Rd Partnerships Come Of Age

They may never replace traditional venture capital, but for some companies these deals are a better way to raise money.

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An $11.98 plastic contraption, the Super Soaper Pet Washer, and a $25,000 De Lorean car sheathed with stainless steel may not have advanced the frontiers of technology very far. But the two disparate products -- along with any number of high-technology devices that have advanced them -- grew in part from the same source: capital provided by a limited partnership formed specifically to finance research and development projects of American companies.

R&D limited partnerships aren't exactly brand new. The concept first emerged in Silicon Valley's fertile environs about eight years ago. But recent events, including John De Lorean's well-publicized financing efforts and Gene Amdahl's successful public offering of $55 million through Merrill, Lynch, have raised interest in the technique to dramatic levels.

As the label implies, R&D limited partnerships allow investors -- usually individuals in the highest tax brackets -- to invest money directly in the work of inventors and inventive companies.Since a favorable Supreme Court ruling in 1974 (see "The Drift of Snow," page 73), the twists and wrinkles of such arrangements have proliferated. But all spring from a basic concept.

Simply speaking, investors put taxsheltered money into a project. If the project is marketed profitably, the partners are bought out by the inventor; if not, they lose their investment. For a rudimentary illustration, let's say a modernday Thomas Edison wants to improve the light bulb, but his company doesn't have enough capital to pay for the necessary R&D. So Edison turns to a limited partnership. He enlists 10 well-heeled acquaintances. Each of them gives him $100, which they deduct on their tax returns. In exchange for the $1,000, Edison gives them ownership of the technology he is about to create. He makes arrangements to buy it back later if it's a smashing success, expecting to have to pay $400 to each partner to make it worth the risk that the new bulb may not work. All shake hands, and the partners leave Edison to his labors. In a year or so, Edison's brilliant idea becomes a marketed product. He sets the price at $1 and starts to sell bulbs on behalf of the owners. As a means of payment for buying back his technology for himself, Edison pays the partners 10? for each bulb sold. Eventually each owner gets his appointed reward and the partnership turns back everything to Edison.

But that's hypothetical. In the real, more complicated business world, the technique of R&D partnership funding came along just in time for publicly held Hadron Inc., a maker of computer-controlled laser production tools. In 1978, when an investment group including now-president Dominic Laiti purchased the Vienna, Va., company from Xonics Inc., its prospects seemed bleak. Hadron stock, which had traded as high as $7 over-the-counter, then was selling around 30?. In the company's 14-year history, sales had never gone over $3 million. It was Laiti's hope that new management could play on the reindustrialization and capital investment themes being trumpeted by the current administration. One thing Hadron did have going for it was 100 patents in laser technology. What the company needed to help make it competitive was some additional products.

But Hadron's problem was that one of the most promising products -- a laser market that could etch code numbers into tiny objects such as silicon chips -- was only an idea. The idea needed much more development, and development cost money. Money that Hadron didn't have.

"We'd bought a bad balance sheet," Laiti admits. "The company had unusual debt for its size, with a current ratio of one to one, and we had a lot of creditors. We couldn't even get near a bank to apply for a loan."

His partner, venture capitalist Earl Brian, realized Hadron didn't need a bank. The situation was tailor-made for an R&D limited partnership. Laiti and Brian wrote a 60-page private-offering memorandum that included an extensive list of the risks involved in developing the invention (competition, marketability, the possible need for additional financing, and many more), arrangements for assigning any new patents to the partnership, royalty payments of 7% of sales, and an option to buy back the technology at a future date for shares of stock. If the project was successful and the option exercised, Hadron ultimately would be able to reap the fruits of its labors, and, possibly, strike it rich.

Because they were offering the deal privately, Laiti and Brian became their own underwriters. Their goal was to sell 14 units at $50,000 each. Within two months they virtually had made it: 13 units were placed. In September 1979, the partnership -- called Laser Associates -- came into being. Laiti and Brian were its general partners; for legal and accounting expenses, they kept 1% of the $650,000 raised.

Hadron's wholly owned subsidiary, Compulaser, which was in the process of developing the marker, turned over its patent licenses to the partners. Before a year was out, Compulaser had manufactured four laser markers and sold them for $100,000 each. Laser Associates received $28,000 in royalties, providing instant cash flow to the partners.

But there was a hitch. To keep the product competitive required some refinements, and there still weren't enough earnings. Undaunted, Hadron went back to the well. With the necessary majority vote from the original 13 limited partners, in September 1980, a second private offering was made as an extension of the first. This time, however, it cost investors $100,000 each to get in. Fourteen (three of them from the first partnership) signed on.

"We figured people would pay more per unit because we now had a product," says Laiti. "We were building on something. It's like running out of money when you're drilling for oil, and toward the end you find a few traces of oil. That oil hole will attract a lot more investors, and you can charge more because there's less risk." The second partnership was sold with the help of some independent brokers (who took a 7.5% fee from the proceeds), and Hadron had a cool $1,295,000 to push onward with.

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