(FORTUNE Small Business) – Jerry Michaud isn't afraid of risk. As managing director of GATX Ventures Inc., in Farmington, Conn., he lends money to startups between their first and second rounds of venture financing, a time that bankers would shun because most of these fledglings don't yet have revenues or profits. Undaunted by these high-wire acts, Michaud gives them funds because he believes that their valuable technology (and backing from top-tier VC firms) gives them a good shot at going public. But there is a catch: Borrowers must give up warrants that are convertible to stock if the company goes public at a later date.

This type of lending, which is known as subordinated debt financing, began quietly in the late 1980s as a microniche within the venture capital and equipment financing markets. GATX Ventures was an early pioneer in the field. Under the direction of Michaud it carved a foothold in the industry by marketing this concept to venture capital firms. Since its founding in 1984, GATX has lent $100 million in subordinated debt financing to 50 companies. We talked with Michaud to learn more about how this unique funding scheme works.

What kind of businesses benefit most from subordinated debt financing?

Emerging growth-technology companies that have raised their first round of financing from a VC firm and now need additional working capital. Most of these startups cannot get bank financing because they have no revenues. They can't even get asset-based funding, since they don't have receivables or inventory that can serve as collateral. If they don't want to give up more equity to raise money, this is an option.

There are hundreds of startups out there with great ideas. How do you determine which are best suited for this type of financing?

We only fund those that are backed by prestigious venture capital firms specializing in technology sectors, such as Kleiner Perkins Caufield & Byers, the Mayfield Fund, Bessemer Venture Partners, and Charles River Ventures. These investors do considerable due diligence on the companies they back. We look for companies that have unique technologies with great profit potential. They must also have strong management teams with experience in taking a company public.

How are subordinated debt deals structured?

Transactions are a blend of debt and equity financing. Typically we offer three- to four-year loans at rates ranging from 12% to 18%, depending on the quality of the deal. In exchange for the cash, borrowers must give up between 5% and 20% of the loan's value in warrants.

Can they get special terms?

Whenever possible we allow entrepreneurs a three- to six-month grace period in which they are only obligated to pay interest on the loan. In certain instances we let them pay off their debt by converting it to equity at a prearranged price.

What are the pitfalls of subordinated debt financing?

Our contracts do not allow companies to do subordinated debt deals with our competitors until they pay us off. However, we do not stop them from getting bank or equipment loans in the future.

Many young firms are closing because they're burning through their cash and can't raise a second round of financing. How do you know the firms you finance will be able to pay you back?

We are confident they will, since they are portfolio companies of prestigious VC firms. These investors put millions of dollars into the first round of financing for the ventures they back, so they have a lot of incentive to make sure these young firms succeed.

What should a small business owner look for in a subordinated debt lender?

Find someone who's experienced in lending money to venture-backed companies and who understands that there will be bumps in the road. He should also be knowledgeable about your business sector. Don't worry if he's not a Ph.D. Just make sure he has stellar relationships with VC firms you trust and a history of standing by clients in good times and bad.