, his company is already airborne. In fact, Kline hopes to be able to repay the venture loans from operating revenues. "Thanks to the venture debt, we have already launched an exceptional product-customers are saying we're six years ahead of the competition," says Kline.

There are as many reasons to look for venture debt as there are businesses to fund, but the value of a good venture lender is clear. In a world of pencil-sharpening bankers and demanding VCs, venture lenders may be the best of both worlds.

 
REWRITING THE RULES
 
In most cases, venture borrowers have truckloads of VC cash and a vault full of assets for collateral. There are, however, exceptions to the rule. "One in 20 of our accounts has reached the stage where the company qualifies on its own," says Dave Wanders, executive vice president of Technology Finance for Transamerica in Chicago.

Those fortunate few include eBags Inc., an online retailer of luggage, handbags and accessories. Although eBags has raised venture capital-about $30 million total-the last VC round was in October 1999, says co-founder Peter Cobb (pictured). These days, eBags is focusing on the bottom line: The company posted its first net profit earlier this year, despite declining air travel and weak luggage sales.

When eBags first took on venture debt in September 2002, it had two consecutive quarters of positive cash flow (earnings before interest, taxes, depreciation and amortization). That, plus the company's uninterrupted growth and a laser-focused business model, was enough to convince Transamerica to roll out a $1 million revolving credit line. Says Cobb, 45, "The money was meant to help fuel our growth and to give us a backup plan."

-D.W.


David Worrell is a financial writer and business advisor in Charlotte, North Carolina.