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THE WALL STREET JOURNAL / CALIFORNIA
Lenders Get An Appetite For the Net
By Ryan Tate
Staff Reporter of The Wall Street Journal

09/01/1999
The Wall Street Journal
CA2
(Copyright (c) 1999, Dow Jones & Company, Inc.)

After turning the stock and venture-capital markets on their heads, the dot.com phenomenon of Silicon Valley has finally hit the world of business banking.

With a twist on the bridge loan, a new breed of lenders is making the same bet as Internet investors, banking that a borrower's ideas and technologies are far more important than its tangible assets. And like the stockholders, they have profited handsomely from the run-up in tech issues because they collect cheap shares through special contracts with their borrowers called stock warrants, which can produce big returns when the borrower goes public. The warrants, which are in addition to collecting the loan's principal and interest, are to make up for the added risk of taking on an unproven client like an Internet start-up.

Previously, companies with venture-capitalist funding were shunned by bankers. But these bankers have "developed" a taste for the sometimes jaw-dropping returns on Web IPOs. "It's not just that people are getting more and more risk hungry," says Jim Rutter, co-founder and senior vice president of special markets for the Emerging Growth Division of Imperial Bancorp of Inglewood, a business-lending bank that makes bridge loans. "It's that what characterizes risk has changed."

"It's basically an evolution," says Greg Becker, senior vice president of the venture-capital group at Silicon Valley Bank, a unit of Silicon Valley Bancshares in Santa Clara. "Three or four years ago . . . not as many institutions were comfortable with how venture capitalists supported their companies. Over time, we've developed that comfort."

In short, the new businesses are filling in the gap between the regulated world of banking and the freewheeling venture-capital business. The terms of the new type of bridge loan have been stretched from a previously typical 30-60 days to two to six months, while loan sizes have ballooned. A company that wouldn't have dared ask for more than $200,000 four years ago can now get as much as $2 million in bridge funds.

But that hasn't done much for the popularity of bridge loans. Of the $18.1 billion in debt and equity financing extended to venture-backed companies in the U.S. last year, $167 million came in the form of bridge loans, according to VentureOne Corp., a San Francisco market-research company.

The new bridge loans have evolved in Silicon Valley because the founders of Internet start-ups are using them to preserve equity between their initial public offering and successive venture-capital financing rounds. Today's start-ups aren't expected to turn profits even five years after their IPOs and the losses are usually even steeper in the embryonic months leading up to the offerings. If a company bleeds cash more quickly than it planned -- and investors say that is increasingly the case in the Internet stocks -- the only place it could historically turn to was investors.

But that option carries substantial downside, according venture capitalists. Investors demand more ownership of the company every time they fork over more cash and that means less control and a smaller slice of the profits for the founders. A company also has to be careful about when it goes to investors for money. Premature fund-raising can, in many cases, hurt its overall valuation. A Web portal that's negotiating a deal with, say, Microsoft, may be able to raise far more money for a chunk of the company if it comes calling a week after the deal is inked than if it came hat in hand a day before.

The bridge loans are being used differently by the start-ups. No longer are they the tools of new businesses looking to expand by, say, buying new equipment. Sand Hill Capital, a closely held bridge-loan company on Menlo Park's famous Sand Hill Road, lent Looksmart Ltd., a San Francisco-based Web-site directory, $1 million to cover payroll and other operating expenses in March of last year. The money was paid back within 90 days plus 12% interest. More important, Sand Hill took 2% of the company in stock warrants, now worth a little more than $30 million since its IPO on Aug. 20. (The company, though, must wait six months to sell, due to its lockup agreement with underwriter, Goldman Sachs.)

Next door at the headquarters of Transamerica Technology Finance, an investment-banking unit of the Dutch conglomerate Aegon NV, Ian Schnider, senior vice president and general manager, says his company held nearly double the principal of a $2 million bridge loan to Tut Systems Inc., a Pleasant Hill maker of networking gear that turns telephone wires into fast Internet ports, in shares acquired through the deal. Due to market fluctuations, however, the total value of those shares is now at $1 million. Still, once a loan is paid off (with interest of 11%, typical of Transamerica's deals), "you have a return of infinity," says Mr. Schnider.

To be sure, bridge lending isn't for the faint of heart. The risk is higher than with a more conservative bank-issued bridge loan, because the borrowers have little track record -- and what history there is shows nothing but losses. Sand Hill Capital's managing partner, William J. Del Biaggio III, says his firm has made "just over" 50 loans so far, with one written off entirely and three others recovered by assuming ownership of the borrowers. Mr. Schnider says he has seen one problem loan out of about 25 others, and he is negotiating to salvage that one.

Judging the risk of the loans can be tricky. For example, a widely publicized program launched three years ago by Silicon Valley Bank to extend bridge loans to start-ups based on a standardized set of criteria ($300,000 to $400,000 in loans for every $1 million in venture-capital backing) has been abandoned after problems collecting on the loans. The loan criteria have since been tightened, says Mr. Becker. Mr. Del Biaggio says he won't lend to a company that hasn't completed its first round of venture capital fund-raising, or fund a company that is backed by the wrong venture capitalists.

Indeed, bridge lenders are gambling that they know something traditional banks don't: That tangible assets like inventory and a strong balance sheet over three to five years aren't much more important than intangible assets like intellectual property, special technology and talented staff. But unlike the junk-bond craze of the 1980s, they say, this banking trend is built on solid, if new, fundamentals.

Says Mr. Rutter: "People have finally realized that the value, the true collateral, in the digital age and the Internet economy and in any tech industry, is not just the assets you can kick the tires on. The true value is in the `technology-plus'" -- such as "the strength of the management" as well as such factors as "do they have a first-mover advantage, do they have proprietary trade secrets?"

Traditional banks aren't able to measure the technology-plus, he says, "because they need to judiciously maintain the quality of their loan portfolio" to withstand the scrutiny of a regulator.

Not neccesarily, says John Stafford, a spokesman for the California Bankers Association; many traditional banks might simply not be aware of the market, due to geography, he says.

"The kinds of companies that are growing rapidly and getting by on venture capital and trading on the value of intellectual property and future earnings are the kinds of companies that tend to be clustered where, for instance, Silicon Valley Bank is located," he says. That's why, he says, lenders in that area have been "not really high risk, but less orthodox in their approach to start-ups and companies that are growing more rapidly."