How to Finance Anything
Money is easier to get than ever, and there are brand-new places to find it. Here's the smart way to land your share
Remember October 1997? All those Asian markets were taking hair-raising nosedives. Once-invincible Hong Kong looked weak. Closer to home, when the Dow Jones Industrial Average collapsed by a record-breaking 554.26 points, the whole global economy seemed poised on a precipice. The only question was, how bad could things get?
Oddly enough, prospects never looked brighter for Cornelius Geer, "Cam" to his business associates and friends in Middletown, Conn. Geer, the founder and president of Connecticut River Interactive LLC, a two-year-old Internet-development company, completed a deal for a $100,000 financing package from the Small Business Administration during the final days of October, "right in the middle of all that chaos," he recalls.
"The amazing thing," he says, "is that not once during the whole process of finalizing that loan, not once--with all the people we had to deal with to close it--did anyone ever express anxiety about getting involved with us when all those other markets looked so shaky."
He's not alone. Stephen King's entrepreneurial accounting firm, Virtual Growth Inc., based in New York City, raised $250,000 from outside investors during those same tumultuous autumn weeks. "What was going on in those markets was totally irrelevant to us," King says.
Clearly, the financial realities affecting small and fast-growing companies like Virtual Growth and Connecticut River Interactive are just not reflected in the headlines. There's no end to the erroneous conclusions one might draw from media coverage and statistics that focus only on Wall Street, on the megamergers and acquisitions, the biggest company deals, the glitziest initial public offerings, and the most public investments in American business.
The bottom line is this: The capital markets--that vast universe encompassing private and public investment arenas as well as the U.S. and international banking communities--have changed in many far-reaching and deep-rooted ways. But the most significant impact of the changes may well be their effect on the world of entrepreneurial businesses. During the past decade so much wealth has been created, in so many ways, in the United States and abroad that the capital markets have been flooded with money in search of new, profitable investments.
The private-placement market is just one example. During the first three quarters of 1997, just over $250 billion was invested in these deals alone, according to Securities Data, which tracks the financial markets. That amount was nearly twice the $128-billion private-placement level of 1993.
"Too much money chasing after too few good deals" is a refrain repeated up and down Wall Street and elsewhere. Investors and financiers have come to recognize that they can't keep pursuing the same very short list of desirable growth companies and growth industries with take-it-or-leave-it, one-size-fits-all deals. The resulting competition and cooperation among all the cash-rich players have created myriad financing choices for business owners.
Granted, not even the best of times will last forever, which means we'll undoubtedly experience slowdowns, probably even big ones, within the more cyclically driven sectors of the financial markets. But thanks to other strong forces, including demographic trends (all those baby boomers should continue to boost investments and savings, at least for the next decade or so) and the sheer momentum fueled by all that money that has been made during the past decade, America's entrepreneurial community can expect a wide range of financing options to remain vibrant, even if the global stock markets continue their roller-coaster ride. How's that for a new world order?
"Let me tell you a story about a breakfast meeting I had recently," begins Gill Cogan, a managing general partner at Weiss, Peck & Greer Venture Partners. The venture-capital firm, with offices in San Francisco and Menlo Park, Calif., has invested in more than 200 growth companies over the years, which gives Cogan some degree of authority. "I was meeting with a group of people who manage tens of billions of dollars in institutional money," he says. "They told me, very simply, that they were still underallocated in venture capital and alternative assets," meaning growth-company investments. "That's what they're telling me after all the turmoil in the global markets," he says.
"The reality is," Cogan continues, "there just aren't that many places to invest all this capital. And people are beginning to realize that there's no point in trying to time your growth-company investments to what's happening in the stock markets. You can't tell when it's exactly right to get in or get out. But given how profitable this sector has proven to be, investors are figuring out that you just have to get involved."
These days, getting involved can mean a lot of things. Take the private-equity marketplace, a broadly defined investment sector that includes venture capitalists, large and small angel investors, hedge funds, private investment pools, and even insurance companies and other institutional players that either participate through money-management funds or make direct capital investments in growth companies. The one element binding this diverse group of investors together is that they receive some type of equity or stock vehicle when they put money into a growth company; each group then has its own set of goals in regard to how much of an investment return its members hope to earn on that stock and how quickly they hope to earn it (usually when they cash out during an initial public offering or in a merger or acquisition deal).
In the assessment of Mendy Kwestel, a partner and director of entrepreneurial service at accounting and management- consulting firm Grant Thornton LLP, in New York City, "there is a ton of money--so much liquidity throughout the marketplace--that there is now private-equity money available for companies at every stage of development." What a difference from the traditional state of affairs that most growing businesses have been forced to deal with: no money at all for start-ups or companies that were too small or too old or too dependent on their founders or even too needy for cash (that is, unless they happened to fit onto the investment community's shortlist of sexy companies du jour).
