The Year of Dealing Dangerously
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Should I merge? Go public? Sell out? That's the biggest decision any founder makes. And as these members of last year's Inc. 500 discovered, it's never simple
Deals, deals, and more deals. never before has so much action been centered on so many young businesses. And as companies on this year's list are tempted by offers of funds to feed their three- or four-digit growth, they are likely to be pursued by more suitors than ever before.
While the once-white-hot market for initial public offerings has cooled, nearly one-quarter of the companies on this year's list expect to be public by the year 2000. Grabbing countless headlines of late have been mergers and acquisitions. While those deals have most often involved multibillion-dollar pacts between the likes of banks or telecommunications companies, the huge amount of capital looking for decent returns has led to a record number of smaller deals as well.
The numbers tell the story, says Richard Peterson, an analyst at Securities Data, the clearinghouse for M&A trend information. In 1992 M&A deals involving companies with less than $100 million in revenues totaled $17.3 billion. The dollar amount grew consistently over the following years. By 1996 the value of small-company deals had reached $37.7 billion.
But no one quite expected what happened in 1997--a 66% spike in dollars--Peterson says. Securities Data recorded 1,679 deals last year, totaling $62.5 billion--a record in terms of both volume and value. As for this year, the total dollar amount of M&A deals surpassed 1996's total of $37.7 billion several months ago, Peterson says. This year may not set another record, but it will certainly be a blockbuster.
For CEOs, the choices can be overwhelming. "Selling a business is such a big distraction emotionally and otherwise," says Russell Robb, an investment banker who specializes in selling small manufacturing companies. "A lot of companies get so wrapped up in doing a deal that the business deteriorates, and the CEO winds up being a sad puppy." But that's after the fact. Beforehand, the possibilities are limitless.
Vic Odryna is one Inc. 500 president who hopes to find himself swimming in the deal pool by the end of the year. Odryna runs PixelVision Technology Inc. (#450), a company that makes flat-panel displays. "I've got a broker hired," he says. "The market for my product is exploding, and that's my biggest problem. We need fuel."
The experiences of some of last year's alumni suggest that the biggest problem facing Odryna is determining exactly what kind of deal is right for PixelVision. Responses from last year's CEOs, chronicled here, range from "It's better than we expected" to "It's been a disaster." At the least, their stories suggest that Odryna--and others like him--would do well to proceed with a dose of caution.
Company: PhotoDisc, #10 in 1997
Deal: Merged with competitor
Goal: To link its distribution technology with better-quality images
Outcome: Merged company dominates a growth industry and gets love letters from analysts.
Drawback: How powerful is a cochairman?
Sometimes old money and new money can get along. That's been the experience of Mark Torrance, the 52-year-old founder and CEO of PhotoDisc, a Seattle-based supplier of stock photo images. PhotoDisc's management team had been seriously considering an IPO for the summer of 1997. But Torrance was afraid that the small-cap stock would get lost in the shuffle. "It's hard for a $100-million company to get attention in this market," he says.
Thankfully, a suitable alternative presented itself. While preparing for the IPO, Torrance was contacted by another Mark--Mark Getty, grandson of oil tycoon and art patron John Paul Getty, and cofounder of Getty Communications PLC. Getty's outfit was based in Britain but traded on NASDAQ. Getty, formerly an investment banker, reports that he became aware of PhotoDisc's value through his company's market research. "That research made it very, very clear to us that it was important to know them and, if possible, join forces," Getty says. In the summer of 1997, the two Marks negotiated much of the PhotoDisc-Getty merger personally at Getty's family home near Siena, Italy.
Both companies sold stock photography to advertising agencies and publications. PhotoDisc's specialty was technology; it delivered images to a large number of customers via CD-ROM and the Web. Getty Communications' forte was in quality and exclusivity--the company sold certain pictures only once. Though its images were of higher quality, they were distributed in an antiquated format--Getty shipped transparencies to its customers.
By February 1998 the merger was completed. A new U.S. company--Getty Images Inc.--replaced Getty Communications on NASDAQ. Getty's company received 19 million shares of stock, and PhotoDisc got approximately 8 million shares plus $39 million in cash. The total deal was valued at roughly $240 million. The Torrance family owns 17.5% of the new company.
