EXIT STRATEGIES

Company Profile: True Value

A close-up look at how a new company emerged from failure, and how the cofounders are protecting themselves this time.
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Grady Hesters and Linda Olsen were self-made millionaires -- on paper. Only when they lost nearly everything did they learn to create value in business and in life. Here's how a couple of survivors are getting it right this time around

On High Street in Auburn, Calif., you can't help noticing the bronze colossus of a prospector panning for gold. You pass it on the way to the modest headquarters where Grady Hesters and Linda Olsen, wealth seekers of a different sort, are also looking for gold. But Hesters and Olsen, partners in business and marriage, couldn't be more different from the prospector on the town square or the many like him who once flocked to this valley to fish gold from its streams. It's not that the pensive Hesters and his creative partner don't know or appreciate a gold nugget when they see one. It's just that they harbor a healthy suspicion of the other stuff that glitters: the glamour of growth, the pleasures of profit, the thrill of dominating a market. They have sworn themselves instead to creating value -- that rare compound of growth, profit, and market share taken in just the right proportions. That, they reckon, is the alchemy of pure gold.

"My purpose here is to create value," says Hesters with the matter-of-fact resolve of someone who's been at it for a long time. "It's an absolute objective." His is not a mission to rack up growth or maximize profit, except insofar as those practices foster value -- value that can be measured, extracted, and converted to cash -- just as surely as gold was extracted from the eddies of the American river a century and a half ago. Only never as randomly.

You can't fault Hesters and Olsen, a couple in their fifties whose net worth is almost entirely baked into their business, for thinking about ways to extricate it. "I'm 52 right now," says Hesters. "You become conscious that that's all some people get." Still, their value consciousness is neither a spasm of financial insecurity nor a midlife longing for liquidity. Both insist their business is not on the block, and their deliberate consideration of how and when to cash out is not the consequence of declining fortunes or flagging interest. "The thrill is not gone," says Hesters, who envisions an exit that resembles a leisurely promenade more than a hasty retreat. It will be a passage calibrated in small, surefooted steps.

They're quite familiar with its polar opposite -- the grow-fast-and-hope-you-take-something-with-you-when-you-go approach. As cofounders of Newman Communications, a company that soared, crashed, and burned in 1987, they kissed $60,000 in savings good-bye and watched 68 people lose their jobs. "The stock, which had effectively cost us 3¢ a share, was worth $5 a share at one time," Hesters recollects. "You learn that there's a certain fiction to business -- a fiction of anticipated rewards -- that has to be converted to reality."

Hesters and Olsen have devoted the eight years that have passed since then to a work of nonfiction: Audio Partners, built from the rubble of Newman Communications and dedicated to the preservation of jobs and the liberation of equity. It's a true story -- not a fairy tale, not a Greek tragedy -- about building something that lasts.

* * *

Audio Partners, the gilded cage in which Hesters and Olsen's net worth remains locked, is a direct-mail marketer and publisher of books on tape. The company has enjoyed robust growth for most of its history, reaching $4 million in revenues in fiscal 1994. It has shown modest profits in most years, and in its best years paid the owners generous bonuses. It's not such a bad trap, really, for an anticipated $2 million in equity, considering the founders invested less than $30,000 at the start and hold all but the 10% stake Marvin Goff, their operating partner, paid cash for when he joined the company, in 1993.

A burgeoning audio-book market, which in 1993 alone grew 40%, to $1.2 billion in retail sales, has propelled the growth of Audio Partners and expanded the distribution channels through which books on tape are sold. Retail specialty chains that peddle only recorded books have quadrupled in the past year. Titles have proliferated, and publishers, who often bid aggressively for audio rights, promote the recorded books vigorously. Even Hollywood is in on the act. When Sharon Stone signed a recording deal to narrate The Scarlet Letter, an industry that only 10 years before boasted nothing more exciting than a gravel-voiced Robert Frost reading his poems could now delight in the hot embrace of a starlet. Audio publishing has become, improbably, sexy.

Amid heightened competition, the founders have positioned the company, quite cannily, as a veritable encyclopedia of audio books, its catalogs touting hundreds of books on tape and its backlist topping 3,000 titles. One-third of its revenues come from the library market, which cottons to the company's exhaustive product line; the rest from its list of 50,000 serious aural "readers," who spend an average of $65 an order.

Pledged these days to temperance, the partners have had their benders with growth. Two years on the Inc. 500 list of fastest-growing privately held companies attest to that. Since 1989, the year the company published its first catalog, sales have increased nearly 600%. But the company's financing -- out of cash flow -- has kept the founders sober. The elixir of growth is beneficial only in doses that enhance value; the owners refuse to buy market share and only cautiously trade earnings for growth. Their company currently grows apace or slightly ahead of its market -- a rate that Hesters considers both "sustainable" and necessary. To grow slower than the market would erode the company's value.