And that is a trend that keeps snowballing, thanks primarily to the activities of two groups: first, the pension funds, insurers, and other large investors that continue to accelerate their investments in growth companies; and second, the investment-world professionals, who are responding to the deluge of money by continually setting up new funds. Most of those activities occur without anyone outside the financial community even noticing, except--once again--in cases of the very largest deals. But both developments show signs of longevity, which means the changes in the entrepreneurial-financing marketplace may well turn out to be both structural and permanent.
Case in point: today's institutional investors are flush with cash not only because their previous investments have paid off so beautifully during the recent bull market but also because Americans keep pumping funds into 401(k) and other retirement-savings vehicles. (Granted, cash-ins of some of those investments will start mounting in about 10 years, when the oldest boomers can start drawing on their retirement accounts, but the youngest of this group are still in their thirties.) So long as demographic trends are on the buy side, new investment pools will keep getting launched. What that means to owners of small entrepreneurial businesses is plenty of new opportunities. Private-equity investors and others have been forced to broaden their notions of what constitutes a desirable growth company. And, increasingly, investment groups are specializing in niches where they perceive the competition from other investors to be less fierce.
The Sprout Group is one example of the niche players. "We've responded to the competitive environment by focusing on industries that are currently out of favor with the public-equity market, like biotech, medical devices, and early-stage information-technology companies," says Patrick Boroian, a general partner at Sprout, which is the New York City-based venture-capital affiliate of financial-services giant Donaldson, Lufkin & Jenrette. By scouting off the beaten path, Sprout has significantly increased its financing opportunities: through the third quarter of 1997, the firm managed to invest $130 million in growth companies, up from $129 million during all of 1996.
Ted Stolberg and his partners at Stolberg, Meehan & Scano, in Denver and New York City, are another good example of niche players. They set up their first private-equity fund several years ago with $70 million in investment capital; they just raised another $100 million, to support a second pool aimed at their particular investment niche.
"We like to call it M&Ms, meaning misfits and mavericks," Stolberg says, laughing, "the kind of companies and executives that might otherwise fall through the cracks." While some of the deals he and his partners have gotten involved with have been much larger, one of the group's investments was a $300,000 infusion of capital into a "re-start-up" of a sidewalk-chalk manufacturer aimed at the children's toy market. "We like the M&M niche because there's dramatically less competition here, and we believe that the potential returns are fantastic," Stolberg says.
Broader investment parameters, specialty niches, and other new developments have opened the private-equity door to many companies whose owners, up to now, have felt like wallflowers at the money-market ball. In the past they were overlooked by investors despite whatever strong fundamentals and market potential they had going for them.
Listen to Bill Vogelgesang, a senior vice-president at the Cleveland investment- and merchant-banking firm Brown, Gibbons, Lang & Co. "We see deals--and are doing deals--now that could never have gotten done five or six years ago. Companies that never looked attractive before--maybe because they were service companies without any collateral, or they were operating in industries that weren't glamorous--suddenly have all kinds of financing opportunities before them. We just completed a deal involving a foundry that wound up earning a much higher valuation for its equity than we might ever have imagined possible. It's a whole new environment."
Still another sign of the many different sources of financing capital now available shows up in the behavior of investors who are looking for companies to buy. "One thing that we see is the involvement of 5 or 10 potential buyers for every one business seller who's out there. That trend has many side effects," explains Gayle L. Veber, the managing partner of Veber Partners LLC, an investment-banking firm based in Portland, Oreg. "One is that investors who might otherwise be interested only in outright purchases of a company or in buying only majority equity stakes are now willing to consider deals where they invest in significant minority stakes instead. That broadens the capital-raising opportunities for all kinds of growth-oriented companies."
In a quicksilver marketplace like this one, entrepreneurs more often than not need the assistance of a well-plugged-in investment banker, a corporate finance lawyer, or an accounting firm to help them track down one of the new breed of specialty investors who are definitely not listed in the yellow pages. Still, a word of caution: given the frenzy within all the capital markets, scam artists and incompetents abound who are more than willing to proffer advice and provide connections--for a fee.
Consider the unhappy experience of one East Coast software manufacturer whose chief executive retained a small and less-than-prominent investment-banking firm in his efforts to woo private-equity investors. "My investment banker and I flew down to meet with one group during the summer," he recalls. "I began the meeting by giving my presentation, which I thought went well. But just before my banker was supposed to come in with his clincher, he received a telephone call, left the meeting, and never came back." Since then, one potential lead after another has faltered. He notes ruefully, "I had planned to upgrade my team of advisers, especially my accountant, after I raised the private-equity money. Maybe I should have done it the other way around."
