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Limiting Liability

Cheap debt in Switzerland; power from the wind (and from RD limited partnerships); taking the slow track in venture capital.
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The grass, as they say, is always greener on the other side of the fence, but money may be greener on the other side of the ocean. Such, at any rate, was the conclusion of Knogo Corp. of Hicksville, N.Y., when it recently set out to find new debt financing.

Knogo is an 18-year-old, publicly held maker of electronic article-surveillance systems -- the devices that set off alarms when, for example, a shoplifter tries to leave a store with merchandise under his coat. Last year, the company had revenues of about $25 million, much of which came from sales of large-store systems costing $50,000 and up. At such prices, Knogo has found that in order to grow, it had to be able to provide customers with attractive lease financing. "In our industry," says vice-president of finance James R. Dellomo, "the financing is really part of the product. We need to give buyers the lowest rates possible."

In the past, Knogo has supported its growth by, in effect, gambling on interest rates: When customers needed financing, the company boosted its borrowings from U.S. commercial banks. This approach entailed obvious risks, since Knogo generally offered its customers fixed rate loans over a period of several years while its own cost of this money floated up and down with the prime rate. Nevertheless, the company felt that it had to provide such fixed-rate financing in order to remain competitive.

Last summer, the company seized an opportunity to pay off its burgeoning bank debt with the proceeds of a $14-million equity infusion. "The market was strong," notes founder and president Arthur J. Minasy. "So it was the cheapest way to go." But, shortly thereafter, Minasy and Dellomo began looking for a new way to bankroll Knogo's future expansion without piling up more floating-rate debt. "We figured that our needs would be $30 million to $40 million over the next two or three years," says Minasy. "So we started talking to our investment bankers about financing possibilities."

One possibility was to sell long-term bonds that would be convertible into Knogo stock. Says Minasy, "We were quoted fixed rates of 9 1/2% to 10%, which compared quite favorably to our 11% borrowing costs." Then, last December, the 57-year-old president came upon an even more favorable option. While on a business trip to Europe, he met with bankers at Banque Gutzwiller, Kurz, Bungener S.A., a private bank in Geneva, and learned that Knogo could borrow long-term in Switzerland at rates that were as much as four percentage points lower than those in the United States.

Minasy responded quickly, hammering out a deal within days. Banque Gutzwiller agreed to lead a syndicate of Swiss banks in raising 75 million Swiss francs (at press time, the equivalent of $35 million) for Knogo at a fixed rate of 6 1/2%. The eight-year subordinated debentures would be sold to private Swiss investors, who would get annual interest payments on the 5,000-franc bonds in Swiss currency.

The danger for Knogo was that the dollar might weaken in relation to the Swiss franc, making the whole deal increasingly costly. As protection against such foreign exchange risks, Minasy obtained the right to pay off the bonds in a fixed amount of dollars. "We didn't want to have to worry about whether the dollar was losing ground," he explains. "We paid a little extra, but we limited our total liability to $35 million."

Then again, Knogo may never have to pay off its new Swiss bondholders in hard cash, thanks to a special conversion feature, which becomes effective this June. If, at any point, the company's stock trades at a price exceeding $21.04 (a price that is about 20% over the trading price at the time the deal was signed) for 20 consecutive days, Knogo may ask investors to convert their 6 1/2% bonds into common stock. "Each bond would be worth around 127 shares," says Minasy.

Whether or not the company ever does convert the bonds, Minasy is confident that Knogo has solved its major financial problem. "We think we've found an awfully good way to lock in our borrowing costs and reduce our exposure," he says. "We can sleep a little more peacefully. And now that we don't have to spend so much time looking for money, we can go out and build up the business."

What does a privately held research company do when it wants to bring a new product to market but cannot afford to tie up its own precious capital? Flow Industries Inc. of Kent, Wash., pondered this question back in 1982 and came up with an interesting strategy.

Flow Industries is a $14-million-a-year research and development company that has been doing government-sponsored research in a variety of technical areas for more than a decade. In 1981 and '82, Flow raised $800,000 from an R&D limited partnership to develop an innovative wind turbine for generating low-cost electrical power. Flow's turbine -- which rotates on a vertical axis like an egg beater -- had been fine-tuned and tested, and Michael Pao, the company's 49-year-old founder and chairman, thought it was time to launch full-scale production. "Our long-term plan was to develop and operate wind-power facilities all over the world," he says.