Now, watching their market mature, the founders "are throttling back to concentrate on profitability," Hesters explains. He wants profits to double or triple to between 5% and 10% of gross revenues in the next few years. If he and Olsen achieve that goal, they will multiply their own exit routes and make the company more attractive to investors -- those for whom earnings are paramount as well as those whose interests favor growth or market share.

Hesters reckons that today's world of publishing will leave few "freestanding elements" like Audio Partners. So he primps the business for a yet-to-be-arranged marriage. "We have to structure ourselves so we can be attached to somebody else in case this company is no longer viable on its own." In 1992 he and Olsen split the company in two -- publishing and direct mail -- because direct mail's promise of greater growth would make it more appealing to an investor or buyer. The company thereby bettered its chances of attracting capital and added another exit scenario.

* * *

Value: Let Me Count the Ways
The five-year plan entertains several versions of a closing scene: Hesters and Olsen might sell out -- completely or partially -- to a larger company for cash or stock or a combination of both. They might woo an independent buyer, whose acquisition they could finance. They might sell all or part of their stock to their current operating partner or to their employees. Or bring in managers to run the business while they draw dividends from its earnings. An initial public offering, one option they reject, is "an expensive, time-consuming, and complicated way for a company our size to realize its value," says Hesters. "We'd have to reinvent the company and devote too many resources to selling this new product called stock." Hesters's ideal exit: to reduce his active role, perhaps to chairman of the board. Olsen's dream: to devote more time to travel, tennis, and pet publishing projects. Both aim to decrease the percentage of their net worth tied up in the company. "No more than a third," Hesters says.

As he and Olsen see it, they must continue to grow just enough to catch the fancy of a strategic partner -- a larger company in the direct-mail or audio-publishing business -- looking for market share in an acquisition. Profits cannot be sacrificed for growth, however, since a corporate buyer with higher cost structures would expect to see margins that could support its heft. The partners also consider courting an independent buyer who, they figure, would pay more for earnings than for growth. The possibility of a buyout by Goff or their employees demands profits sufficient to finance it. And the scenario in which the owners hire a chief executive and assume an investor's role is impossible without bolstering profits to support the dividends they'd take in return.

Growth without earnings gets you nothing but bragging rights. "The value of this company exists only to the extent we make it worth something to somebody else. Unless it produces income and doesn't require risk to sustain it, it isn't fully real," says Hesters.

That's a coolly rational assessment from a man who loves his company. But the company is not a monument to growth or profit or even the entrepreneurial Élan of Grady Hesters and Linda Olsen. It is a piece of masonry, built brick by brick, according to the founders' blueprint for value. And while it has been constructed to enrich the owners, it has been crafted as well to please other beholders: employees, customers, vendors, investors. The owners concede that if others can't see the company's value, it's a myth.

After witnessing firsthand what can happen when lenders or investors lose faith, the founders know not to risk their displeasure. "I want to create value that bankers and other investors respect," says Hesters, "so we have to produce results that are easily understood by bankers or potential investors." It's a game of managing perceptions.

"Grady is a meticulous thinker," says former partner Hal Newman. "His thinking moves like a flow chart." His postulates on value reflect that mental orderliness. First there's the market value -- what someone else will pay an owner for his or her equity. The most popular interpretation of value, it is also the most variable, dependent upon who sits across the table, how fast a seller must dispose of an asset, and when and how he or she will be paid.

That's why Hesters considers alternative reckonings of worth. For example, the company as cash flow. How much income can the founders collect -- through salaries, interest payments on loans they've made to the company, and dividends? If they bettered their profit margins to 5% of, say, $5 million in revenues, that would put $250,000 in the pretax kitty. At least half of that would go to taxes and a CEO's salary if Hesters were to step aside. The couple currently take just over $100,000 in combined salaries. Interest payments account for $14,000 to $15,000 more each year, but that income would balloon if they chose to finance a sale. If the business could sustain an annuity of $200,000 or so, the two might live golden years without really selling.

* * *

The Death of a Business
In the sun-washed attic office where Hesters's desk overflows with business cards and trade magazines and, of course, cassettes, a hush falls. "It's worse than the death of someone close," says Hesters, "because when you own it, a company is really a living, breathing thing. It has a life of its own but at the same time you see yourself in it. Then one day it's just gone, and you can't believe it." So begins his memorial of Newman Communications, his firstborn, the company that made him rich (if only for a moment), died too young, and left him broke.

Founded in 1981, Newman Communications set out to pioneer the distribution of audio books in a then-nascent market. Distribution operations were headquartered in Albuquerque, where Hal Newman lived; sales and marketing as well as direct-mail operations were run out of San Mateo, Calif., where Hesters and Olsen lived. The couple, new to audio publishing, sank personal savings of $30,000 into the start-up and later took out a second mortgage to provide more capital. They jointly held 40% of the business. Newman, the company's cofounder and president, held 60%.

