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."
By now you're probably getting the picture. While many factors have yet to fully shake themselves out within these turbulent capital markets, the balance of power has clearly shifted.
Salem Shuchman, a managing director at Patricof & Co. Ventures, a New York City-based private-equity firm, is far from unhappy about that. "We're still doing deals--we invested $74 million just during the last six months of 1998. That included 11 new investments for our firm." From Shuchman's vantage point, it's great that companies that recently might have gone directly to the public markets are now approaching his firm about investment possibilities; after all, the more good companies to choose from, the better. Meanwhile, as he adds, "deals in the last half of 1998 were priced differently, which makes sense in a market in which the public-company valuations were 40% or 50% lower than they were a year earlier."
So here's today's reality: financing deals are getting done, but with lower valuations, tighter restrictions, and much tougher investment and loan criteria. The entrepreneurs who succeed in raising funds in a marketplace like this one will be those who are capable of adjusting their mind-set and lowering expectations that were nurtured during more than a decade of largely uninterrupted growth.
The one certainty in an uncertain economic time? The entrepreneurial companies that thrive during the next few years will be the ones that focus effectively on building healthy cash flow and on meeting financial projections and goals. That may help them win investor or bank financing, but those techniques absolutely will support growth activities in leaner and meaner capital markets.
What remains to be seen is whether the current disruptions and adjustments that are taking place within the global financial universe will impose equally real changes upon today's and tomorrow's entrepreneurs. We're betting they will--if only because many companies will be forced to figure out how to achieve their goals with less growth capital. For all those whose level of personal indebtedness has risen precariously high during the past decade, capital options will be even tighter, since those business owners simply won't be able to rely on the entrepreneur's traditional last line of defense: putting up personal collateral, such as a home, to fund growth.
What all this may mean is that the fast-growth entrepreneurial model of the 1990s is being replaced by slower-and-steadier-paced models in all but a handful of industries that continue to attract early-stage investment capital. Many more companies will find themselves with little choice but to set more modest growth goals that can be supported by internal cash flow. If that pattern does emerge, it will certainly change investors' expectations about how long it will take for an entrepreneurial investment to pay off. Will some redirect their investments elsewhere? It seems almost inevitable, at least in the short to middle term.
The worst of all worlds? Maybe not. One unfortunate by-product of the overheated capital markets of the 1990s has been the sense of unreality that has pervaded so many deals: unrealistic time frames, unrealistic expectations, unrealistic valuations. That situation has defeated the growth prospects of many companies, in part by blinding them to the financial realities that really should matter to them and to their backers.
First and foremost among those realities is the need to build and maintain healthy cash flow and to achieve profitable sales growth. If tight money markets restore that type of discipline to the entrepreneurial community, owners of growth companies can rightfully expect that the pendulum will swing back in their favor once again.
'The problem with many small companies' business plans is that they don't actually meet their projections.' --Fred Marcusa, partner
COMPANY: Kaye, Scholer, Fierman, Hayes & Handler, with headquarters in New York City
BUSINESS: Represents corporations, lending institutions, and investors in financing and other transactions
"The capital markets--most especially, but not only, the IPO market--are driven by psychologies," says Fred Marcusa. "Right now they've been affected, in the most general terms, by a change in the perception of credit risk, a change that has taken place at every level, ranging from countries to large corporations to small private companies as well." Many investments are perceived as potentially more risky, and that's affected the liquidity of capital and the terms of investments.
What does all that mean for capital-hungry entrepreneurs? They need to adjust to the changing mind-set of investors and creditors, in large part by demonstrating that risks are under control within their companies. How not to do that: by building unrealistic expectations into a business plan's financial projections and trying to inspire excessive optimism in prospective bankers and investors.
In capital markets as uncertain as today's, those strategies can come back to haunt entrepreneurs. "The problem with many small companies' business plans is that they don't actually meet their projections," Marcusa says. "When they try to raise additional financing early enough, that doesn't necessarily hurt them, because their failings aren't yet obvious."
But these days some companies may decide to delay new rounds of financing, especially IPOs, because they're dissatisfied with interest rates or valuation levels. "If they now find themselves waiting an extra six months or a year or longer, prospective bankers and investors may find that they're better able to evaluate a more realistic growth curve and cash-flow capabilities for their companies," Marcusa says. "And that could further weaken an entrepreneur's chances of working out the right deal even in stronger markets." To avoid that risk, keep your projections more realistic the first time around.