Thanks to a team of top-quality advisers, including an accounting firm and an investment-banking boutique with strong ties to new-media-oriented investors, Garnet Heraman managed to avoid the difficulties that can surround the search for capital. Heraman, the chief executive of StockObjects, a New York City-based new-media stock library, and his partner managed to raise $700,000 from private-equity investors within a year of their company's launch, all the while managing to retain close to 90% of its stock.
"This financing marketplace is so full of opportunities for good growing companies that one of the main challenges is not to raise more than you really need," Heraman says. The other challenge? "Since we were able to choose between all this money that was available to us, we needed to enforce one shibboleth: investors had to bring more to the table than just money alone if we were going to let them get involved in our company." Company owners like Heraman expect their investors, lenders, and financial advisers to leverage their funds with high-quality contacts and industry expertise.
For all the changes sweeping through the equity side of the financing marketplace, there's as much, or more, taking place in the credit or lending arena. These are tumultuous times for bankers, who either must reinvent themselves at the giant banking institutions being formed through a series of mergers and acquisitions across the country, or must figure out new ways to compete against those giants from their own smaller regional bases. Either way, it boils down to a set of competitive pressures that are remarkably similar to those facing equity investors. Today's bankers can no longer simply sit back and rely on all those old business-as-usual strategies that often left cash-starved entrepreneurs out in the cold.
Brett W. Kaplowitz, a vice-president at Potomac Valley Bank, in Gaithersburg, Md., exemplifies some of the changes occurring among small banks. One morning last November, Kaplowitz had just finalized plans to bring lunch to the offices of a business customer too busy to meet him at a local restaurant. "I try to sit down with my business customers over lunch or a cup of coffee regularly," he says. "That way I can stay on top of what's happening with them and their companies and look for new ways to help them solve problems."
With only $190 million in assets, the Potomac Valley Bank might seem at first glance to offer growth-oriented business customers only limited options, besides those chats over lunch. But that's not the case. "We're part of an affiliation of 22 community banks, mainly in the state, which among us hold $7.1 billion in assets," he explains. "On the one hand, we at Potomac Valley have the ability to approve loans of up to $1.8 million by ourselves. On the other, we can offer much larger financing packages, when our clients need them, by working with our affiliates. And we've also got the ability, as part of a large network, to provide the same sophisticated kinds of cash-management, 401(k), and other services that the giant banks can offer." Such affiliations are cropping up among small banks all across the country, in part because they've got to compete not only with bigger banks but with credit-card companies and other financial-services organizations that offer this type of full-service menu and are hungry for a share of the small- and midsize-business market.
While not every banker wants to be every entrepreneur's friend, the bank-financing marketplace too has been changing in all kinds of positive ways. Some of the country's biggest banks, including Fleet and Wells Fargo, have aggressively stepped up marketing campaigns in the interests of wooing more entrepreneurs.
Another hopeful sign is an increase in so-called microlending, typically defined as business loans less than $100,000. According to a recent survey by the U.S. Small Business Administration's Office of Advocacy, 478 banks across the United States are involved in a significant way in this market. The group increased microlending activity by 26% just from 1995 to 1996, raising its total level of involvement to $15.8 billion at last estimate.
There are other indicators as well. One is the willingness of many bankers to form partnerships with other financing entities in cases in which they might be afraid to assume all those growth-company risks by themselves. For lack of a better phrase, think of this as the world of layered-financing opportunities--since bank deals get layered into arrangements involving equity sales or other transactions. The good news is, it's a world that's only as limited as your imagination.
Layered financings are the ultimate outcome of all that competition out there that's transforming the financial marketplace. The idea is that business owners can be on the lookout for both loans and equity financing. On one hand, they can allay bankers' anxieties over proposed loans through the involvement of seasoned investment professionals in their companies. On the other hand, they can reduce the amount of equity they need to give up by including bank financing to meet their cash needs. It is really just a growth-company version of the kind of multitiered-financing strategy that large corporations have been able to rely on for years. Here again it's a way that more and more of today's entrepreneurs are getting to share the goodies that the capital markets have to offer.
There's no single formula for how to make a layered-financing deal happen. In the world of fast-growing businesses, it usually takes place because cash-strapped owners pursue every possible capital lead they can come up with, often at the same time. In some cases, a banker gets interested, but he or she expresses anxieties about perceived risks; a credit-line commitment might be offered, contingent upon the company's being able to carry out some type of equity offering simultaneously. In other cases, the financing sources might get layered in one after another, as is the case when an angel investor can use his or her own network of contacts to quickly bring in a banker or other financing institution.
Granted, whatever the type, layered financing can be time-consuming to coordinate, since business owners (or their chief financial officers, if they have them, or their investment bankers or accountants) need to pursue two different sources of capital simultaneously. But the results can be well worth it. Square Earth Inc., for example, a $2-million New York City-based Web-systems developer, tried but failed to qualify for a term loan by itself. "But given the financing opportunities that exist for us in the private-equity arena and our growth rate this year of 25% per month, we were able to win a loan commitment from a bank that would come into effect as soon as we carried out a private placement," notes CEO Brad Galle. "That's going to work just fine for us."
