How to Finance Anything
Here's how to find financing in today's unpredictable, often discouraging U.S. capital markets. Includes six case studies of companies that overcame failed attempts to land capital.
Today's capital markets are changing faster than ever. Here's how to make sense of them
How can one begin to describe the current state of the U.S. capital markets, especially as those markets affect financing prospects for entrepreneurs? Volatile? Unpredictable? Downright chaotic? Absolutely. One need look no further back than last August and September to recall the meltdown in public equities, followed by October's near-death experience for the initial-public-offering marketplace--and then to those markets' record-breaking revival once the Federal Reserve Bank eased global anxieties by reducing key interest rates.
Maybe the best way to describe today's capital scene is simply this: paradoxical. The trends that have whipsawed various U.S. financial markets during the past year--and especially since late last summer--are tough to interpret as they relate to the country's small-business sector. Paradox #1: Why have financing deals gone bust, and financing options dried up, for so many entrepreneurs when--market jitters aside--the capital markets are still so very flush with funds to lend or invest? Paradox #2: At a time when more companies than ever have money to invest in growth businesses, why is it that the only ones they actually ante up for are the "dot coms" of the world (or others in a very short list of desirable industries)? Paradox #3: Why does what we call the "Trump Syndrome" raise its ugly head at the first sign of any real difficulties in the financial markets? (You know the pattern: businesses with money problems so huge that they could threaten whole financial sectors get bailed out--like Donald Trump's troubled real estate empire during the late 1980s or like Long Term Capital, the wildly overleveraged hedge fund that nearly went belly-up last fall--whereas small companies with better prospects and sounder business fundamentals can't borrow a dime, simply because bankers have become more risk averse.)
While there aren't any easy answers to those questions, it's undeniable that the capital markets have entered a state of tremendous flux and uncertainty--and will likely remain there for some time. "We've gone from a spoiled to a spooked market," says Steven Sonberg, a partner and the head of the south Florida corporate-securities practice for national law firm Holland & Knight. He adds, "I use the word market very broadly because everyone's been affected: business owners, venture-capital and private-equity firms, lawyers, other investors. I don't think we've ever in recent history seen the kind of wall we hit in October, where basically everything shut down dead. One day you'd have a negotiated deal; the next day it would be, 'No thank you.' We've seen everything you could imagine in recent months."
Taking the pulse of this market isn't simple. Its dynamics are so tightly interwoven that one set of changes--like a tap on a pendulum--can generate wild gyrations. So, for example, banker anxiety about growing credit risk at all levels of the global economy hasn't just made things tough for young and small companies seeking credit lines. It has also shut down (or drastically altered) much larger financing transactions, in which private- or public-equity sales that were to be layered with additional bank debt have now become costlier or inaccessible.
Meanwhile, volatility in the public stock markets has postponed (or foreclosed) the possibility of initial public offerings for many growth businesses. And that volatility has forced entrepreneurs to seek capital from private-equity funds, angels, or asset sales at the very time when company valuations have dropped and larger companies have joined the competition for funds, since they, too, have fewer financing options available to them. Right now venture capitalists and private-equity funds are still rich, thanks to the prolonged stock-market boom and a seemingly endless flow of new institutional investors; there are plenty of well-heeled angels looking for deals, too. But if a volatile IPO market delays or shrinks backers' opportunities to cash out down the road, that source of capital could begin to look shaky as well.
And in the short term? The pendulum effect has already increased the competition for private capital through such techniques as "private recaps." (One example: reduced stock prices encourage managers to carry out leveraged buyouts and thus escape from life in the public-markets fishbowl.) "Small companies are up against a real problem when it comes to all that financing competition from bigger companies trying to carry out bigger deals that won't now work in the public markets," explains John LeClaire, a partner at Goodwin, Procter & Hoar, a law firm based in Boston. "The mind-set at many private-equity firms is that they have a lot of money they need to invest and it's more cost- and labor-effective to put it out in big deals. So the reality about today's marketplace is that the big names that were once financing $5-million deals now wouldn't even look at a deal unless it's for $20 million or $30 million or more."
Cliff Atherton, a managing director at the Houston-based investment-banking firm GulfStar Group Inc., can only agree. "Some of the larger private-equity firms we work with are now telling us they don't even want to hear about companies with EBITDA [earnings before interest, taxes, depreciation, and amortization] of less than $8 million anymore," he notes. "But what can you say? I get telephone calls all the time from companies with revenues of less than $8 million, and they're trying to raise capital. Where can they go?"
As if this trend were not bad enough, contemplate the effect of a wild pendulum swing on the payrolls of all the growth companies that used to hire and retain top talent through the heavy use of stock options. Volatile stock prices and a shaky IPO market mean that small companies will need to pay higher salaries and bonuses to remain competitive as employers. That should drive up the level of their financing demands and, thus, further increase the competition for private-equity funds, according to Dennis J. Block, head of corporate mergers and acquisitions for Cadwalader Wickersham & Taft in New York City. "In recent years," he explains, "growth companies have actually been able to keep their cost of employees artificially low, thanks to options."
