Like getting involved with someone in the throes of a nasty divorce, courting a troubled company that is on the verge of bankruptcy can lead to more problems than it is worth. In addition to nervous creditors to be dealt with, there are often outraged stockholders; suits and countersuits among principals and purveyors; defensive executives; tarnished product reputations; disgruntled workers; assets and inventory that turn out to be worth a fraction of the value at which they were carried on the books; and a host of other warts, scars, and handicaps that only an insolvency lawyer could learn to love.
But one California corporation has proved that there can be an attractive side to all this, despite the possible complications. For Applied Technology Ventures Inc. (ATV), a private holding company in Santa Ana, giving corporate shelter to industry's lame and halt has been a particularly profitable way of capitalizing new businesses and product lines. An operating officer thinking of acquiring a foundering enterprise can well afford to forgive previous management mayhem if, as ATV president Frank Gleason calculates, the acquiring company's development programs can be accomplished for as astonishingly little as one-tenth the investment -- not to mention immeasurably less risk -- of an internally financed seed venture aimed toward the same ends.
And that is precisely what ATV has been doing since its own inception four years ago. Of the 13 acquisitions it has made, 5 were once individual enterprises on the brink of fiscal disaster. Four of those were or are in the process of being reorganized under Chapter 11 of the Bankruptcy Code, which protects a business against the full claims of creditors while providing for the continuance of that business under a plan of eventual repayment acceptable to the creditors; the fifth was pulled from the verge of Chapter 7, under which the assets of a company are liquidated and the proceeds distributed to claimants, thus closing down the business -- and a creditor's hopes for further recovery -- for good. When sniffing out such an acquisition, ATV looks for a well-established entrepreneurship with customer, product, and market already in place, but one that is helplessly dangling at the end of its capital rope. "The business world is clogged with guys who've dropped half a million or a million," Gleason observes with some relish, "and ended up with nothing."
The remaining eight purchases were also struggling, although not yet down-and-out, enterprises -- mostly unprofitable divisions of larger companies. For example, in June 1981, ATV's Computerized Restaurant Systems bought GTE Comp. -Acct., which had been losing money for years, from General Telephone & Electronics Corp. If ATV hadn't offered to buy it, GTE -- admitting that it had bitten off more than it could chew in getting into computers -- would simply have closed Comp.-Acct. down. To ATV, such a situation is luscious fruit. A similar purchase of the Business Systems division of Memorex Corp. was made one month later. "A lot of times it has nothing to do with the product in the market," says Gleason, "but rather the execution. To us it is less expensive, takes less time, and involves much less risk to make the acquisition of a troubled company to meet a product objective than it is to apply the people and money to do it internally."
From this ragtag band of 11 private and two public companies snatched from the steps of bankruptcy courts and out of trash barrels, ATV has built a robust corporation that expects sales for fiscal 1983, ending March 31, to total more than $60 million, and for fiscal 1984 to approach $100 million. As a holding company consisting entirely of these investments, it has pasted together two lines of high-tech businesses -- one in point-of-sale and back-office operating systems for restaurants and hotels, the other in office management.
Applied Technology Ventures was formed as a general partnership in 1979 -- coincidentally, the year that Congress's bankruptcy-law reforms went into effect. The three founders -- Frank Gleason, Philip T. Gomez, and Douglas J. O'Connor (who joined in 1981) -- each well past 50, were long-term alumni of Texas Instruments Inc. Gleason, a 15-year veteran, had become its worldwide marketing manager; Gomez, corporate group vice-president, also worked there for 15 years; O'Connor was U.S. marketing manager. TI provided solid managerial training for what was to come. It was a production-oriented company "where we made lots of things in high volume," says Gleason. But even giant TI made marketing mistakes (remember its digital watches?), and in the course of their managerial careers there the three had become gunslinging specialists in profit-and-loss problem areas. "In every case," Gleason recollects, "we were able to turn them around and make them move."
Later, the three left Texas Instruments to take executive positions in outside rescue situations. Two of the founders -- Gleason and ATV chairman Gomez -- completed a stint at Western Gear Corp., where they revamped product lines, divested and closed inappropriate divisions, and computerized procedures, changing a stodgy one-family company with a market value of about $16 million to a healthy, modern business that was sold (to Bucyrus-Erie Co.) for $183 million only three years after their arrival. Before becoming ATV executive vice-president, O'Connor repaired Applied Solar Energy Corp., where, as its president, he was able in a few years to increase the value of the company tenfold and to bring it public successfully.
But eventually the trio tired of restitching sows' ears into silk purses for others. They had enough capital from former high-level employment, so they figured, "let's grab hold of one and do it for ourselves," Gleason remembers enthusiastically. "We looked for troubled businesses without fear of why they were troubled. We were confident of our ability to change the game."