A growing trend in some areas is for federal or local government-financed programs to provide whatever capital gets layered in with bank money. "Here in Los Angeles, we've got about half a billion dollars' worth of federal money supporting community-development banks. They can provide venture-capital funds, revolving lines of credit, and all kinds of other financing arrangements for small businesses," notes Jesus Arguelles, a Los Angeles-based business financial consultant who helps entrepreneurs raise funds. "What I see, when I'm putting together capital deals, is that traditional banks will be much more, shall we say, flexible when there's government money coming in at the same time."
In a financing universe as rich with capital and opportunities as this one is, a fair number of small and young companies will be able to steer their way clear of banks altogether--at least for a while. That's because many of the so-called nonbank banks--some of the big credit-card companies and brokerage houses, for instance--have based their own business plans on growth within the entrepreneurial marketplace, in large part because that segment of the economy has been ignored by much of the banking community for years.
For Marilynn Capen, the nonbank-banking alternative is working well. The owner of Kids Korner Day Care, in Costa Mesa, Calif., Capen tried and failed to get a bank line of credit. "I wanted to upgrade our nap facilities by making a large purchase of cots, but the bank just said no--I didn't have any collateral, and I wasn't trying to borrow enough to make it worth their while. I kept saying, 'I'm running a business like any other business. I make money. I pay my bills.' But we just weren't big enough--or the right kind of business."
When American Express sent Capen, a cardholder for the past six years, a notice that she was preapproved for a $25,000 line of credit, she leaped at the offer. "Among other things, I was able to use my credit line to buy a $4,000 piece of playground equipment for only $2,000 because I had the money in place to make a purchase right then and there," she says. American Express Small Business Services touts as selling points unsecured credit lines ranging from $5,000 to $50,000, equipment loans and leases, and a willingness to be flexible on ways to structure payment terms.
On another front, Jesus Arguelles in Los Angeles recently helped a $3-million food-processing company raise the $1.5 million it needed for expansion activities. The nonbank-banking source? A local investment-banking firm that has gone into competition with local banks by offering entrepreneurs a revolving line of credit.
"It's a fantastic product," says Arguelles. "They promise a 10-day decision-making process, and in fact, our turnaround was even quicker." When financial markets get as competitive as those in the United States, there may be few surprises left--but here's one: this investment-banking firm demanded absolutely no equity kicker, no stock warrants, nothing involving an ownership stake. The bankers requested only interest payments on the loan, plus an annual reevaluation.
Nonbank-banking options abound. For Tom Thompson, the owner of Nu-Way Relocation Services Inc., a moving company based in Chicago, a $50,000 line of credit from regional barter company Chicago Barter gave him working capital to use on everything from payroll services to a major electrical upgrade and even personnel bonuses. A veteran of the banking scene (he's had lines of credit as high as $750,000 in the past), Thompson is now firmly hooked on barter credit as a way of reducing bank borrowing.
"How can I compare the two experiences?" he muses. "With the barter company, all I had to do was give them a current financial report on Nu-Way, as well as sign a commitment that we would provide $50,000 worth of moving services to members of the barter network. To get that same $50,000 from a banker, I'd be on the phone with him or her about 60 times. I'd have to fill out about 100 forms. I'd have to give them every single piece of personal information about my family, right down to my children's birth certificates."
That's the sound of a happy entrepreneur. And in this wide world of financing options, he's far from alone.
Jill Andresky Fraser is Inc.'s finance editor.
BUSINESS: New-media stock library
LOCATION: New York City
THE DEAL: Heraman and his founding partner raised $700,000 within a year of start-up--and kept close to 90% ownership. To find the technologically informed investors they were seeking, they worked with an investment-banking firm that specialized in their industry. "We've got other people who want to invest," says Heraman. "But they don't bring in that extra value we wanted in terms of knowledge and contacts. Raising money," Heraman says, "has taken 70% to 80% of my time. The system is flawed," he concludes, "but it's ripe with opportunities."
COMPANY: Kids Korner Day Care
BUSINESS: Home-based day-care center
LOCATION: Costa Mesa, Calif.
REVENUES: Less than $300,000
THE DEAL: Too small to get a bank line of credit, Capen, an American Express cardholder, took advantage of a mailing from the credit-card company offering a preapproved line of credit for up to $25,000. "I wanted to upgrade our nap facilities by making a large purchase of cots," Capen says, "but the bank said no. I kept saying, 'I'm running a business like any other business. I make money. I pay my bills.' But we just weren't big enough--or the right kind of business." She leaped at the offer from American Express.
SPECIAL REPORT: HOW TO FINANCE ANYTHING
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