Present At The Creation
By today's strike-it-rich standards of entrepreneurship, the story of Microcomputer Systems Corp.'s James S. Toreson could be the story of almost anyone else who inhabits a large, corner office in Sunnyvale, Calif. The protagonist leaves a big corporation, gathers together some fellow engineers, and, with $8,000, founds his own technology business. Eight years later, MSC hits $300 million in sales and is expecting $100 million in a few more years.
Despite all those zeros, the plot thus far would hardly interest Horatio Alger.But this business adventure has a twist: MSC sustains itself in large part by giving birth to other companies, providing them with operations lessons in accounting and administrtion, and preparing them for big-money suitors. So far, MSC has been blessed with three little ones. Eventually the parent will become a private holding company of the public companies it has nurtured itself, a strategy rare in the annals of entrepreneurship. There are some public holding companies that finance private companies; there are venture capital arms of large corporations and institutions; and there are holding companies that expand their portfolios through acquisition. But there are few -- if any -- other holding companies that are private and create their holdings out of whole cloth. MSC's compounded annual growth rate of 117% placed it 35th on last year's INC. ranking of the country's fastest-growing private companies.
All the more remarkable, this growth, from the $8,000 seed, has occurred before any toddler has taken its first big step into the arms of a venture capitalist. "This is the final stage -- positioned and poised to go after something big," says Toreson, MSC's 39-year-old founder. "It's like giving birth to a kid. Then we'll get to work on the next embryo." And the youngsters will keep coming -- if MSC's potency holds up. "We'll be like United Technologies," Toreson reflects, "except that we'll generate them, not acquire them."
Toreson's initial experience with creating a business from scratch was hardly indicative of such prowess. During the venture-capital drought of 1971, a start-up he was involved with was unable to secure second-round financing and expired. It was back to the drawing board and eventually to a position as engineering manager at Splectra Physics. Three years later the dauntless engineer decided to try his hand again, and MSC was conceived. This time, though, Toreson was determined to fund the effort himself. "I didn't know anything about accounting, finance, capital, marketing, sales, or anything," recalls Toreson. "I had to learn the hard way." His first income was derived mostly from consulting. There was no business plan. What was to unfold at MSC and, in retrospect, seem an ordered and inspired progression, in fact "just sort of evolved."
What evolved was a foolproof means of entering markets. Toreson sought out original equipment manufacturers that needed component development but didn't have the research or manufacturing wherewithal to do it themselves. Contracts were struck with such fully extended companies as Hewlett-Packard, Digital Equipment, IBM, Ampex, Intel, Memorex, Sperry-Univac, and Texas Instruments. Each agreement came complete with built-in buyers -- the contractors, who committed themselves to substantial orders.
MSC gladly filled these, while retaining ownership of the technology it developed. As chance -- and Toreson's engineering background -- would have it, MSC began by focusing on disk-drive controller architecture, a field that adds information storage to, in this case, personal computers, by utilizing small, rigid magnetic disks, electronically controlled by a single board. MSC has since become the country's largest independent supplier of disk-drive controllers -- a status that was substantially "funded" by its contractors.
This process of finding and filling market niches provided the capital stream for MSC's growth. But its president and chief executive officer anticipated that MSC couldn't become a $200 million company simply by patching chinks in the marketplace. "If you participate in niche markets," Toreson reasoned, "you could grow companies to $10 million in a whole variety of areas without a hell of a lot of money. But you can't become a $100 million or $200 million company. It's tough walking into a market that has a giant sitting there. In addition to all the other things a successful business requires to operate in such large markets, it requires money. You can't do it on your own."
But sooner or later MSC had to go for larger markets on its own. The problem was that the "magic act," as Toreson refers to such customer-financed progress, kept MSC tied to large original-equipment manufacturers. Because it was undercapitalized and had no budgets for advertising and sales, MSC had to leave the end-user to the big guns. But serious profits lay with the end-user in the exponentially expanding micro- and minicomputer arenas. MSC had not only to find but then to cement pathways to the end-users.
To do this, the company would have to open itself to formal funding or fall behind well-heeled competition that also is sniffing out marketing opportunities. The trouble is that niche-seeking would scare off formal investment because of the quick maneuvering it involved. "You have to be able to adapt very fast to work the niches," says Toreson. "And therein lies the problem with venture capital: Investors don't understand that. Venture capitalists don't know how to zig and zag fast enough. And if you do it, they think you're out of control. They're excess baggage in the marketplaces we're now in. I'm sure I would have been thrown out of this company long ago if we had venture capital money."
