Equity Without Tears

A retailing company attracts equity without selling the store; New Hampshire businesses set up a computer "dating" service -- for entrepreneurs and investors.

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There comes a time in the life of almost every vigorous, privately held company when it has to face up to a difficult choice -- one between growth and control. It is a choice forced upon the company by the need for equity capital to finance future expansion. In order to get the money, the company usually finds that it has to offer investors some degree of control over its destiny. Alternatively, it can scale back its expansion plans.

This was more or less the dilemma faced by the owners of John S. Cheever Co. of Hingham, Mass., back in 1983. Unlike many others, however, they found a way to eat their cake and have it, too.

For most of its 91-year history, Cheever had been a small, family-owned wholesaler of specialty paper goods. Then, in 1968, the company changed hands, and in 1971, Paul E. Cullinane, son of the new owner, decided to try his luck at retailing. He began by opening a discount store in a room off the warehouse, where the company sold a limited assortment of bulk paper items -- bags and pizza boxes, for instance. Before long, the cash-and-carry business started to take off; Cheever's annual revenues grew from about $700,000 in 1971 to $4 million in 1975.This success encouraged Cullinane (who became president and chief executive officer in 1975) and executive vice-president Jack Allegrini to invest the company's profits in two new outlets south of Boston.

While Cheever's wholesale paper business saw little or no growth in the next few years, annual sales of the three discount stores, named Paperama, climbed to about $7 million in 1981. By then, the stores were carrying a broader selection of merchandise, ranging from party supplies and stationery to aisles and aisles of such seasonal items as rakes, snow shovels, and holiday decorations.

Cheever's future clearly lay in retailing. Over the next year, the company opened two more stores, and Cullinane, Allegrini, and treasurer Stephen Dreier began to explore long-term options for Paperama. Retained earnings, they figured, would be adequate only for bankrolling slow growth, perhaps one or two new outlets per year. But what if the company wanted to expand the chain more quickly? Where would the capital come from?

Fortunately, the company was in excellent financial condition. It had financed seasonal inventories with a revolving credit line from its commercial bank, repaying the borrowings in full at the end of each selling season. What's more, there was almost no long-term debt. On the other hand, management had thoughts of opening 13 stores over the next four years -- a move that would require new sources of capital. "We realized that unless we got some new equity, the bankers would get nervous," says Dreier.

At the same time, however, they were determined to retain full control of the company. "We didn't want anybody to interfere with the way we ran the business," explains Allegrini. "We wanted to grow at the rate we deemed reasonable."

So, in the summer of 1983, the company set out to find long-term investors willing to put up about $2 million in equity under certain strict conditions. Cullinane and Allegrini -- the principal shareholders -- made it clear from the start that they were quite prepared to walk away from any deal unless they were assured of continued control. "Frankly, we didn't think we'd find anybody," Allegrini admits. Nevertheless, a few months later, their attorney introduced them to a British-based investment company that seemed to find Cheever's conditions quite reasonable.

The investment company was called Investors in Industry, or 3i. Its shareholders included the Bank of England and eight British banks. It had recently opened offices in Boston and Newport Beach, Calif., and was looking for promising U.S. companies in which to invest. In the summer of 1983, it opened discussions with Cullinane and Dreier, during which the latter spelled out their conditions: They didn't want to give up a majority of Cheever's equity; they didn't want the investor in a control position on the board; and they didn't want be forced within any set time span to sell the company or to go public. Much to their surprise, the British investors voiced no objection. Rather, 3i did a thorough analysis of the business and listened closely to management's goals, then proceeded to suggest a series of mechanisms for meeting Cheever's terms.

To enable Cheever's owners to retain as much control and equity as possible, 3i proposed investing the $2 million in two types of nonvoting preferred stock. The first type would function more or less like an eight-year fixed-rate loan: Cheever would receive $1.5 million and would have to pay the investors an annual dividend of 6%. Eventually -- in years 6 through 10 -- the company would redeem the $1.5-million principal in equal installments. The second part of the deal called for 3i to invest an additional $500,000, in return for which it would receive a 3% slice of Cheever's aftertax earnings. Unlike the fixed-rate preferred stock, this participating preferred stock would not be redeemable, and thus the investment would remain in the company indefinitely. When and if management ever decided to sell the company or take it public, the participating preferred would convert into a minority percentage (something under 30%) of the common stock.

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