The direction ATV took in getting under way back in 1979 was a matter of accident. From the start, the founders wanted no part of businesses such as metals or machine tools, with their low spreads between cost and selling price, but they welcomed high-risk, research and development-intensive industries with big gross margins -- namely, computers. The first such company that happened along was HLx Data Systems Corp., a California supplier of computer-based point-of-sale systems to fine-dining restaurants. ATV brought HLx out of Chapter 11 in March 1979, thus pointing the way to its initial line of business in the hospitality industry.
HLx happened to be one of a number of different companies under consideration at the time. It was the smallest in sales volume, and ATV almost didn't proceed with it. But, coming from a formal, highly trained computer background, the three were smitten by how casually the electronic restaurant was run. "They just took a computer and immersed it into a pot that cooked a chicken," Gleason recalls, skipping a number of technical details. "There was no training on the operator's part, but here they were operating a full-scale, on-line, state-of-the-art system without any of the things you customarily expect -- air-conditioning, raised floors, guys in long white coats. It was a fascinating idea."
Before making such an acquisition, ATV runs a computer model on the way the business ought to have looked in different operating sections. Each business is examined in relation to a pattern of costs and expenses, and the margins that ought to be forthcoming. Since the founders have been dealing in electronics-related enterprises since 1955, based on their own experience rather than industry standards, they have "very strong" opinions as to how the figures should stack up. ATV views the business the way it ought to be, and if it operates much differently, ATV concludes it is because it isn't being managed properly.
With troubled companies, such divergences can be stark. For example, ATV has been able to pare down the work force of its erstwhile unprofitable businesses from 2,400 people to 800 and has housed those businesses in one-third the space they separately occupied on the outside. "There were too many hands and feet," comments Gleason. Another direction that has been confirmed by operating models is ATV's decision to do its own manufacturing, rather than buy from OEM vendors. They found that model margins are substantially different for a merchandiser of others' equipment. To keep up gross margins, ATV felt it needed to control the manufactured product. Now, although its lines-of-business go directly to end-users with systems applications, ATV is primarily a manufacturing operation.
Like an auto body shop booking in a wreck, the worse things look, the closer is ATV's affinity to them. The HLx model appeared "way out of proportion" to the way an efficient business ought to have been run. Costs and expenses were unacceptably high, but the product itself was faring well enough in the market. ATV determined that users were paying off the equipment in anywhere from 3 to 18 months -- a tantalizingly brief capitalization period. Obviously, the problem was management -- or lack of it. "Gee, they don't know what they're doing," concluded a delighted Gleason.
Thus, ATV entered the hospitality market -- a knock-down-drag-out arena, it was to discover, where no combatant was making money. As ATV became involved with HLx, it realized that everyone vying for a share of the systems business of the half-million or so point-of-sale dining and hotel outlets was marketing by price-cutting. Suicidally, each competitor was bent on squeezing the others out of business. "We went up against one company that had 35% of the market, and they responded by dropping their prices," Gleason relates with astonishment. "They were fighting the wrong problem." ATV surveyed the battleground and decided that it would rather earn its share of the market than buy its way into it. "The competition," Gleason reasoned, "is not some other guy selling a similar product at lower and lower prices," but end users, who just had to be persuaded to use ATV's kind of equipment. Its pitch was simply that ATV's proprietary hardware and software save money and thus pay for themselves quickly, even if you have to spend a little more for the ATV quality brand. It worked. ATV now has restaurant systems in 70 of the country's top 100 chains.
But the feat wasn't accomplished overnight. Once ATV had HLx in its pocket, it set out to grab some of the important factors in the field, a market out of which ATV now realized it could fashion a big business. "We felt we had to get hold of some of the other people who were in the business -- buy them and control them," says Gleason, "or invest a lot of money in R&D and marketing." They opted for the former. Since things didn't appear to be going well over at GTE's competing Comp.-Acct., ATV aggressively sounded out GTE as to what direction that business intended to take. GTE intimated that if it didn't get better, the direction would be straight out the door. "Shortly thereafter," Gleason relates, "they assigned their corporate people to find a buyer." ATV was waiting with cash in hand.
ATV has been so successful at revivification projects that now interested parties -- law firms, larger corporations eager to pare unprofitable divisions, and business casualties themselves -- seek out ATV before going elsewhere. In 1982 alone, ATV helped with four bankruptcies -- but not out of sheer sympathy. When ATV proposes participation in a reorganization plan to bring a company out of bankruptcy court (it does this as a third party by entering into plans of arrangement with original management before or after it has filed for protection), it provides that ATV will own at least 80% of the fallen company if it is to become a party to the emergence. The remaining 20% of the shares are divided among the other parties to the transaction. If a holding company owns less than 80% of a portfolio company, rules regarding consolidation for tax purposes change adversely, and ATV tends to drop its interest. To the shareholders of the ones it owns, ATV submits appropriate financial reports as if those companies were independent entities.