'My memorandum probably just sat on a lot of people's desks.' --Tim Bocher, cofounder and CEO
COMPANY: Virtual Frontiers, in New York City
BUSINESS: Internet consulting and E-commerce
1998 REVENUES: $500,000
NEEDED: $5 million to $10 million in growth capital
FIRST TRY: Private investors
Tim Gocher financed Virtual Frontiers, which he founded in 1995, with his own money. But by last year he realized that further growth would be difficult, if not impossible, with that financial model. "I needed to offer my customers a one-stop shop. I couldn't do that without raising capital," he says. "Initially, early last year, I thought we would need $5 million to $10 million and felt that the right way to raise that would be from private investors or venture capitalists. So I started talking to some of them. But then I realized by the summer that merging with a strategic partner, with the goal of eventually taking our combined companies public, made more sense." With the help of his accounting firm, he developed an investment memorandum that he circulated to every possible contact he could think of. "But I got almost no leads at all from that course," Gocher says. "My memorandum probably just sat on a lot of people's desks."
Not one to waste time on a strategy that wasn't working, Gocher shifted gears within a few months and hired Ben Boissevain of E-Technologies International, an investment banker who specializes in serving technology companies. "I agreed to pay him a monthly retainer, as well as a commission based on the final financing package," he says. "But the money was worth it, since he was able to help me find the kind of deal I wanted."
In a transaction that closed on New Year's Day, Gocher swapped his stock for a multimillion-dollar package of cash plus stock in a larger Internet-systems company, SenseNet, the name under which the two merged companies will operate.
'Don't expect a bank to know what's best for your business.' --Lisa Argiris, founder
COMPANY: Music Starts Here, in Des Plaines, Ill.
BUSINESS: Musical-instrument rental
1998 REVENUES: $500,000
NEEDED: Line of credit for capital-intensive business
FIRST TRY: Longtime banker
Lisa Argiris started her first company, International Musical Suppliers, out of her dorm room in college 13 years ago and landed her first line of credit, for $50,000, just four years later. "It took me a long time to realize that my bank was really just interested in supporting me because of my public-relations value to them--as a minority and female business owner--not because they really understood or believed in my business concept," she says.
The more aggressively Argiris pursued growth, the more her bank balked. "The company, which was a mail-order house for instruments, really grew in sales--it's up to $4 million today--but the margins were slim. I knew it made sense to diversify." Six years ago Argiris established Music Starts Here, an instrument-rental business that serves local schools. "Its margins are going to be much higher, but the company is very capital intensive in getting off the ground," she notes. Argiris was unable to get an adequate line of credit from her bank.
Last year she decided to shop around for a new bank, finally landing a $1-million-plus loan package from Citibank, based on the track record of her first company. She concludes: "If you're unhappy with your banker, move on quickly. If he or she only wants to support you because you're a woman or a minority or whatever, don't waste your time. And above all else, don't expect a bank to know what's best for your business. You've got to know that--and know how to communicate it to them."
'I've been knocking on bankers' doors for years now.' --Mario Tolisano, cofounder and president
COMPANY: Ciprietti-Tolisano Associates Inc., in Tuckahoe, N.Y.
1998 REVENUES: $5 million
NEEDED: Credit line to cover payroll and operating expenses because of an industrywide problem of late payments
FIRST TRY: Banks
Don't talk to Mario Tolisano about bankers. He's been pursuing bank financing, with little success, for years now as his company developed from a part-time venture with less than $200,000 in revenues to a full-time business. "Invariably, I end up being a banker for my customers. What we need is enough of a credit line to cover our payroll and operating expenses for 30 to 60 days," he says. But no luck. "I've been knocking on bankers' doors for years now, but the minute you tell them you're a construction company, they laugh at you," he says. "It seems as though I've spent my whole life chasing after money, only to find every door closed."
Tolisano has funded his 13-year-old company's growth mainly with personal savings and some contract-financing credit that he was able to land, albeit at a high interest rate.
Finally, convinced that he could spend the rest of his life unsuccessfully chasing after an adequate credit line, Tolisano decided to enroll last fall in GE Capital Small Business College, which runs a three-month part-time program, organized around such key issues as financing alternatives, strategic planning, and accounting.
"I've already made some accounting changes as a result. But the main thing that I'm hoping is that the GE Capital contacts I've made through the course will help me improve my financing prospects," Tolisano says.