A private placement of $250,000 financed a public stock offering on the penny-stock exchange in 1984 that raised $1.5 million more. The stock won its listing on NASDAQ before the year was out.

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.

"In a small business, the balance sheet is an interesting piece of fiction," Hesters, who ordinarily prefers his tales truer to life, explains. "Cash is what counts." A balance sheet is a stylized rendering of a company's value at a given time. That's why the founders chose to report certain outlays as capital investments rather than as expenses. In the surmise of bankers and investors, the company appears more profitable. Keeping a watchful eye on their ratios, especially current assets to current liabilities, the partners improved their creditworthiness, a quality they had ignored at Newman. They reapportioned debt to strengthen the catalog company. Outstanding debt to lenders remains at just over $130,000. Equity remains at $400,000. "By the time Dun & Bradstreet gets a look at our next balance sheet, it will be a pretty sight." Is appearance on a credit report so important? "You bet. That's part of the image. We've learned to present financial information in the way that investors and lenders are accustomed to seeing it -- and within the ranges that put them at ease," says Hesters.

One plus one doesn't always equal two. Or, as Hesters discovered, occasionally, twin businesses are better off -- and worth more -- apart. One set of financial standards for a direct-mail catalog company and an entirely different set for a publishing company made their union a handicap. To meet expectations in one industry, the company would have to fall short in the other. Consider profitability: 10% to 20% is the range considered healthy for a publisher; 5% to 10% for a direct-mail marketer. The company's value was obscured.

The synergies -- the catalog is both a distribution channel and a marketing tool for the publishing company, while the publishing company is a reliable and low-cost supplier for the catalog business -- still make the two businesses a pretty pair, Hesters maintains. But he decided to uncouple them and focus on building value in the direct-mail enterprise.

The tangible assets embedded in that business include a list of some 200,000 names, which might fetch $350,000; another $350,000 in inventory; and capital equipment that includes a computerized order-fulfillment system, 12 personal computers, a dozen or so phones atop the same number of beat-up desks, five years' worth of surplus catalogs, and an old fridge. Hesters and Olsen would be lucky to get $25,000 for the lot. But the intangible assets, Hesters argues, account for half the company's value. First, the company's knowledge of the market: six years of sales and customer data could be worth plenty, he contends, to industry newcomers such as Columbia House or Doubleday. Then there are the relationships the company has forged: two-thirds of libraries that buy audio books buy from Audio Partners. The founders have fostered strong ties with nearly 100 audio publishers. "No one in the industry does not like to deal with them," says Jim Brannigan, vice-president of Highbridge Co. "You get as honest a deal as you can have in business."

The Value Mason
There is little about the value of their company that Audio Partners' owners leave to the vagaries of growth or profit. Olsen and Hesters don't presume that a booming market or even bolstered earnings will beget a valuable company in the end. No invisible hand sprinkles gold dust on the company, even in the best of times. So they conscientiously weave value into every aspect of their operations.

"The direct-mail business is our effort to draft behind the energies of major publishers," says Hesters, who strategically leverages what he calls OPT -- other people's titles. Lavish promotional efforts of large suppliers attract new customers for audio books. By Hesters's estimation, each audio convert is on the road to becoming the volume consumer his company targets.

On the publishing side, Olsen focuses on titles that don't risk hefty advances. That acquisition strategy allows Audio Partners to take shelter from bigger players such as Bantam or Nightingale-Conant, which for obvious reasons avoid stuff that John Grisham didn't write. With a few serendipitous exceptions , they have eschewed mass-market titles in favor of specialized books that hold marginal mass-market potential. They have acquired rights to a collection of Isak Dinesen's work and to The Diary of Anne Frank, among a handful of classics. "We want a backlist with legs," pronounces Olsen. Evergreen titles that promise a long life cycle are "like residuals. They keep selling and selling," adds Hesters.

Direct-mail customers who have bought from Hesters and Olsen in the most recent two-year period number 50,000. And the company carefully slices that roster into fine segments -- those who have bought in the last 6 months, 12 months, and 24 months -- and determines what they ordered and how much. The high return on each mailing reflects the company's attending to only those buyers likely to perform. The demographics of its own customer base provide a template for renting the right names from the right lists. The direct-mail division usually prospects for new customers in the few months before the holidays, when people are predisposed to spend. The company doesn't mail more than three consecutive catalogs to a prospect who has never ordered.

Back in 1992, when the direct-mail company topped $1.5 million in revenues and the founders detached it from the publishing business, they embarked on a hunt for an equity partner -- someone with a background in direct-mail operations as well as finance who would join the company as a hands-on manager; someone who would add value to the business, not simply pay them for the value that already resided there. They sought an equity investment, earmarked for working capital, equal to the cost of the new partner's salary. "Just in case," says Hesters.

