By 1986 Newman Communications had branched into publishing and direct mail, and topped $7.9 million in revenues. But the company's inventory burdens relentlessly burned through cash. "As a distributor in a developing market, we were just a variation of a banker," Hesters recalls. "We had an insatiable appetite for working capital, and the strain on cash flow was enormous."
Inevitably, the company's cash-poor condition unnerved its California-based lender. Newman's management had turned to a secondary stock offering and filed a prospectus with the Securities and Exchange Commission to sell an additional $3.5 million worth of equity. The red herring was released on a Thursday. By the following Monday, the market had dropped 100 points, dooming the offering, on which several thousand dollars in fees had been squandered.
Bad news fell like broken beams. An inventory backlog at one of the company's largest accounts produced an onslaught of refundable returns. Nothing could stanch the flow of cash. Discount channels had yet to emerge: there was nowhere to dump excess inventory. Accounts receivable plummeted. A disfigured balance sheet made Newman abhorrent in the eyes of bankers and investors.
Its primary lender pulled the company's operating lines of credit and demanded it pay down the balance, which exceeded $1 million. "Technically, we were immediately in default," recalls Hesters. In March 1987 the bank dispatched its workout specialists. The three principals hastened to reduce expenses, liquidate inventory, and pump in more personal cash. By May, at the bank's insistence, they had initiated a third round of layoffs. "I started to see flesh come off the bones. I was losing the people I needed to make sales that would pull us out," Hesters realized. The company, its accounts payable hopelessly in arrears, couldn't buy product. "We just ran out of oxygen."
A million dollars' worth of orders remained on the books, and only weeks earlier Newman's largest competitor had offered to sell out -- in an act of surrender that would have crowned Newman undisputed market leader. But the company was being dismantled for auction. "I didn't understand that cash flow had an absolute limit," says Hesters.
* * *
Moving Toward the Light
The day a U-Haul truck loaded with the flotsam of Newman Communications backed into the driveway of their home in San Mateo, Linda Olsen left town. "I was not prepared to cope with this. In Albuquerque, Newman had an auction and locked the doors. That's what I thought should happen here. I felt it was dead. Over with. 'What are we doing moving this cadaver into our house?' I said. 'Why don't we just bury it?' I didn't have the energy to argue." But she wasn't about to welcome it into her home. She spent two weeks driving around the Northwest in an RV, instead.
Hesters, meanwhile, was adamant about salvaging valuables from the wreckage. "It was a matter of moving to the light," which meant, at that moment, into the living room. "I couldn't think of anything I could do where my value would be greater than to continue something I knew inside and out."
Ultimately, Olsen set aside her objections. But there was plenty to be leery about. Newman Communications had been a publicly traded company, and its shareholders could well sue. Then there were the creditors, who'd accepted a small fraction of their due in the settlement of Newman's outstanding debt. Even rights to titles Newman published had been compromised by nonpayment of royalties. Hesters and Olsen devised a clever legal strategy: "If anyone made a claim on an asset," Olsen recounts, "we'd just say, 'Fine, it's yours."
Orders continued to roll in from the 2 million catalogs that had been mailed over the previous two years. Libraries across the country kept the company on their vendor lists. "We saw a new business that could be built from the remnants of the old," says Hesters. Those remnants included the name of the catalog (Audio Editions), the rights to 60 titles (many with liens), the operating system, and the leftover inventory. Everything else had been sold at auction, for pennies on the dollar. Since Simon & Schuster had purchased the mailing list, Hesters and Olsen had to build a new list from scratch.
"I thought, 'What's the worst thing that could happen?" recalls Olsen. "We could lose everything. Well, when you've already gone through a serious dress rehearsal for that, it's not such a big deal anymore." Olsen honed her financial skills. She learned enough accounting to keep the books the first year and generate financial reports. "I'm going to take more responsibility," she vowed.
Their goal was to resurrect a venture in direct mail, a cash business that would pay them up front and obviate worries about sell-through. They scraped together $30,000, paid $14,045 for furniture, a computer, and a phone system, and used the rest for inventory. They bought the publishing rights back from the bank on a royalty basis, agreeing to pay five points for each copy sold for three years. For the first year and a half, they simply filled orders from the Newman catalogs.
* * *
Go Forth, Multiply, and Divide
"When Newman went to the penny-stock market, we raised expectations for growth that were impossibly high," says Hesters. "In the context of that money, growing only 30% a year was failing. We were always frantically asking, 'How can we get to $11 million? To $20 million?'
"The single greatest damage that money can do is to require that which is not possible or profitable. So we chose business activities that would have fewer cash demands." This time he and Olsen decided to finance their company out of cash flow. By bootstrapping, they would not risk losing too much control too soon, for too little. If they chose to raise capital later, they figured, they'd get a better price for equity they had layered with value.
Profits from the Newman orders underwrote the resurrection of the direct-mail company. A shrewd eye for value and a stroke of good luck had won them the rights to The Hunt for Red October. The tape, produced by Olsen, shot to the top of the best-seller list and subsidized the entire first year of the catalog company. She and Hesters carried losses from the catalog operation for two years before covering them with equity. They judiciously limited their capital burdens to equipment and facilities. The lines of credit they reserved for the ups and downs of operating cash flow.
