A Little Help From Your Friends
No matter how specialized the financing or how demanding the prospective financiers, when a company needs money, there is always a structure to be found that will accommodate everyone involved. So believes small-business specialist Dennis O'Connor, a Massachusetts attorney whose practice is what he preaches.
A prime example of that philosophy is the jury-rigged vehicle O'Connor pieced together early last year to raise $350,000 for Laser Engineering Inc. The little start-up needed funds to start producing a sophisticated surgical laser device its founder and owner Robert Rudko had brought to working-prototype stage. So straightforward a request ordinarily would be filled by a bank, a venture capitalist, a public offering, or a second mortgage. But in this case, Rudko demurred. Not only was he loath to put up personal property, but he was unwilling to dilute his holdings through selling equity. He refused to pledge corporate assets, because he wanted to save them for collateral against larger loans.
Given such self-imposed shackles by an unproved company with an untested product without a sales force to sell it, any vessel that could float this deal was destined to go down in Ripley's -- unless the owner knew some angels who would part with rankly speculative cash on good faith alone. Rudko, guided by O'Connor's counsel to test all relationships for possible investors no matter how unlikely they seemed, came up with the idea of his father's retired cronies. Approached discreetly, the seniors might be persuaded, since the proud sire had been continually filling them in on the progress of his son's high-tech endeavors.
To convince them to take a chance, the particulars of golden age had to be addressed. "Equity in a small business doesn't do anything for them," Rudko understood, "but return on their money does." As retirees, they would expect to be paid interest quarterly, but at a rate that would convince them to part with their CDs. And surely there would have to be something in the arrangement that recognized the uncommon risk and severe illiquidity to which they were being subjected. No conventional boilerplate would do the trick.
An R&D limited partnership on a given product might have filled the bill, but educating inexperienced investors in its intricacies would have been too tricky. A convertible debenture would provide yield -- but this group of investors should live so long for the chance to convert. "Laser Engineering is not some grocery store," O'Connor says. "It is very high tech, and the investors were very low tech." The swiftest and cheapest course, he reasoned, was to tailor something out of whole cloth.
In an ordinary arrangement involving one lead investor, a deal can be negotiated, but in approaching this pool of poolsiders, the terms had to be right the first time out. "If you go with a vehicle that doesn't make sense to them," O'Connor contends, "you simply run into a brick wall. On the other hand, you can't say, 'We're thinking of doing such and such. Do you like it?' You have to offer them a sensible deal, and basically, tell them to take it or leave it."
Dubbing his new financing apparatus "a performance promissory note," so he did. "The feeling was that the investors should get a break. After all, this wasn't a T-bill," he says. "Let's give them a couple of points over market rate and a specified prospect for extra return." He must have gotten it right the first time, because the investors took it.
Here's what they took, and O'Connor's reasons why:
* A four-year unsecured note at 12%. The principal is to be retired in a lump-sum payment, but there is no sinking fund or other arrangement to reassure holders there will be enough money to meet the payment in 1991.
"The deal is not that big, so I don't imagine retiring the notes will be a problem," O'Connor says. "From the company's point of view, debt is not as good as equity in regard to balance-sheet formulas and ratios and the like, but it's better than not having any money put in. This was not a deal that the bank had to be convinced of. On the balance sheet, it appears as debt, but so far as a bank is concerned,it's like stock. The bank's interest payments come ahead of it, and if there's a problem, it gets the same treatment as stock. Even as an addition to existing debt, there is usually no need to get a bank's approval. Any time people put money into a company that the bank is ahead of, the bank loves it, whatever it's called."
* A slight percentage of gross of each surgical instrument sold during the period, to be paid in lieu of interest when the dollar amount exceeds interest. If the product is a winner, the investors stand to double or treble their rate of return, as there is no ceiling. However, the terms do not direct the company to spend the money exclusively on manufacturing and marketing that product, nor are there performance standards for production or selling efforts that the company has to meet. An additional risk for the investors, therefore, is that despite the upside enticement, the product need not be marketed during the four-year interval.
"The agreement is not specific," O'Connor says. "It is an obligation of the company for working capital and related activities. Fundamentally, we said we were going to use some of this money to finish developing a prototype and get it out into the field. But it wasn't that the company had only a vague idea of what it wanted to do -- it wouldn't make sense to develop it and then not market it. This is more advantageous to the investors than if the note had said that we would give them a piece of every instrument we sell, period. This way, their floor is 12% return in any event; thus they aren't betting on only that one product."
* Warrants for common stock within the same four years as the note. If Laser Engineering decides to go public or to merge, it is required to give the warrant holders 60 days to decide whether they want to exercise them.
"The warrants balance the deal neatly," O'Connor says. "In the scope of things, the dilution will be insignificant to the company, but for someone putting in $25,000, the warrants are a significant sweetener. The investors aren't going to make a fortune from them, but if the company is sold or goes public, the effective return on the warrants alone could surpass 12%. Theoretically, the company could drop that product, still sell out, and these guys would get a nice kicker."
As smoothly as the deal has gone so far, one concession to signing on relatives and friends, Rudko discovered, has been that "they all know where to find you." The first few months were marked by noteholding phone callers seeking reassurance that the company was still in business. Now, the calls have stopped, and "everyone is happy with it," he reports.
As everyone should be: by the end of 1988, Rudko expects the investors' share of sales to overtake interest payments. When they get their extra reward, he anticipates, some of the recipients are going to wonder where it came from. "They were not professional investors. To them, just the 12% was fine."
Indeed, these days, inexperienced investors do well merely to get repaid regularly, since the Securities and Exchange Commission's exemption, in 1983, of private placements of less than $500,000 from net-worth and sophistication tests (see box, "The Rule of the Game," previous page). Not having to meet disclosure standards at that level (except in some states with so-called blue-sky laws), a business is free to raise money by any method at any degree of risk without having to issue a thick offering memo.
"You still have to make disclosure so you can sell the deal," O'Connor says, "but there's no requirement to do so." Because formal compliance was not a factor, fees for drafting the Laser Engineering deal were relatively low -- less than $5,000. "It was not terribly hard to do," O'Connor admits, "and for a small, emerging company, it was just right. It met the objectives of all the players."
Could some other equally concerned business owner pull off a similarly unconventional arrangement with some other equally unseasoned investors? Sure -- if circumstances merit, O'Connor says. But it's a mistake to try to force the toothpaste into the tube by starting with a preformed notion. "I've been at this stuff for 20 years, and it still bothers me when a guy comes in and says he wants to do a convertible deal or debt with sweeteners or dual-class common. Usually, it's something he just heard about when he was playing golf, and it won't work."
THE RULE OF THE GAME
What Rule 504 says about private placements of $500,000 or less
Virtually every instrument a corporation offers investors is considered a security, and therefore every deal must meet federal standards to qualify as a private placement. But that's not as hard as it used to be.
Regulation D of the Securities Act of 1933, adopted by the Securities and Exchange Commission in 1983 to provide specific safe-harbor guidance in what once were tricky waters, spells out simple guidelines for exemption from registration.
For better or worse, in placements of $500,000 or less, Regulation D's Rule 504 pretty much removes the feds from supervising. To comply, only three criteria must be met:
1) The offerer cannot advertise for investors.
2) A simple form must be filed with the SEC within 15 days of the first sale.
3) The offerer cannot be a public company.
(There are some exceptions involving offerings restricted to states that require disclosure. These exceptions raise the ceiling to $1 million and do allow advertising.)
Rule 504 waives such tests as an investor's net worth and net income. An offer can be made to a limitless number of people, and the number of buyers, as well as their sophistication, is not subject to regulation.