An ad placed in a trade newsletter delivered Marvin Goff, a 22-year veteran of $3-billion Hormel, for which he'd been controller for a division that sold fruit by direct mail. A long courtship preceded Goff's joining the company, during which Hesters, Olsen, and Goff agreed to ready the business for sale by 1997. In late 1992 Goff bought 10% of the company for $75,000, pegging the company's value at $750,000 -- about half its 1992 revenues. Goff immediately set out to improve the company's financial reports and operations. He shepherded the installation of a new information system, which revolutionized order processing and customer service.

Hesters and Olsen do not grant options on the stock they hold dear, but they don't overlook the contribution that people make to the worth of their business. "Good employees may not be capital assets, but you don't sustain or increase the value of the company without them," says Hesters. In addition to Goff's infusion of equity and badly needed expertise, Janet Benson's mastery of desktop publishing allows the company to produce its catalogs quicker and cheaper. Keri Walker, the company's first employee, ardently promotes the business; "800-231-4261," she says. "Make sure you mention that." Her car's rear window sports a bumper sticker with the same message.

The dedication of current employees and the memory of the 68 souls set adrift when Newman failed compel the founders to reciprocate the value that employees bring to Audio Partners. "It's part of my responsibility as a business developer to see to it that people are learning skills they can use elsewhere," Hesters says. "They have to get something they can take away from here. Besides a paycheck. Something that makes them more valuable than when they came."

And that value "is the value of the experience that the company creates for us and the people who make the trip with us," says Hesters, who like a Sufi sage reminds himself continually that the value of the business is more than the value of the company. Most difficult to measure, it's the easiest to recognize. "Perhaps you can't count the value of a worthwhile experience," says Olsen. "But it's the only one we really have right now. So it's the value that's most real."

* * *

"This is a company that 25 people depend on for a living," Hesters states. "Linda and I make sure the company can operate under a variety of circumstances, including our absence." In 1993 they spent five weeks in Europe. The freedom to take off is one way the partners reap a return on their investment now. The company is, after all, an asset that holds and accrues value. It can survive a few weeks without them. Olsen and Hesters have made it a practice to test its survival skills a little more each year. "We had to accept that either we were not going to make as much money or we were going to lose some for doing so," says Hesters. But it has been worth it. Each return confirms the durability of the business apart from them.

However the story of their nonfiction business progresses -- whether they become prisoners in their own castle or, more likely, a little rich and a lot happy -- they are confident that Audio Partners will endure. They, no matter what, are its authors. And its chronicle continues to enrich their lives. "We make sure that what we do is of value to us as we go," Hesters says. "That's the one value we'll never lose."


THIS WAY OUT

A pocket guide to exit routes Linda Olsen and Grady Hesters might take to realize the value -- and to liberate the equity -- in the company they've built

Exit: Corporate Buyer or Strategic Partner

Prerequisite: Grow 30% to 50% a year; improve pretax margins to 5%.

Upside: A cash-rich or publicly traded corporate buyer would likely pay a premium.

Downside: There are only a handful of likely acquirers. A low stock bid from an overvalued corporate buyer could prove disappointing.Stock is only so liquid.


Exit:
Individual Buyer

Prerequisite: Boost profits to at least 7% of revenues; grow apace of the market.

Upside: There are more of this type of buyer. They might pay a premium if the owners financed the transaction: more time equals more money.

Downside: The owners might be left holding a million-dollar note. Not exactly a clean getaway.


Exit:
Partner Buyout

Prerequisite: Slow annual growth to 30% or less and strive for profit margins as high as 10% to finance the buyout.

Upside: There's less risk in the transition. Plus, the bird's already in hand.

Downside: This bird knows too much to bid high. Financing the deal would most likely fall to the owners.


Exit:
Employee Buyout

Prerequisite: See partner buyout. Groom successors.

Upside: No relocation. No downsizing. No upheavals for employees.

Downside: Once again, the owners are left holding an IOU. Will employees be prepared to run the company?


Exit:
Hire New Management (Assume Chairman Title; Draw Dividends)

Prerequisite: Cut the same financial physique as the one sought by individual buyer. Add task of finding the right CEO.

Upside: Owners can continue to reap profits and retain control.

Downside: It's no small burden to maintain earnings that can support a CEO's salary and dividend payments. And the owners risk a less-than-triumphant return if new management screws up.


Exit:
Initial Public Offering

Prerequisite: Blow the doors out and expand. Buy growth if necessary. Leverage more. Crank profits above 5% of sales. (Owners say, "No way.")

Upside: Instant millions for the owners. Again.

Downside: On paper. Again.

Last updated: Jan 1, 1995




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