'We launched the IPO again last summer and again wound up pulling it in July.' --David Tusa, CFO and vice-president
COMPANY: U.S. Legal Support Inc., in Houston
BUSINESS: Litigation support
1998 REVENUES: $50 million
NEEDED: $35 million to $40 million to reduce debt and fund acquisitions
FIRST TRY: Initial public offering
Two-year-old U.S. Legal Support Inc.--founded by a group of litigation-support companies--is already a $50-million business, thanks to 14 acquisitions it made in 1997. "Our industry is highly fragmented," says chief financial officer David Tusa. "It was fairly simple for us to raise the private-equity money we needed." Next on the company's growth agenda was its plan to carry out an initial public offering in the hope of raising $35 million to $40 million to support additional mergers.
Unfortunately, the IPO market didn't cooperate. The company's underwriter tried to bring U.S. Legal to market during January 1998, then pulled its offering (along with those of several other companies) because conditions seemed too volatile. "We waited for things to settle down, launched the IPO again last summer, and again wound up pulling it in July," says Tusa. "We actually cleared the SEC twice and wound up raising nothing. It's very frustrating when your business operations are great and the capital markets won't support you," he adds.
Tusa and his colleagues now believe that even if the IPO market settles down, the "benchmark changed between 1997 and 1998 for the kinds of deals that will get done." Now, he says, "we need to be larger for the current public-market mind-set. I think we'll have to grow sales to $75 million to $100 million before we can hope to carry out a public offering."
'The company didn't meet a bank's standards for financing.' --Joe Elizondo, CEO
COMPANY: C.V. Date Co., LLC, in Coachella, Calif.
BUSINESS: Processes, packages, and distributes dates
1998 REVENUES: $1.3 million
NEEDED: Funds to cover uneven cash-flow cycle owing to seasonal business
FIRST TRY: Bank line of credit
For Joe Elizondo, raising capital was absolutely essential. "We needed the financing to help us purchase our product from growers and cover our operating expenses during those periods when revenues aren't coming into the company," he says. Elizondo spent two months in late 1996 trying to raise about $400,000 in a bank line of credit, but he couldn't get anywhere. "Our company's owners, two Latina women, had purchased it during a period of financial trouble and aimed to turn it around. But we didn't meet a bank's standards for financing, since the company's assets were encumbered by an SBA loan, its financial history had been troubled, there had been problems with the IRS under the old owners, and its new owners didn't have a lot of personal assets."
With the help of Jesus Arguelles, a private investment banker in La Quinta, Calif., who focuses on small, growing companies, C.V. Date was able to pursue more flexible sources of credit instead. "We've put together a package of working-capital financing that ranges from $350,000 to $800,000, mostly in credit, depending upon where we are in our cash-flow cycle," Elizondo says. The package includes vendor financing, accounts-receivable financing, and what Arguelles calls "friendly-investor financing," in which a company outsider, a contact of Elizondo's, purchased some equipment for C.V. Date and leased it to the company. "I could never have accomplished all this on my own, especially while running a company in turnaround," confides Elizondo.
HARD LESSONS'Selling equity seemed like a way to raise a lot of capital.' --Marshall Rafal, founder
COMPANY: OLI Systems, in Morris Plains, N.J.
BUSINESS: Chemical-simulation software
1998 REVENUES: $3 million
NEEDED: Growth capital
FIRST TRY: Investment-banking house
During the past year Marshall Rafal pursued what he calls "the broad spectrum of equity possibilities" for his company. "Selling equity seemed very tempting," he says. "It seemed like a way to raise a lot of capital at a time when we needed it for our growth strategy. And I liked the thought of bringing in an equity investor who would be an asset for us on our board."
Rafal contracted with a regional investment-banking house to explore his company's options. Early in 1998 the timing seemed right. But by last autumn, when turmoil in the public stock market had deflated the value of many possible private-equity transactions, Rafal decided it made better sense to stick to debt. "When you combine the reality of falling valuations with the specter of giving up at least some control of the company, debt was just clearly a better way for me to go," he says.
Rafal pursued a Small Business Administration loan application that had been wending its way through the paperwork and approval process for nearly a year. "The SBA insisted on all kinds of collateral, including personal assets," he says. Still, the loan, which closed in mid-November, "has given me the funds we need to push our company to the next level, while also allowing me to keep control of our stock."