Analysts approved heartily of the marriage because the new company links PhotoDisc's novel distribution technology with Getty's valuable content. And Getty's seasoned senior management also sits well with Wall Street. Though Torrance managed PhotoDisc to 7,195% growth between 1992 and 1996, he has taken a backseat to Getty Images CEO Jonathan Klein--who sits on the new company's three-person executive committee along with board cochairmen Torrance and Getty.
"That's a bit of a ticklish subject," admits Torrance, who nevertheless says he's comfortable with the new arrangement in which Getty has an upper hand. "It's a trade-off, as are many things in life." He claims that his rapport with Klein and Getty is solid, even though he's in Seattle and they're in London. And he says he's happy focusing on strategy and research and development rather than on day-to-day issues.
Torrance's contract with Getty Images runs out in February 2001, as does his noncompete agreement should he decide to leave, but he plans on being active in the company for quite some time. As for the present, Torrance says he's wrestling with a quandary every entrepreneur covets. "You don't think about it in the thrill of the chase," he says, "but liquidity brings with it a whole new set of problems."
Company: Scrip Plus, #4 in 1997
Deal: Sold option to buy business to division of large corporation, with long-term consulting agreement tied to profits
Goal: To finance the growth of capital-intensive business
Outcome: The option to buy was exercised sooner than expected.
Drawback: The founders were dismissed from the company, its 73 employees were let go, and its assets were sold to a nonprofit. The founders are trapped in a noncompete agreement.
Lawyers, judges, and even priests have had a part to play in the drama that unfolded at Scrip Plus. It's a confusing plot, with everyone pointing fingers. What's not in doubt: the assets of the once-booming company have been liquidated, and left in their wake is a series of legal skirmishes.
Scrip Plus's business was buying "scrip"--discounted gift certificates for retail stores--from large retailers like JCPenney and Sears. It then sold the scrip to schools and other nonprofit groups, pocketing the difference between its buying price and the price it charged to the nonprofits. The nonprofits sold the gift certificates at face value to raise money for their activities. A strange business, but a lucrative one for Scrip Plus, which reported revenues of $180 million last year.
Such eye-catching receipts attracted the Signature Group, in Schaumburg, Ill., which is a direct-response-marketing subsidiary of retail giant Montgomery Ward. A subsidiary of Signature, National Dental Service Inc. (NDS), purchased an option to buy Scrip Plus from founders Bob and John Coyle. The deal included $1.5 million to be paid to the Coyles over two years in addition to their salaries, and a 10-year consulting agreement, during which they'd receive as an annual bonus a 50% share of pretax earnings for the first 5 years and 25% for years 6 through 10. The contract was expected to make millions for both the Coyles and their corporate brethren. Over the 10 years NDS would provide Scrip Plus with financing and management assistance. The deal was signed on April 15, 1996.
Today the Coyles are being sued by (and are suing) NDS. According to court documents, NDS exercised its option, thereby becoming the sole owner of the company, and then proceeded to terminate the consulting agreement with the Coyles and obtained a court order barring them from the premises. John Coyle speculates that Montgomery Ward's declaration of bankruptcy on July 7, 1997, was the reason for the pullout. NDS, on the other hand, cites a $5-million loss the previous year. The Coyles call it a "hostile takeover" of Scrip Plus and say that last December, just as they were being taken to lunch at an Applebee's restaurant by NDS representatives to discuss the situation, guards were arriving at Scrip Plus's headquarters to secure files and other assets. "It was like the wild, wild West," John Coyle says.
Both NDS and the Signature Group, as well as their parent, Montgomery Ward, are tight-lipped about the matter. "We're a privately held company," says Fanette Singer, a spokesperson for the Signature Group. "We don't discuss our investments at all."
NDS then sold Scrip Plus's assets, mostly scrip gift certificates, to the nonprofit National Scrip Center, run by a Catholic priest, Monsignor Thomas J. Keys. Included in the $5.2-million deal is the Coyles' noncompete agreement.
The Coyles, who are Catholic, now find themselves in a bizarre situation. They can't start another scrip company because a charity affiliated with their church intends to hold them to the noncompete. In California such agreements are rarely enforced-- except when a company shareholder tries to enter the same business after his or her company has been sold.