The process of acquisition through Chapter 11 can be looked at as a round of financing that takes place in a bankruptcy court instead of a bank. "The commitment we make is not just to buy some shares and sit back," says Gleason. "It's to put in the amount of money it takes to make a big business out of it."
ATV's considerable experience in working with bankrupt companies makes it a central candidate for fitting into reorganization plans. The struggling entrepreneurs themselves are greenhorns at trying to cajole investors, customers, and employees to join in and give reformulation a whirl. Besides, they would probably be just as inept in a second chance as in the first. ATV finds that failing entrepreneurs tend to squander too much time and money on the bureaucratic side of business; purchasing departments accounting departments, shipping and receiving all sop up resources as if they were paper towels at Rosie's Place, yet they are not integral to the product and therefore have no direct bearing on whether the product will be successful. "Our criteria first," says Gleason, "is that [the product] has to be a good idea and that it has to be well executed. Second, it has to have reasonable gross profit margins -- are the customers willing to pay a healthy price for it? Last, will it fit in with the other things we do? We don't believe in the random walk."
One recent Chapter 11 example that tucked neatly into ATV's line of business was Evolution Technologies Inc. of Orange, Calif. (see INC., October 1982, page 53), which ATV brought into bankruptcy court and was officially granted control of last December. The struggling company virtually fell into ATV's lap. A bank that had secured interests in Evolution had read about ATV's first-aid mission in the local press and telephoned them. "We've got a problem," they said, "and we'd like to talk to you guys about it."
So talk they did. "Evolution was so far in debt that no rational person would have tried to get everyone out even," says Gleason. ATV arranged a plan by which Evolution could be brought into Chapter 11. The plan was filed after a preliminary agreement with the creditors and was ultimately accepted by the court.
But bankruptcy, even one so carefully spelled out ahead of time as in Evolution's case, is by no means a certain procedure. Creditors may bring other prospective saviors into the program at any time if doing so enhances their prospects of collecting faster. And, explains attorney Ronald S. Itzler of Ballon, Stoll & Itzler, a New York law firm specializing in such events, while the case is being considered by creditors, another outside party can come along and promise to do better than the plan filed. The creditors, who eventually get to vote on accepting or rejecting a plan, could fall for the new pitch. They have the opportunity to make the best deal for themselves until the day the bankruptcy is confirmed and the court rules that the debtor shall be governed by a specific plan. Until then, the outcome remains uncertain.
Last year, for example, ATV was working with Computer Communications in Torrance, Calif. They had been in agreement for seven or eight months, when another company came along with slightly better terms. Wanting to avoid a bidding war, ATV chose not to respond. Another complication is that a court can vacate a plan that doesn't seem to be satisfactory. The chance taken in this mode of growth is that acquisition is not etched in stone until the final gavel falls.
Evolution makes a minicomputer data-base management system that ATV has placed at the top of its line in both the hospitality group and the office information group. At the time Evolution made itself "available," ATV had plans in place to develop units for both sectors. But Evolution came in at well below what it would have cost to bring a company to the same stage internally. So far, ATV has put only $250,000 in cash into the company, besides supplying it with manufacturing space and office services and picking up its payroll. Gleason estimates that, dollar for dollar, Evolution's assets could have been bought for about $1.5 million. But, of course, the buyer would have had to take on the obligations as well -- $1.6 million in unsecured obligations and $1.6 million in secured debt -- bringing the total outlay to some $4.7 million.
But ATV's bankruptcy-basement deal for 80% of the company (the cash price was somewhat more than the assets would bring in liquidation) wasn't the end of it. ATV has agreed to meet a substantial portion of the secured obligations of Evolution over a period of time, and the unsecured creditors will get something, too -- perhaps stock after a reverse split brings the capitalization down to manageable proportions.
"Don't forget," says Gleason, "there's less than nothing there. We're starting from below zero, and we're saying we'll supply the capital to let the company grow." ATV calculates that the money it takes to provide the current assets of a business -- the inventory and receivables -- runs $400,000 for every $1 million of billing. ATV has undertaken to build Evolution's sales to $10 million in a couple of years, so, in essence, it has agreed to come up with $4 million. ATV sees such business failure as a "lack of control of the balance sheet," having detected a recurring pattern of top-heavy asset utilization in the digital electronics business. What happens, says ATV, is that utilized assets tend to climb to $1 million per $1 million of sales as the company undergoes a brief period of rapid growth. These assets are paid for through financing at high interest rates, and debt rapidly reaches unserviceable proportions. ATV asserts that asset utilization under $500,000 per $1 million in billings is "easily achievable in this class of business." This, ATV maintains, compares with an average of abut $800,000 per $1 million for Fortune 500 corporations.
