Some financiers combine venture capital methods with those used in LBOs to provide money for business expansion.
Some investors are providing it by combining the leverage of a buyout and the growth potential of venture capital
Once upon a time, venture capitalists were venture capitalists, buyout specialists were buyout specialists, and never the twain would meet. That made life simple, if not easy, for the capital hungry. If you were an entrepreneur with a hot new product, you knocked on venture capitalists' doors. If you were the owner of an established business, you went to the leveraged buyout experts.
Gradually, though, both kinds of investment groups began to dabble in each other's disciplines. Eventually someone was clever enough to come up with the idea of combining the best of both investment techniques. The simplified recipe for such a hybrid: add some of the leverage of a buyout to the growth orientations of a venture investment.
By itself, that's not a particularly stunning concept. But the way it's being applied is creating some unusual opportunities for entrepreneurs who are strapped for expansion cash. Instead of waiting for a good idea to walk in the door, these professional investors are spotting their own business niches and starting companies to exploit them. One of their favorite strategies is to "McDonaldize" a mom-and-pop industry. But instead of building a chain store by store, these new-style investors are constructing national companies acquisition by acquisition. Harry Hopper, a professional entrepreneur we'll meet again in a moment, calls this "shirt-sleeve investing" because the venture capitalists and buyout pros who do it are so active in shaping these companies.
The idea, of course, is to snap up as many mom-and-pop businesses as it takes to create a company with a large market share. The key is to pick an industry in which fixed production or overhead expenses don't increase significantly as the company grows. Such economies of scale (the business school jargon for this phenomenon) translate into greater profitability.
Because it's still relatively new, Carol Rabe didn't count shirt-sleeve capital among her options when she found herself at the crossroads in 1987. She had started The Seedlings Inc., a child-care business in Philadelphia's Main Line in 1981, when day care meant "a bunch of kids in a garage with no windows," Rabe recalls. Her first two centers met with immediate success, but the third struggled. AT&T had guaranteed that its employees' kids would fill 25 of 60 spots. Then, just after Rabe had signed a lease for the center, the company laid off about 2,000 workers. AT&T ended up taking only 2 of the spots.
In addition to constantly worrying over the third center, Rabe was tiring of the relentless responsibilities of being an owner. Monitoring and marketing the centers by day, she paid bills, figured out withholding taxes, and answered parents' phone calls at night. "The glow of ownership faded quickly," remembers Rabe. By the time the third center was filled, she was burned out.
As Rabe saw it, she had two options: sell out, or find more capital to expand. Maintaining the status quo with three centers wouldn't work in the burgeoning child-care industry. Rabe's affluent Main Line territory was highly coveted. If she didn't expand within it, Rocking Horse, her largest competitor, would be happy to. The choice was the same one that any entrepreneur faces in a quickly consolidating industry: eat or be eaten.
Rabe went looking for capital for expansion, and unlike many, was lucky enough to find a group of individual investors who would provide $500,000. The trouble was Rabe would have to commit to staying on for another three to five years -- with no relief along the way.
She decided to sell, though that wasn't a very palatable option either. "Once you've given a child-care business the local personality that made it successful, it is very difficult to give that up to a national personality," she explains.
It was simply good luck that Rabe found she had a third option: growing by selling out. Keeley Management Co. -- the local investment bank that Rabe had turned to in order to sell her company -- shipped off a copy of The Seedlings' selling memorandum to Michael Connelly, the gregarious president of Lepercq Capital Management, the venture capital arm of New York City investment bank Lepercq, de Neuflize & Co. Lepercq Capital had $32 million earmarked for shirt-sleeve investments and had already given Harry Hopper, an entrepreneur for hire, $2 million of it to start American Family Service Corp. (AFSC). Hopper had acquired Greentree Learning Centers Inc., a five-center child-care operation in southern New Jersey, in early 1988.
At first Rabe thought that selling to Lepercq would be no different from selling to a chain, since building a national business was Lepercq's ultimate goal. Gradually she began to see some important differences. Connelly wanted The Seedlings to capitalize on its preeminent local reputation by retaining its identity, not submerging it. The potential for introducing economies of scale was what drove all of Lepercq's shirt-sleeve investments, but that meant systemizing back-office operations, not producing cookie-cutter child care.
As attractive as AFSC's approach seemed to be, Rabe felt sure she wanted no part of the company's future. She agreed to sell 100% of The Seedlings, which had 1987 annual revenues of $604,000, for about $900,000. Still, something didn't seem right. Rabe realized that she wanted to stay involved; she just didn't want all the responsibility that was involved in running the day-care centers. Connelly and Hopper, who wanted her to stay on anyway, persuaded Rabe to take the title of director of special proj-ects.
Relieved of the burden of ownership, she began to get excited by Lepercq's plans for growth and its determination to maintain a high standard for quality. Revitalized by such prospects, Rabe became vice-president of operations three months later. By the time Hopper was ready to move on to his next entrepreneurial project, less than a year later, Rabe was sold on Lepercq's strategy and confident of its support. She agreed to take Hopper's place as president and chief operating officer.
