Equity Without Tears
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.
After considering the proposal, Cheever's management decided to accept. To date, the British investors have agreed to remain passive observers, with no representation on the company's board. "They've told us that we control the reins," says Allegrini."They want us to keep doing what we've been doing."
And what if Cheever had wanted the opportunity to buy out its investors entirely? Well, says 3i president David Shaw, that flexibility could also have been structured into the deal -- for a price. In fact, 3i recently participated in a leveraged buyout of a Massachusetts apparel company whose new owners insisted on an option to repurchase the participating preferred stock after the eighth year. The put-call feature doesn't have to be exercised. If it is, the redemption price will be based on a multiple of earnings from the previous two years.
"We're in the capital gains business just like other venture capitalists," says Shaw, a 36-year-old Scotsman."But we can be a very flexible investor. If we think an opportunity is attractive, we can attempt to solve any problem."
How many "angels" can dance on the head of a silicon chip? An enterprising group of New Hampshire businesspeople is hoping that the answer is up in the hundreds -- maybe even higher. "Angels," of course, are those well-heeled individuals, found in every area of the country, who like to invest in promising young companies. What the New Hampshire group has done is to put together a new type of computer "dating" service, whose purpose is to match up New England-area angels with local entrepreneurs seeking modest amounts of capital.
The idea for the new service, called Venture Capital Network Inc. (VCN), grew out of a 1981 study on the availability of risk capital in New England. The study -- conducted for the Small Business Administration by William E. Wetzel Jr., a professor at the University of New Hampshire's Whittemore School of Business and Economics -- showed that entrepreneurs and angels were locating one another by largely random methods. "It was all very informal," says Wetzel, "and the investors were essentially invisible."
As one might expect, the entrepreneurs Wetzel interviewed felt extremely frustrated by the situation: Their capital needs were often too modest to interest venture capitalists, yet it was very difficult to find other potential investors. The research suggested that the pool of money available in the informal private market was at least as large as the more organized venture capital market.
That informal market was made up of thousands of business angels looking for companies that needed as little as $30,000 to $50,000 in capital. As it turned out, the angels were as dissatisfied as the entrepreneurs with the random nature of the search process. "The information needed to support a real market for smaller investments -- anything from $50,000 to $500,000 -- simply wasn't available to them." The obvious challenge, then, was to develop a way to bridge the information gap.
In 1983, the Business and Industry Association of New Hampshire, a private business organization, decided to meet this challenge, setting up VCN as a nonprofit corporation. The new organization spent the next year designing its service. In May 1984, it began sending out confidential questionnaires to entrepreneurs and investors in New Hampshire and nearby states. The entrepreneurs were asked to supply a two-page business summary, as well as information on their financial performance, their growth projections, and their estimated needs. A $100 filing fee was established to discourage frivolous proposals. Potential investors, meanwhile, were asked to describe their areas of interest and their personal investment criteria, including their geographic preferences.
VCN plans to begin doing regular computer matchups this summer. "When we get a potential match, we'll send them along to the investors," says executive secretary James K. Hoeveler. To avoid potential legal liabilities, VCN will not act as investment adviser or broker-dealer, but will limit itself to making the introductions.
Wetzel is the first to admit that VCN is only experimental. Even so, he has already fielded inquiries from people in other states -- including Florida, Nebraska, and Louisiana -- who are contemplating the creation of similar services. "The market we're trying to serve revolves around the entrepreneur who needs more than he can get from his Uncle Charlie and less than what it takes to interest a venture capital firm," explains Wetzel. "That's the hole in the market that the angels fill."