Notes Gleason: "Whatever we happen put in initially, the real sum comes from putting in more if the company is successful, more so than an absolute amount at the start." And if the original owners end up with nothing, well, Gleason points out, "their future looked kind of bleak anyway, just on the basis of whether they had jobs or not." In Evolution's case, its three founders came along with their company.
Could ATV have accomplished the same ends by taking out a license to the operating system that Evolution used, hiring some engineers, and coming up with a product less entangled by disaffected outsiders? Perhaps, admits Gleason, but ATV views the situation as "a good deal for us, and a good deal for the other interested parties." One advantage of going about it this way, Gleason insists, is that when ATV takes over a more-or-less going business, it knows pretty well what that business can do. On the other hand, if it were to start out fresh, the situation would not be so clear.
"We know what we've got when we do a deal like Evolution," says Gleason. "We know how the equipment performs, we can talk to the users and find out how they like it, and so forth. But if you start with a speculative product development, you put out the specifications, then basically you wait a year. Part of this whole thing is compression of time. The other part is we also have the marketing channels and the support force, so we can market a product at much less incremental cost in terms of dollars or equity." And a hidden third ingredient is that, because there are no separate accounting or support staffs among ATV's companies most of the money pouring into Evolution can be funneled directly in to the product itself.
Besides the solace of solvency, the dressing that ATV applies to such wounded entities is its experienced guidance. ATV repairs the damaged merchandise it acquires by "straightening out management," as Gleason puts it. Essentially, the lone entrepreneur is good to about $10 million. Then, Gleason believes, "most small businesses, no matter how successful, don't make the transition." Operational techniques change drastically; the small business becomes a miniature big business without the entrepreneur's sensing it in time. Authority must be delegated, competent people must be found for management, financing considerations are much different, the marketing structure must be reevaluated, and so on -- all of which strain undeveloped entrepreneurial skills. A lot of companies can't make it past that level, and the money runs out. That is when ATV's salivary glands start pumping. One of ATV's tastiest morsels was the 100% acquisition of word-processor maker Jacquard Systems Division from parent AM International Inc. in March 1982. Of any company yet taken in by ATV, Jacquard had the most assets, in terms of money and work previously put into it. AMI had plowed huge sums into R&D, had expanded a skilled staff, and had established a worldwide sales network. Nonetheless, some $100 million had eventually been lost. ATV was able to acquire Jacquard for "a lot less than [AMI's] basic investment." (Reportedly, AMI had purchased Jacquard for $18 million.) ATV was able to take the remainder of the assets and "redeploy" them in its own company, where they are now producing handsome profits. ATV's studiously modeled approach to the redeployment of assets people as well as R&D, inventory, marketing networks, and the like -- Gleason claims, is unique in corporate finance.
Historically, ATV tends not to keep the previous top management, since management was probably the source of the initial trouble. When ATV got involved with Findex Corp. (see sidebar, page 50), a California portable computer maker created by a missionary who wanted to harness data processing to keep tabs on overseas proselytizing efforts, most of its white-collar force was let go. Original management can be the source of later trouble as well: In the midst of bankruptcy proceedings, Findex's founder filed suit alleging fraud against the company's venture-capital backers for illicitly trying to gain control.
Old-liners who don't want to "jump in and fight," Gleason warns, are summarily replaced. "We believe in people making it work. For a company our size, management credentials are essential." Given this philosophy, even if the founders lose their equity position through bankruptcy agreements, deposed entrepreneurs "who want to do things our way" stand a good chance of clawing their way back to fiscal respectability through liberal stock incentives offered by ATV. They may even do better than if they kept their original business. "Lots of entrepreneurs who work for larger companies make it as big or bigger than if they owned their own," says Gleason. Texas Instruments, he claims, had more millionaires per square foot of floor space than any other place he has heard of. "And it's going to be that way at ATV, too."
On the other hand, nothing prevents any entrepreneur without a business from going into bankruptcy court and acquiring one on the cheap, just as ATV does. "It's much less expensive, and there is a much higher probability of success picking up ideas that way, than to go through the venture capital route," Gleason insists. But few entrepreneurs think that way, undoubtedly finding secondhand dealings anathema to the American way of growing a business. Noble as that may be, it discloses a lack of practicality that ATV's three founders have profitably shunned.
CORRECTION-DATE: June, 1983
Picture, In "Courting Disaster" (April), the founders of Applied Technology Ventures should have been identified as executive vice-president Douglas O'Connor, president Frank Gleason, and chairman Philip Gomez. Tony Korody