The $67-million countersuit the Coyles have filed against NDS goes to arbitration this winter. In the meantime, John and Bob Coyle have done what any self-respecting entrepreneurs would do: they've started another company--an Internet-service provider that markets itself exclusively to schools and nonprofits. "The best advice our lawyer gave us was to go start something else," John Coyle says. Their 61-year-old father, however, is back in the scrip business. It seems he isn't covered by the noncompete.
Company: Nantucket Allserve Inc., #13 in 1997 (#71 in 1998)
Deal: Sold majority interest to a big corporation
Goal: To ramp up marketing and distribution efforts
Outcome: The company traded an angel investor for a partner whose cash came with expertise in the industry.
Drawback: Employees' behavior changed conspicuously.
Tom First and Tom Scott, two thirtysomethings who present themselves as relentlessly low-key, sell Nantucket Nectars juices in more than 30 states. Despite their laid-back image, First and Scott were anxious to steel themselves against competition from the juice initiatives of beverage megabrands Coca-Cola and Pepsi. That meant the company, based in Cambridge, Mass., would have pressing marketing and distribution needs to meet.
Though the Toms claim not to have solicited attention, word had spread that they were looking for cash. The call that finally sparked their interest came from Jim Gold, a managing director at Lazard Freres & Co. Gold represented Ocean Spray, the $1.4-billion cranberry-juice company also based in eastern Massachusetts. The overture was especially intriguing since Ocean Spray, a private cooperative of 950 farmers, had not bought another beverage brand in its 68-year history.
On August 7, 1997, Scott had his first meeting with Gold and three Ocean Spray executives. The imagined deal: Ocean Spray would buy a "significant" stake in the company, which, in addition to funding distribution and marketing expansion, would provide liquidity for Michael S. Egan, an original angel investor and the former owner of Alamo Rent a Car, who had discovered the company in 1993, when he moored his yacht in Nantucket harbor.
Ocean Spray's interest was in Nantucket Nectars' strong brand in the single-serving blended-juice market. The investment would give the company a stake in diversified fruit juices (lemonade, orange mango, and raspberry iced tea) sold at a premium everywhere from delis to pushcarts. Most of Ocean Spray's revenues come from cranberry-juice drinks sold in grocery stores--making the Nectars a complementary, but not competing, product.
After four months of give-and-take, Ocean Spray and Nantucket Allserve announced the investment, though they have never disclosed the sum. Ocean Spray bought about 85% of Nantucket Allserve "for less than $100 million," Gold reports. The shell that holds that stock is named T3 Holdings, which stands for the first initials of Tom First, Tom Scott, and Ocean Spray CEO Tom Bullock. Scott and First retain day-to-day control of the company. "Ocean Spray wants us to be independent," First says. "They want to live vicariously off the entrepreneurship of this company."
Scott reports that the deal's only negative side effect, so far at least, was to make his own people curiously self-conscious. "Early on in the relationship, our employees would ask, 'What does Ocean Spray think of this?' and I'd say, 'Guys, we're Nantucket Allserve Inc."
Scott muses that many deals probably don't work out because the smaller partner fears it will offend or upset the larger partner, so it stops taking risks. "There was a pervasive feeling of 'There's got to be a guy at Ocean Spray who's better educated than me," he says. "But if that was true, Ocean Spray would have started their own Nantucket Nectars. They bought into us, after all."
Company: Qualix Group, #266 in 1997
Deal: Went public
Goal: To provide an exit for venture capitalists and cash for new products
Outcome: Let's just say that Qualix is no Amazon.com--at least not yet.
Drawback: An unforgiving market is slow to recognize improvements in operations.
An IPO is the Silicon Valley thing to do," Rick Thau says of his desire from day one to take his company public. Day one was in 1990, when Thau started a business-to-business software company, Qualix Group, in San Mateo, Calif. Along the way, he lined up financing from four venture-capital firms.
So Qualix went public in February 1997 under the aegis of the valley's premier investment bank, Hambrecht & Quist. The company's stock, which debuted on the NASDAQ national market at $8 a share on February 12, 1997, ended the day up, at 9 1/ 4. Thau's company--which has since been renamed FullTime Software Inc.--issued 3 million shares for a total offering of more than $27 million. The company netted $17 million.