Rather than making a general infusion into one company that was involved in various phases of niche exploration, wouldn't it be a sensible tactic to peel off each technology and the market it appealed to and fund it separately? In that way, not only could the parent get more capital altogether, but a venture capitalist would know exactly what he was investing in and what the expectations would be for each product line. Venture capitalists are used to possessing everything short of the founder's spouse, just in case there is unexpected profit to be made. But Toreson feels now that he is changing their way of thinking. At MSC they get to look down the barrel of a particular company and see a particular target.
True to Toreson's evolving plan that included ultimately finding formal financing for each business line, two companies were extracted from MSC in 1980 -- an act of creation that, if all goes well, will help the donor keep to its rapid growth rate. Management teams were brought into run them indeendently of MSC, which provided them with floor space, manufacturing facilities, and operations services.
One of the wholly owned subsidiaries was named Microscan Systems. Its laserbased electro-optical technology was applied to point-of-sale supermarket electronic cash registers, for reading the coded stripes on packages. The second was United Peripherals, organized to address end-users directly through selling and servicing self-contained subsystems -- disk drives, printers, and whatever else might be developed -- for minicomputers. MSC itself was now a stripped down, lean, and lithe manufacturer specializing in the vertical development of disk-drive controllers for desktop processing units such as Hewlett-Packard's Series 80 and 90.
But as procreator, MSC continued to perform multiple roles. It was at once an engineering and research and development facility (MSC spent more than $3.2 million for R&D in 1981 -- a sales-to-research ratio of more than 20%), a market researcher, and a specialized venture capitalist that, at least, appreciated zigging and zagging. MSC gave Microscan, for example, a first-round injection of $2 million plus a patent to develop, which MSC's research had come up with before the spin-off decision. Because some of the products pick up closely where others leave off, parent MSC can reshuffle them among the subsidiaries to make the most effective package while the youngsters are still malleable.
Synergism -- the ability of two entities to accomplish together what neither could accomplish by itself -- is a central concept in spin-off relationships. At first the established companies help shape the stirrings of new technologies. When an idea takes root and starts to sprout, a kind of "inverse synergy," as Toreson views the process, occurs. In this instance, an operating division will perform better on its own, with separate management and a work force involved in one well-defined product area.The spin-off is effected, and a new company is sent out into the world. But it does not quite cut the cord: The new company still uses some of the parent's business mechanisms, such as administration and accounting. Eventually, even these attachments will be withdrawn, and the spin-off will be totally self-operating, awaiting blandishments by venture capital or the adventure of going public or, ultimately, possibly both.
One important element in a the-partsare-greater-than-the-whole phenomenon is that spinning off a company complete with management instills a sense of entrepreneurship. (Legally, it also isolates each company from possible liabilities and problems of the others). The resources of MSC create the atmosphere of a large company, but the spirit is one of a small company.
"Each company consists of a handpicked, topflight management team given the charter to make it succeed and grow as if it were their own company. Because it is their own company," Toreson declares. As an incentive, engineers in an MSC company are put on royalty programs based on gross sales, as well as given salaries competitive with others in Silicon Valley.
Although Toreson, who owns more than half of MSC, obviously stands to benefit from the gross as well, the largesse is not entirely self-serving. "One reason we want to get the company very large," he says, "is so that the other stockholders who have worked for the last eight years can have a chance to hit the jackpot. That's the American dream, right?" The other stockholders of MSC are mainly engineers.
The family connection is reassuring to the patriarch, too. The entrepreneur, Toreson muses, typically "starts up the company, grows it to a point, either takes it public, screws it up, or has it acquired. Two years after it's acquired, he's gone. In my situation, I never have to leave the company. I can always participate in it and make money. It's a different kind of philosophy. If we were public at this point I probably would outlive my usefulness. But this way, nobody can fire me."
A major problem, Toreson concedes, is finding good management. "Once you get the embryo started, it's very difficult to get a management team to come in and act like the parent of the idea, as opposed to the typical entrepreneur who comes up with the idea and starts the company." But, he adds, "that's probably the only problem."
