Where Has All the Money Gone?
HOW TO FINANCE [almost] ANYTHING
You've built a profitable company on the cusp of expansion. All you need is some capital to fund your growth plans. But if your company isn't high-tech, getting it will take creativity
After a wild and crazy year in the capital universe, the first E-mail message that I got after New Year's Day seemed to be, well, just one more sign of the times: "We are in need of anywhere from $30 million to $100 million. ... Can you help me with some advice please. This project has been dropped in my lap. That's OK but I could use some good advice."
There's never been a time like this. Forget tulip-bulb mania; no matter how besotted Holland's investors of the 17th century might have been, there probably weren't too many burghers of the time who had the audacity to ask for help in finding -- and to expect to get -- their equivalent of my correspondent's megamultimillion-dollar goal. Just consider what happened in the financial world in 1999. Some 544 companies raised a record-breaking $65 billion from initial public offerings, thousands of other businesses merged-and-acquired their way through at least $1.4 trillion worth of deals, and the Nasdaq Composite Index rose by more than 85% -- the biggest annual gain of any major stock index in the history of the U.S. equity markets.
There has never been a time like this.
Thanks to a remarkable rise in the market trading value of public stocks (and an economy boosted by low inflation and technology-driven productivity gains), we have entered an era in which a huge amount of capital is wending its way through the equity and debt markets. It's not so surprising, then, that many people, like my correspondent, have concluded that it's now possible to raise money for just about any and every business venture.
But the sad reality is that they're wrong.
Despite all that available money, especially in the equity arenas, many entrepreneurs -- maybe even most entrepreneurs -- still face significant difficulties when it comes to finding outside funds to support their company's growth strategies.
It's heartbreaking but true. Investment banks may have raised a near-record $2.1 trillion for deals in 1999, but the vast majority of business owners (especially owners of small companies and low-tech start-ups) didn't stand a snowball's chance in hell of getting their hands on any of it. For plenty of good companies that had strong prospects (if they could only raise the capital!), financing options were -- as usual -- somewhere between limited and nearly nonexistent.
Here's the straight story behind all those jubilant headlines and dizzying statistics that tend to pervade the media these days. During the past year or so -- as tremendous new wealth was being created and entrepreneurship flourished across the nation -- two distinct tracks developed in the equity-financing market. And while it may seem simplistic to define them as "the dot-coms" and "everybody else," those descriptions are not far off. As Paul Schaye, a managing director at New York Citybased Chestnut Hill Partners, an investment-banking firm specializing in mergers and acquisitions, puts it, "The markets have become bipolar."
The most favored child of today's capital markets is, predictably, a hypergrowth technology company: a kind of business that runs the gamut from online retailer to telecommunications service. So many companies in this category have successfully bucked all the age-old financing rules of thumb that it sometimes feels as if an entirely new world of capital has been created. During 1999 everyone from private-equity firms to day traders seemed to have money to burn when it came to investing in this endlessly proliferating, financially voracious sector. Meanwhile, low-tech companies, even those with well-established niches, healthy cash flow, and vibrant growth potential, were left to fight for the table scraps.
The photograph of iVillage cofounder Nancy Evans smoking a celebratory cigar after her red-ink-trailing company's $87-million initial public offering seems emblematic of one side of today's capital markets. The other side might be perfectly encapsulated by Schaye's description of one of his recent airplane flights. "I sat next to a guy who had built up a $200-million Main Street, America, type company. Profitable. Very successful. And he was complaining to me that he had absolutely nowhere to go unless he was willing to sell out to a larger company. He couldn't go public. He couldn't attract venture capital," Schaye says. "Those markets were completely closed off to him and to any other company that wasn't a dot-com, a real glamour business like Martha Stewart, or a massive leader like UPS."
"There's no question that a lot of sectors have simply been left out in the cold in these capital markets," agrees Howard B. Adler, a partner in the Washington, D.C., law office of Gibson, Dunn & Crutcher LLP. "There's so much money around, but most of it is chasing those tech deals. Last year I saw very established companies, venerable companies -- in areas like real estate, finance, manufacturing -- that just couldn't raise capital. Good advisers will tell business owners to go back to the office and wait for the market to change."
If that's the situation that large, well-established companies now face, it's not too surprising that conditions are bleaker still for small or fledgling businesses. "As a director, I've been working with a company, a medical-device manufacturer with about $12 million in sales, strong pretax profits, great product, specific niche," says Michael D. