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One Step Forward, Two Steps Back

In a start-up, one thing worse than a bad product is a good product with too little money behind it, as Evolution Technologie's founders learned the hard way.
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In the fall of 1979, Richard Pick, owner of Pick & Associates Inc., decided to get out of computer manufacturing to concentrate on research and software development. Tim Sullivan, Pick's acting general manager, approached his boss to ask about taking over Pick's highly regarded line of Evolution computers and peripherals. "How much do you have in cash?" Pick asked. "Twenty-five cents," joked Sullivan. "I'll take it," said Pick, "if you can raise the rest."

The entrepreneurial urge was irresistible, and Sullivan, with three associates, "put up our wives, our dogs, and everything we owned" to answer the knock of opportunity. They called the new company Evolution Computer Systems Corp., and if evolution is truly a struggle for survival of the fittest, the name is apt. The young company has managed to persevere in the midst of tough competition and the thin pickings of a recession, but neither the founders' labors nor the dozen or so financing gambits they have so far pulled off will be worth a floppy disk unless Evolution can attract the second-phase capital it desperately needs.

And that may prove to be the toughest task of all. This spring the company was in default on a $345,000 bank loan, thus jeopardizing an already shaky credit line, and reportedly was in arrears of royalty payments. Its stock had been delisted from NASDAQ because the company was unable to meet minimum working capital levels. It had posted a loss of $1.3 million in fiscal 1981, and the first two quarters of fiscal 1982 also showed red, with no immediate relief in sight. The balance sheet offered little consolation. For example, Evolution's current ratio -- current assets divided by current liabilities -- was 1.06 and heading down. In short, this was not the kind of promising picture that inspires a second round of investment.

To make matters worse, there was a classic catch involved. To stay afloat, Evolution needed working capital. The company's stock could be relisted on NASDAQ, with enough working capital Relisting might shore up the stock's price, which had fallen to less than 20 cents per share in June 1982 from $1.675 per share a year earlier -- an 88% swoon. But to get working capital, the stock price had to be in reasonable shape, and, of course, to boost the stock's price, Evolution needed working capital.

Yet as close to the grave as the company appeared, it was also poised on the edge of success. Although it is less than three years old, Evolution has a quality product line capable of competing in the database management system business with the likes of Honeywell, Wang, Prime Computer, Microdata, IBM, and Hewlett-Packard. Moreover, analysts foresee extraordinary growth in the minicomputer industry that will yield $20 billion in annual revenues by 1986. If Evolution were to penetrate this huge market by only 0.5%, it would achieve its projected sales of $100 million a year. And there, as of midsummer, the matter stood, in perilous balance.

To understand how Evolution and its founders found themselves in this ticklish situation, one must go back to its origins. The three men Sullivan originally persuaded to join him all had solid marketing backgrounds in the computer business, though not in the intricacies of either manufacturing or corporate finance. Wayne W. Wahlenmeier, 35, came from a Pick competitor, Applied Digital Data Systems Inc., where he was western regional manager. From the same company came Lawrence R. Weiss, 42, Southern California district sales manager, and Harry Slamkowski, the Applied Digital senior account manager who happened to handle the Pick account. For three months after Sullivan accepted Pick's challenge the four negotiated and planned. "We wanted to make sure we could make something out of what we were buying," says Wahlenmeier.

The precaution was premature. First they had to make sure they could buy the company. The four were such financial babes in the woods that none of them had ever heard of a small business investment company. Says Wahlenmeier, "We thought a venture capitalist was just a person with a lot of money." So when the foursome's first plan, to meet pick's purchase price of $1.55 million through a sale/leaseback arrangement, fell through, they went to a local bank and pledged their assets on a note -- for a total of $50,000. Clearly the deal was going to require an "angel" of some sort if it was to ever see the light of day.

Their angel appeared in the form of the sentimental Pick himself. To see the Evolution system carried on, he agreed to float $1.5 million of the $1.55 million at 11%.Thelast payment was due in January 1982, 20 months after the fonr were to take over. To sweeten an already alluring pot, Pick agreed to deduct $130,000 if payment was made by July 1981. Everyone shook hands, and Evolution Computer Systems was incorporated on February 28, 1980.

Actually, Pick was more than an angel, he was also a saint. In buying the assets, the new owners received $900,000 worth of inventory, plus hardware design, a manufacturing facility, and licenses to Pick operating systems. The last was worth a cool million alone, they calculated, making the buyout an outright gift. Fnrthermore, they acquired existing maintenance contracts that brought in $20,000 a month, plus some time-sharing deals that added another $2,000. Maintenance contracts written on competing machines were used to marketing advantage. Evolution took in the old machines in trade, replacing them with the Evolution line, the retired machines supplied parts.

When the foursome began operations in April 1980, they liquidated the inventory -- memories, parts, controllers, and other elements of the old Pick line. Costs were pared to the bone. From March through December 1980 neither Weiss nor Wahlenmeier took salaries. (Even now, no Evolution executive's salary exceeds $45,000, although there are some percent-of-profit kickers -- if that day should ever come.)

By November the older Pick elements had been wholesaled out, and Evolution introduced its new Series II systems at prices ranging from $34,000 to $250,000. The company also obtained its first outside financing, a line of credit for $500,000 from the Wells Fargo Bank, primarily secured by accounts receivable from sales of the old Pick inventory.

To further enhance cash flow, Weiss devised an incentive to get the company's dealers (Evolution had retained 6 of the original 19 inherited from Pick) to pay cash in advance on orders: He offered them a discount of 10% from the invoice price. To them it sounded great, but in reality was only six percentage points more than the original 40% discount. The tactic helped Evolution's liquidity in the first few months, although it wonld later reduce cash flow. Still, they were in business; they had some income and it felt good. Evolution systems were installed for retailers manufacturers, schools, banks, airlines, and other database users.

In December 1980 Evolution got its first round of venture capital funding, a $1.1 million investment in the form of a note subordinated for up to $1 million of its bank line, from a syndicate of eight SBIC investors led by Marwit Capital Corp., of Newport Beach, Calif. The bank didn't mind the additional debt. In fact, says Weiss, as far as Wells Fargo was concerned, the subordinated note was essentially the same as pure equity. The company's assets were put up as collateral, and, as is standard in such SBIC arrangements, the principal shareholders also personally guaranteed repayment.

The Marwit debenture was convertible into 35% (later reduced to 26 1/4%) of Evolution's stock. To protect the owners' equity position should they be blessed with instant success, they negotiated calls against one-third of the shares, which enabled them, for a certain time at certain prearranged prices, to buy back stock, potentially reducing Marwit's participation to only 19.2%. The seven-year note required no principal payments for two years; until January 1983, only the interest -- 13.4% -- had to be paid.

What persuaded Marwit to take a chance on Evolution? "First," says the SBIC's vice-president, Robert Hoff, "was the fact that the Pick operating system was the basis of Evolution. We thought it was a good system. The minicomputer market was rapidly growing at the time, and we wanted to get involved in that market." Normally, a start-up company would have to give up a reasonable percentage of its common shares -- say 25% -- for such an investment. But because the company could show revenue, a result of having started life as a leveraged buyout, a convertible note was possible. One complication of having convertible debentures outstanding is that they can make second-round financing more difficult -- a predicament that was to compound Evolution's later quest for new money.

The Marwit agreement has since fallen into default and has been rewritten on terms more favorable to the SBIC-(Admits a now-worried Hoff: "There were very large risks.") At the time, though, it was just what Evolution ueeded to move on to the next step -- a reverse merger that turned Evolution into a public corporation without the attendant fuss and expense of bringing out stock through an underwriter. This was done by finding an already public company that was no longer operating.

Through a Denver consultant who specialized in such matchmaking, Evolution was introduced to Solar Farm Industries Inc., a once-thriving company whose business had thinned because of lack of interest in passive solar technology and whose principals were eager to be bought out before they went broke. Solar Farms's books showed $750,000 in cash left over from a Regulation A offering, and a net operating loss of some $500,000.