It's a problem he can live with, because the alternative is unacceptable. The atmosphere in most large corporations, Toreson finds, is political rather than creative. Key positions are often held not by achievers but by manipulators who have mastered the company's political hierarchy. "We prefer the system at MSC -- a distributed entrepreneurship," says Toreson. "We accomplish much more that way than we would within the constraints of being one large corporation. That's one reason why an acquisition of MSC is out of order. If a large company acquired MSC in toto, I couldn't keep our engineers here even if they made their millions.They just couldn't hack the stifling environment of a large company." In spinning off companies, MSC also spins off creativity and contentment.
As noble as such sentiments may sound, the goal of MSC's strategy is to turn each spin-off into a large corporation. But before that outcome and the complications that go with it (Should, for example, a spun-off company spin off grandchildren as its R&D makes technical departures?), the fledgling has to come into some real money. Although no MSC company has yet reached this stage, each will very likely either go public or find backing -- or both.
But since parent MSC can always produce capital if needed at earlier stages, there is no real hurry. Toreson is extremely chary of taking a company public too soon. The drive to boost earnings per share hurts decisions that are necessary to increase or maintain marketing position. A fragile public company also is lawful prey to the cruel world of the stock market.
"The name of the game is destroying somebody's earnings per share if you're a competitor," Toreson observes, "and that's fairly easy to do when a company's out there hanging in the breeze. When you're private, nobody knows what the hell you're doing, and they don't know how to get you."
Toreson views the rush to go public -- and the killings principals make in doing so -- with a jaundiced eye. One company in the computer field went public after only a year in operation; its vicepresident cashed in his stock through the offering and left the company to start yet another. In such instances, Toreson observes, the company is apt to crumble. "Sure, make everybody a millionaire, but do it when the company has its flywheel spinning well enough so that it doesn't need those people as much. There are a lot of hit-and-run artists in our industry, and one result is to screw some little old grandma in Wisconsin. Ultimately, though, they screw the industry up, because that company won't go anywhere."
The questionability of making money by overglamorizing a company's public stock is a prime reason the MSC companies are kept at home for proper finishing. After an MSC company is on its own with only a minimum of life-support from the parent, the tactic is to be patient: Wait until the subsidiary is ready to go with its markets well defined, rather than beating its drums and hoping that someone will hear. "There aren't too many businessmen in this industry who have vision," Toreson says. "If you have the vision, you can give investors a snow job about how great it's going to be, but they may not understand. So rather than waste the time, we hit them on the head later, and they look up and see the money sitting there. Then they're ready to roll. We don't have time to be romancing these companies to all the potential suitors out there."
Although several venture sources have been professing an interest in buying into an MSC company, as of late spring none had been admitted to the family. Waiting for a settlement of investment capital can turn out to be a healthy discipline that leaves an operation hungry but trim. Indeed, Toreson claims, it at least partly explains the success of MSC. "Management can get used to going to the well and getting venture capital money and pissing it away. We've been forced to be resourceful because we don't have a sugar daddy. That puts a load of responsibility on you that says, hey, I've got to do it right the first time. If you don't have any room to screw up, you don't screw up, or else it's curtains. But if you've got money, you tend to spend it and not think about the consequences of your mistakes. We couldn't be here if we didn't, because the only guy we have funding us right now is the banker."
Another advantage of not opening up sooner to investment is that it keeps venture capitalists from dabbling in the affairs of the company. MSC, Toreson feels, gives its spin-offs more sensitive management support and operational guidance than would an outsider. In matters of pricing, for example, Toreson sits in on, but doesn't dominate, management decision-making. "Venture capitalists don't usually understand that much about operations," says Toreson. "In fact, they're usually a pain."
"Basically, we're building a factory for companies," says Toreson. "From start to finish. They go out the shipping door, they get their management structure, they get their marketplace, their business plan, their controls."
To breed such strapping offspring, somebody's market instinct has to be right. But like Thomas Edison, Toreson feels that genius is 99% perspiration and 1% inspiration. Business instinct "is probably nothing more than spending a hell of a lot of time in the market and in the technology. That's what separates the doers from the dreamers. The doers are out there rocking and rolling. They become privy to things the dreamers never dream of. Armchair dynamos think the other guy happens to be lucky. Hell, he worked his ass off. That's the answer."
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