Toward that end, Pao had already created a separate company named FloWind Corp., which generated some cash in 1982 by selling a handful of its $300,000 turbines to various customers, including a utility on the island of Antigua. Pao had big dreams, however, and so he decided to speculate on the development of a $14.9-million project at Altamont Pass, Calif. He drew up plans for a 60-turbine "wind farm," and worked out an arrangement to sell whatever power it generated to Pacific Gas & Electric Co. under a 30-year contract.

FloWind began to develop the Altamont wind farm with money advanced from Flow Industries, plus $4.6 million in secured bank loans, but it soon became evident that the company would need a lot of new capital to grow as quickly as Pao wanted. So he met with some investment bankers from A. G. Becker Paribas Inc. in New York City to talk about bankrolling FloWind's expansion plans through limited partnerships. "It was a way to raise money without giving up equity in the company," he says.

Last December, FloWind sold its Altamont Pass wind farm to a group of limited partners for $14.9 million. The partners, who put up $100,000 each, get regular investment tax credits and additional federal and state credits for investing in solar energy. They also get income from the sale of wind power to the utility. FloWind used the proceeds to pay off the bank debt and to replenish capital that had been advanced by Flow Industies, and FloWind will continue to manage the wind farm for an annual fee.

Meanwhile, FloWind is already planning to develop other wind farms in New York, Oregon, Guam, and other places. Pao says the company will also be designing some new products for storing wind energy. As FloWind grows, its capital requirements will be enormous. "We'll be doing a series of limited partnerships over the next few years to move this company forward," says Hugh Rose, FloWind's senior vice-president.

But that may not be the only way the company raises money over the next couple of years. "Once we're earning $1 million after taxes, we hope to do an initial public offering for FloWind," says Pao.

These days, the term "venture capital" conjures up visions of electronic gadgetry and software, and annual investment returns of 35% or more. But if you believe that nobody is interested in making plain old loans for machinery and buildings, you haven't met Gerald Grossman.

In 1982, Grossman took $1 million of his own money and established a new small business investment company (SBIC) in New York City, called American Commercial Capital Corp. Under the terms of his license from the Small Business Administration, Grossman is allowed to use a wide variety of investment vehicles, ranging from secured debt to equity, but he has decided to play things cautiously. "I'm not very comfortable with equity risks," the 51-year-old former finance company executive explains. "So I lend against the hard assets of a business. Since I don't try for big hits like a lot of venture capitalists, every transaction has to stand on its own."

To date, Grossman has made fixed-rate loans at 17% or 18% to one California company and about a dozen New York City-area companies. Typically, the businesses require $100,000 to $200,000 to buy expensive equipment or to solve basic cash-flow difficulties. American Commercial Capital looks for ways to lend on a secured basis, even in cases where banks have said no. "Before making a loan, I listen to the story and look at the numbers, much the way a banker would," explains Grossman. "But I'm less concerned about the overall condition of the balance sheet than a typical banker. I'm interested in how the proceeds of a secured loan can strengthen the business."

A recent loan of $150,000 to a troubled meat-processing company in upstate New York is a case in point. The $12-million business was attempting to reorganize under Chapter 11, and needed new capital to buy equipment and expand its marketing department. The company's commercial banks had shied away from advancing any new money, but, says Grossman, "the plan for putting the business on its feet seemed realistic." Grossman's SBIC made the seven-year loan at 18% and has protected itself heavily on the downside if the turnaround fails. "If it doesn't work out," explains Grossman, "I'll own a building that's been appraised at about $160,000."

Grossman is the first to admit that there is nothing terribly glamorous about his style of investment. Indeed, his goal for return on capital is a modest 15%. Nevertheless, he believes he fills an important gap in the marketplace. "A lot of the things we finance simply aren't bankable," he says. "But with the money we provide, businesses can take the steps they need to take to become more profitable." To be sure, he admits, "we won't be investing in the next Apple Computer. But when a supplier to U.S. Steel needs a machine to remain competitive, we think we can be part of that package."

Last updated: May 1, 1984




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