Annals Of Venture Capital

 

"Here," one turnaround practitioner frequently says, dropping a key on the desk of yet another major -- and undersecured -- creditor. "You can have the key, and my newly acquired and deeply troubled company is yours.

"Or," he then will continue, "we can sit down and work something out." In the brave new world of turnaround venture capitalism, they usually do.

The Lazarus Syndrome

In venture capital, as the saying goes, lemons ripen early -- and, we might add, rot fast. While it can take a while to see whether a good investment turns great, not so the bad fruit; venture firms usually know after just a few quarters if an enterprise has grown sour and should be abandoned. Indeed, it is an industry tenet that at least 15% of capital disbursed to portfolio companies is destined to be lost forever. As the saying also goes: that's risk biz.

But there's an additional 15% of the venture-capitalized crop that doesn't wither so definitively on the tree: three-year-old-or-so companies with several million dollars already in them whose sales have stalled far short of initial public offering eligibility. The VC community dutifully puts in another round of funding, but with these companies it turns out that promised products are still months away, or that markets have shrunk, or that technology has shifted in other directions, or that there are fiscal storms that nobody foresaw, but that require yet more money to weather. Now what? With ever more stunted fruit piling up as a result of the venture capital industry's five-year seeding frenzy, nongrowing and nearly dead businesses constitute a sizable dilemma today -- and (this being America) a sizable market for even riskier biz.

And thus: turnaround venture capitalism. Like bag ladies of free enterprise, an assortment of capital pools dedicated exclusively to picking through the business garden's shriveled fruit have rushed onto the scene. Gambling on turnarounds isn't a novel concept by any means, but never before has it been so focused. And until now, turnaround investment was mainly passive, putting up the bridge financing and leaving it to existing management to pull itself together and execute the recovery. Today's pools are not so beneficent. To protect their fund's commitment -- often leveraged into yet higher degrees of peril -- hard-nosed general partners (or their hired guns) are now likely to move in bodily, sweep out old management and even old founders, and run the business themselves.

For better or worse, the new funds will have ample opportunity to practice such ruthless weeding. "Ten years ago, there were very few turnaround situations," observes E. Locke Walsh, who founded a crisis- and turnaround-management firm in 1977 to fix whatever few there were. "Now, with $10 billion [of venture capital] put out in the past three years, you've got a whole platter."

And, Walsh adds, there will only be more. "Venture firms aren't structured to deal with their own failures. They'd rather place $10 million in new capital than spend a year fixing an old $2-million investment," he says. And besides, "look past that to future fallout from current LBOs, and you see there'll be a whole other market." Given such abundant pickings, turnaround partnerships are popping up not only in such major money centers as Boston and New York City, but in major laid-back centers like Phoenix, where, for one, Sunbelt Holdings Inc. recently cashed in real estate to start a $40-million turnaround fund. And such hefty players as Chicago's Allstate Venture Capital, a $260-million division of Allstate Insurance Co. devoted mostly to conventional start-ups, are beginning to stir through the lemon orchards as well.

These hapless enterprises are not rescued out of mere charity, of course. For accepting supreme risk -- the possibility of losing everything within a couple of months, not just failing to achieve a decent five-year yield -- turnaround pools aim for rewards that, as one fund manager describes them, "dwarf" those of traditional venture investing. In conventional start-ups, a venture capital firm expects to own perhaps 80% of a portfolio company. But that's peanuts compared with what clever financiers can extract from some turnaround situations: 100% of available equity. Not to be piggish about it, says Dan Morris, president of Glenview, Ill.-based Morris-Anderson & Associates, but "to take any less would make it impossible to get your return."

Here's how one high-return tactic works. The turnaround fund approaches the owner of a business that has, say, $10 million in assets, against as much or more in liabilities. "Look," the owner is advised, "you have no net worth and your business has no market value. But we'll give you $200,000 for it. And we'll write you an earn-out formula, because we want you to stay and help us for a while." Naturally, the owner goes along with so irresistible a proposal. The fund then offers the business's creditors $5 million in cash for the $10 million in payables and debt on the books, explaining that 50? on the dollar is better than they would receive if the company were liquidated.

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