Evolution could use the cash to help pay off Pick in July and to move to a larger plant, while the net operating loss could be carried forward as a deduction against future profits. Not incidentally, the merger would also give Evolution's founders a public market for their stock and thus a chance to earn some financial rewards.

To carry out legally the "going public" aspect of the arrangement (a Type B tax-free reorganization enabling a nonpublic company to be acquired by a public company), Evolution first had to be absorbed by SFI -- the "reverse" part of the merger. This was done on April 13, 1981. The merged entity, called Evolution Technologies Inc., kept Evolution Computer Systems Corp. as a subsidiary to be able to absorb the tax-loss carryforward. The new company had 21,375,432 shares outstanding, of which the four founders kept about 16 million. Evolution was listed over the counter by the symbol ETEC. By June it was bid at 1 9/16 as prospects were judged promising by the market.

Evolution's owners were pleased. "It was a very clean shell," Wahlenmeier says. "Anda good shellis hard to find. We felt it was worth a hell of a lot more than the books showed." As planned, Evolution used the cash to move to larger facilities in Orange, Calif., and in part to pay off Pick, who received his final installment on July 1, 1981. It happened to be Wayne Wahlenmeier's 37th birthday, but most of the celebrating was on behalf of four clever entrepreneurs who now owned an alive-and-kicking public corporation.

But the celebration was muted. Although they had now raised some $1.7 million ($11 million from Marwit, plus the cash acquired from SFI after paying about $190,000 in legal and accounting fees in the transaction) the company remained cash-starved and quickly ate up what it had Some $500,000 went into inventories, for example. Another $250,000 was tied up in receivables, and still more was contributed to the final purchase payment.

The owners understood that money had to be spent not only for the company to remain competitive, but also to grow -- and survive. So what remained was spent on research and product development of Evolution's Series II line. Feeling their oats, and knowing that more cash was needed, the owners began talking to venture capital companies about putting up more money, this time for straight equity. "We were beginning to sense that the thing was growing and growing," says Weiss. "We liked eqnity at this turn, because otherwise interest starts loading up." Furthermore, Weiss knew, equity would increase Evolution's net worth, which could then be leveraged into a bigger bank line.

Unfortunately, the summer of '81 marked a dramatic turning point in both the stock market and the economy. As high-tech stocks plunged and quarterly earnings began to shrink, venture capital companies, slow to jump into a pure equity start-up deal even in the best of times, now were nervous about all computer companies. Evolution couldn't strike a bargain. So the owners raised cash by selling 500,000 shares of their own Evolution stock in a private placement.

Because the proffered stock was restricted under the provisions of Securities and Exchange Commission Rule 144 and generally cannot be resold for two years, it went at a discount -- 60% of the then-public price of $1.50 per share. The principals sold their own stock -- rather than stock issued from the corporate treasury -- to avoid diluting the value of shares held by the rest of the stockholders, and lent the proceeds back to Evolution on easy terms. Because the corporation now has no cash, it is paying off the loan by issuing more stock and returning it to the founders. The maneuver has only slightly increased the stock outstanding and has increased the net worth of the company. But with Evolution's stock currently selling at 20 cents a share, the net effect, ruefully admits Weiss, is that the owners "took a bath."

The stock market slump and the cooling economy affected Evolution in more ways than one As the summer of '81 wore on, orders for Series II systems "stretched out," as Weiss puts it. The company was sticking to its goal of adding one dealer per month from the original six and had developed some house accounts, but business was thinning just when interest payments were starting up in earnest and the need for cash flow was critical. Its 10-Q for the quarter ended on January 31, 1982, made unpleasant reading. Added to short-term debt that quarter was a "note payable to a financial institution." Trade accounts payable increased in a worrisome manner, and accounts receivable nearly doubled in three months. Sales for the quarter were up 138% compared with the year-earlier quarter, but the cost of sales rose 178%. Many ratios were adverse. The company showed a $66,292 loss for the quarter despite the bookkeeping inclusion as revenue of almost $200,000 from research and development contracts.

