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Venturing into debt, buying time

Email|Print|Single Page| Text size + By Scott Kirsner
April 4, 2005

Charlie Tillett knew he'd need more money this year so that his company, Reveal Imaging, could build its first batch of baggage-screening machines and get them installed in US airports. But he didn't like the idea of raising a second round of venture capital, which would require giving up another chunk of ownership in the Bedford company. So Tillett, Reveal's chief financial officer, took on $4 million of what's called venture debt.

Venture debt sounds like the result of losing a sports wager with a general partner at Greylock Partners. But actually, it's a kind of loan, usually to a company backed by venture capitalists, that isn't secured by specific assets like inventory or manufacturing equipment. The loan doesn't come with covenants, like keeping a minimum amount of cash in the bank. ''The profile is typically higher-risk than traditional bank financing," says Rob Pomeroy, the founder of Horizon Technology Finance in Farmington, Conn. ''It's scary."

As a reward for coping with all that fear, the lender typically gets a sweet interest rate, along with warrants to buy stock in the company, usually amounting to less than 1 percent ownership.

In New England, new venture debt firms are popping up, and older firms are increasingly active. (Horizon raised its first fund for venture debt, totaling $300 million, last year.) Both are good signs, since they indicate that this unusual class of lenders thinks the prospects are rosy for tech and biotech companies.

Venture debt is appealing to companies like Reveal because it gives them additional time to build their businesses before they have to raise another round of venture capital (or sell out, or go public).

As Tillett explains, ''We needed a runway extender" to help the company get its product, essentially a sophisticated $300,000 CT scanner for checked airline baggage, out into the world and move closer to profitability.

The next time the company goes to venture capitalists, it won't have to give away as much equity in exchange for its next few million in financing.

For Reveal and its lender, Gold Hill Venture Lending Partners, the $4 million loan is a bet that the company's value will ascend.

''Six months from now, when we've completed some successful pilots, and signed a procurement order with the Transportation Security Administration, we're going to look like a very different company," Tillett says.

If the company succeeds, Gold Hill's principal is repaid, with interest in the low double digits, over three years, and Gold Hill has the right to purchase a smidgen of stock in the company -- roughly $400,000 worth for the Reveal deal.

If the company tanks, venture lenders like Gold Hill and Horizon are usually first in line for the proceeds from any fire sales -- in addition to all the interest they've already collected.

''Even on deals where the VCs lose their money, we've made between an 11 and 15 percent return," says Dave Alpert, managing director of Eastward Capital Partners, a Newton firm that used to be known as CommVest.

Eastward seems to be in the midst of raising a new venture debt fund, but Alpert wouldn't comment. (Venture debt funds are structured very much like venture capital funds: Money comes from institutional investors and some wealthy individuals, and it's invested by a partnership that gets a handsome cut of the returns they generate.)

Between the bust of 2000 and the present, the regional venture debt landscape was remade. Firms like Comdisco, GATX, Fleet, Imperial Bank, and Comerica, which had once been the dominant venture lenders, bowed out.

''The period from 2001 to 2003 was a period where VC disbursements were way down," says Ned Hazen, managing director at Lighthouse Capital Partners in Cambridge, one of the few firms that survived the bust. ''VCs were spending a lot of time working on their troubled companies, deciding which ones to save and which ones to shoot."

Those decisions also involved venture lenders like Lighthouse, which had to decide whether to restructure their loans, or shut down the company and sell off the assets.

Today, ''we think the environment is good," says Pomeroy at Horizon. ''Primarily because optimism has returned -- rational optimism. The opportunity to use debt to stretch the cash runways for these companies is a good one for the management teams and the VCs."

After all, venture capitalists aren't eager to pour millions into a company every year; they like others to share the burden.

But how good is the environment?

Gold Hill, which spun out of Silicon Valley Bank last year, closed a $215 million fund in March. Hercules Technology Growth Capital, a California company with offices in Boston and Waltham, filed to go public in February, and is adding employees in the area. ''We plan to be a formidable force in venture debt," says chief executive Manuel Henriquez.

One person I talked with last week described venture debt as having all of the risk of venture capital, with none of the upside. And it's true that venture debt firms don't hold enough stock in companies to strike it rich when there's a big sale or public offering. But they make out consistently well in other scenarios, turning a profit even when VCs have to write off their investments.

''I joke with the junior people at Lighthouse," Hazen says. ''If you work at a VC fund and are really successful, you can buy your own jet. If you're successful here, you can fly first class."

For companies and their venture capital backers, venture debt has pros and cons. Take on too much venture debt, and it can dissuade future VC investors, who may be concerned that their investment will primarily go toward repaying the venture debt, rather than be used as working capital.

But if a company is on the path to a sale, and just needs another six months to work the kinks out and attract a few more customers, taking on venture debt can be ideal.

''If you do an equity financing at that point, you send a very clear signal to potential acquirers about what the company is worth," says Duncan McCallum, a general partner at Bessemer Venture Partners in Wellesley. ''Venture debt is cheaper capital in that case, and it doesn't put a price tag on the company."

''People loaded up on venture debt during the bubble," says McCallum, a personal investor in the new Gold Hill fund. ''Hemlines were up, and venture debt was up. When the bubble popped, perhaps things over-corrected.

''Now, what you're seeing is normalization."

Scott Kirsner is a contributing editor at Fast Company. He can be reached at skirsner@verizon.net.

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