Equity capital is expensive. Every time you do a raise, you dilute. It makes sense to look for places where you can use other less expensive forms of capital to fund growth. As we talked about in the last post in this series, I’m not a fan of debt for an early stage startup because there is no obvious way that the debt is going to get paid back. But capital equipment provides an opportunity for debt financing because you can borrow against the equipment. There are two primary ways to do this, capital equipment loans and leases.
Capital equipment loans are loans made by banks and finance companies to provide a company the funds to aquire the capital equipment. The company owns the servers, computers, etc and puts them on its books. The company also has a loan obligation on its books to the bank or finance company. The loan is collateralized meaning that if the company defaults on the loan, the bank or finance company can come take the equipment. The equipment is the security for the loan. These loans are usually self amortizing term loans of around 3 years and carry interest rates of between 6% and 12% depending on the financial profile of the borrower.
Leases are a financing tool used by the manufacturers of equipment (and sometimes by banks and finance companies too). Let’s use Dell in this scenario. You want to purchase a bunch of Dell servers to run your web application on. Dell can lease the servers to your company instead of selling them to you. Under a typical lease deal, you will pay the lessor (in this case Dell) a fixed monthly amount for a fixed term, typically three or four years. At the end of the term, your company will have the option to buy the servers for a nominal amount or give them back to the lessor. Some leases will be capitalized and end up on your books and look a lot like capital equipment loans. Other leases will not end up on your books and will look more like renting an office.
In both cases, you are getting capital you need to finance growth (in this case servers and related capital equipment to serve your growing user base) without diluting. And the primary reason for that is the equipment itself provides the security for the loan, not your company, which is likely not credit worthy.
I am a huge fan of this form of financing for startup companies. The risks and rewards are well aligned for both the lender and the borrower and it makes sense for both parties to do these transactions. Don’t use your precious funds raised in dilutive equity rounds to buy servers and other capital equipment. Go see a bank, finance company, or manufacturer about a financing arrangement. It’s the right way to finance these kinds of growth needs.
From the comments
William Mougayar added:
Yes, but it can get tricky when the technology evolution cycles are so short, and you could be stuck with older models. Unless your lease allows you to upgrade continuously.
Why lease servers when you can pay for cloud-services for most needs.
i agree with your points on the cloud. but many of our portfolio companies eventually outgrow cloud services and need to build their own cloud
This article was originally written by Fred Wilson on August 8, 2011 here.