The R&D funds came from two tax-advantaged limited partnerships, set up by Evolution to fund specific system development projects. In typical fashion for R&D partnerships (see INC., March, page 63), the partners will receive royalties on successfully developed and marketed products, and will write off their investments -- the cash in Evolution's hands -- as a loss if the research doesn't bear fruit. The funds are being applied to expanding the Evolution line and to lowering the cost of components, thus widening operating margins, a primary Evolution goal

Evolution had also worked out a $200,000 five-year, nonrecourse, noninterest-bearing note, as an out-of-cash-flow item, with a software-systems company. This joint venture item was payable through Evolution's sales of the software packages. Any balance remaining after five years could be reclaimed only by purchasing Evolution systems to the full extent of the debt.

Despite all these strategies, at the beginning of 1982, Evolution was unable to meet its debt obligations. A chronic condition was that manufacturing costs were too high and margins thus too low even to service the debt, never mind show a profit. One of the first to feel the pinch of delinquent payments was Marwit. A refinancing scheme was reported in Evolution's first-quarter report, but by midsummer it appeared that the plan would not go through. What had happened to sour earlier hopes? "When the economy turned," vice-president Hoff says, "the larger companies made deeper inroads. People tended to go with the big names."

Evolution's weakening balance sheet was ammunition for the competition. Insidiously, word was dropped that Evolution probably wouldn't be in business much longer, so why invest in their product? With such an atmosphere, Hoff doesn't see much chance for recovery. "The management team was their weak point" he acknowledges. Marwit is helping Evolution look for new capital, but, says Hoff, "there's not much hope." They're now looking around for a buyer of the whole company.

For its part, management (now without Weiss, who left Evolution, as planned, to devote full time to his own capital-raising consulting firm) is working toward increasing margins and getting working capital back up to measurable levels. To help the endeavor, Wells Fargo, on whose loan the company is in default to the tune of almost $300,000, has allowed Evolution to use cash sales as working capital while collecting receipts from all credit sales. The proceeds are credited against the note as the bills are paid. Slowly the note has been shrinking. "They really aren't exposed," reassures a confident Weiss, still an Evolution adviser and a member of its board of directors. "The company has enough assets to cover it."

Obviously, another shrinking ingredient in the mix is the principals' percent of ownership. As of February the four founders, who once owned two-thirds of the corporation, held 58.4% of the 21,375,432 shares then outstanding. "You have to give up equity if you're not immediately successful," shrugs Weiss. "It's the gamble you take."

But in Evolution's sunny plant in California's Orange County, the mood is anything but bleak, even though the hoped-for $1.25 million round of new venture or bank financing has not proved feasible. Still acting out of instinct, toughened now by bitter experience, management has turned to offshore sources to carry the day. Exploratory talks with companies in Taiwan and Japan have been promising. Evolution hopes to strike a deal in which a foreign company agrees to take over manufacturing (at about one-third of in-house costs) and inventory in return for guaranteed orders from Evolution. The foreign company also would provide more working capital. "We really don't need a lot of cash," says Weiss. "Our margins already are considerably better."

An immediate Evolution challenge is to work off the mounting trade debts payable that piled up through mid-1981. Falling behind in payables reflects the failure of a central Evolution tactic -- to manufacture all its own electronic subassemblies and thus to control costs and increase margins. Although the principle is sound, the effort suffered in practice from inefficiencies common to many start-ups: A small company must be run as well as a big one, but it doesn't have many of the big company's advantages.

Evolution has been able to keep to the computer industry's rule that a dollar in assets should produce a dollar in revenue (their ratio is even better). But a major handicap is that parts and subcontracting cost more than they do for big-gun competitors, since Evolution couldn't earn a volume discount. To compensate, a smaller company has to produce more with fewer people. While Evolution's 12 manufacturing employees can easily handle a volume of 10 systems per month -- the company's breakeven point -- the orders aren't there just yet. Should things turn up, the space is available (25,000 square feet leased for three years) to produce about 64 systems per month, which in turn would produce gross sales of about $25 million annually.