But after that first day, the stock slowly drifted downward until this past June 26, when it tanked. On that hectic Friday, Thau warned analysts that Qualix was going to report an unprofitable quarter, and a large mutual fund pulled out of the business. Thau and others at the company, following the stock on their PCs, saw the share price dive by 50% at one point during the day. The stock--which had been trading at 2 1/ 4--fell as low as 1 1/ 2 and at press time was hovering between 1 and 2. The analyst who follows the company, Chris Galvin from Hambrecht & Quist, comments sparingly, "This is the wait-and-see phase."
Thau lays the blame for the company's distress at the door of his sales organization, which, he says, underperformed following the IPO. Difficulties in the sales pipeline this year have led to a drop in revenues from $32 million to $30 million, while expenses have surged, leaving Qualix with $6.4 million in red ink.
Thau has brought in two new vice-presidents to oversee sales, and they, in turn, have brought in a new sales team. "What's most frustrating," he says, "is that I can see that we've considered the issues and taken the corrective action, and after nine months of really hard work, the public markets don't recognize or appreciate what we've done yet."
As a result of the company's stumble, 50 people have left Qualix. Half were fired, Thau says. The others, holding worthless stock or stock options, jumped ship. Thau says, though, that he and other members of management have increased their stake in the company. After all, it's a bargain.
Company: Paranet Inc., #109 in 1997
Deal: Acquired by a large corporation
Goal: To achieve liquidity
Outcome: Owners and employees are rich, rich, rich.
Drawback: Welcome to Corporate America!
"I had started the company with the exit strategy in mind of having an IPO when we reached $100 million in revenues," says Michael Holthouse, cofounder of Paranet Inc., a network-services company. After reaching those numbers last year, Holthouse shuttled between the possibilities of either doing an IPO with Goldman Sachs or selling the company through Merrill Lynch. Having turned down seven potential suitors, he was back on the IPO route early last spring. But the tech-stock slump hit and discouraged him from taking the company public.
Not long afterward, Pat Smith, a vice-president at Sprint Corp., a Paranet customer, let Holthouse know that his bosses were shopping for a company like Paranet. Holthouse said he'd be interested only if Bill Esrey, the chairman and CEO of the long-distance carrier, called him personally to outline the financial and strategic benefits of such a deal.
Esrey did and a few days later flew from Kansas to Houston to sound out Holthouse. They talked for hours in a conference room at the airport. "Bill was very patient with me because there were a thousand questions I had," Holthouse recalls. The meeting was interrupted when Esrey's pager announced that Sprint's stock had hit $50 for the first time. After the meeting Holthouse talked to Merrill Lynch, whose contract stipulated that it manage any potential acquisition. The wheels were in motion.
Esrey's final offer was $375 million in cash, plus an earn-out up to $70 million based on performance. Holthouse was to run the company as a stand-alone business unit within Sprint. To celebrate, Holthouse brought out a bottle of 65-year-old Johnnie Walker Blue Label scotch, bought years before, to share with his executives after they'd announced the news to their 1,200 employees via a closed-circuit broadcast. Though Holthouse had purchased the scotch with an IPO fete in mind, that didn't lessen his enjoyment. "And there was no pressing need to go public other than liquidity," he adds.
Employees, on the other hand, had some reservations. Says six-year veteran Brad Morrison: "There was a lot of concern that there were going to be Sprint people in the office the very next day wearing suits. But it hasn't been that way." Instead, Paranet--now Sprint Paranet--has retained much of its small-company spunk. Morrison, a full-time "director of fun and culture," still spends his days coming up with perks for Paranet employees and their families. And the offbeat taped radio show mailed to the company's far-flung employees is still routinely produced.
Does Holthouse ever bridle at Sprint's corporate behavior? "I think I do that every day," he admits. "Sometimes Sprint's people can't help themselves." Still, he says, "I must give them credit for deciding to allow our culture and organization to stay the same."
Well, not totally the same. Paranet's people have a slightly different mind-set. A burst of ambition is the most noticeable new trait of the Sprint era. "The one thing that we're learning is how to think big," Holthouse says. "Before, we thought big within the context we could think in. Inside Sprint, the sky's the limit. Instead of being a world-class niche player, you can think about whole markets."
And one other benefit: many employees--Morrison included--made a killing financially. "Bunches and bunches of millionaires came out of this deal," Holthouse says. "The next month, it looked like a car showroom around here."
Mike Hofman is a reporter at Inc. Research assistance was provided by intern Forgan McIntosh.