No one at Evolution thinks that goal is unrealistic. That is because they have pnt a lot of mistakes behind them. None of the four founders had manufacturing or financial experience when they started, and they engineered each new capital agreernent on their own. But they acknowledge that the learn-as-you-go approach was wrong. "We should have brought in a chief financial officer earlier," Weiss now says. "None of us understood how hard it was to get into manufacturing. It turned out to be more complicated than we thought for a systems house to be actually making things."

Management hasn't yet jettisoned the build-instead-of-buy concept that it intended as the key to profitability. But if offshore manufacturing deals are struck, it is clear that Evolution will concentrate on improving its systems, not on lowering the price of memory boards. Such a step will solve recurrent troubles with inventory control and will go a long way toward making manufacturing costs competitive

Even as the foreign arrangements are pending, Evolution has one more potential arrow in its quiver. To counter Honeywell Inc.'s strong entry into the database management system market -- a maneuver that underscores Evolution's unfortunate timing -- the company has entered an agreement with General Automation Inc., of Anaheim, Calif., giving the larger company exclusive international distribution rights to Evolution's products. Some lucrative private-label orders will probably result, but so far the "big bucks" that Evolution hopes for have yet to be seen.

One eastern Evolution dealer, Tom Alfano of Information Processing Co in Alexandria, Va., sees the General Automation contracts as critical for shoring up Evolution's staying power. But in the beginning, Alfano feels, Evolution signed on dealers in the wrong way. They seemed to "go after a lot of bodies" who were interested in starting their own dealerships rather than persuading established dealerships to take on Evolution.

Alfano recognizes that it is difficult for a small company to sell itself, but he says size shouldn't be a measure of potential longevity. "RCA wasn't small," he points out, "and they were in and out of the computer business in a flash " Alfano thinks Evolution management should concentrate on strengthening distribntion through dealerships and private-label contracts. "Why are they even bothering with assembly?" he asks "If they dropped that and pushed distribution, they'd probably do very well."

Evolution's leading dollar-volnme dealer, Thurman Marketing Services Inc., of Laguna Hills, Calif., retains unshakable faith in the company. "The Pick operating system is probably the finest DBMS in the world," says owner William Thurman. But one handicap is that the Evolution name is not as well known as the others. The best dealers want a surefire thing, so they tend to go with the better-known companies.

Despite Evolution's capital woes, by midsummer it was far from being foreclosed. Indeed, Wahlenmeier insists, management has come a long way by the seat of its collective pants. At first it was selling, by inheritance, an essentially outdated, unprofitable product. "Today," he boasts, "we are manufacturing and selling our own series with a high margin."

But for high margins to start bearing fruit, gross sales have to increase markedly. Whether that will ultimately happen depends on the end of the recession, falling interest rates, a resurgence in office computers, and maybe a big order or two. The fortunes of four fiscal greenhorns could turn eiher way But anyone who has had a chance to strike out in business on his own knows it is an infatuation that is difficult to resist. "We had a tremendous desire to do it ourselves," Larry Weiss reflects, "even though everyone warned us against it. We were willing to overlook the warts and wrinkles -- there was a lawsuit between Pick and Microdata that could have sunk us, there was no operating capital, and there were technological problems. But these are things you always find out about later, either when buying a used car or a used business."

And even without its second round of financing, it is business as usual. Looking ahead to a rosy future, Weiss is working up a tax-advantaged advertising partnership deal by which Evolution would pay royalties on any leads provided by the advertising agency for its new products. As always, Evolution is up to something "We might have been equally happy with a pizza chain," Wahlenmeier admits By the time these words are published they might be buying one -- if it involves a clever tactic they think will benefit Evolution.

On the other hand, they might be working in one.

Last updated: Oct 1, 1982




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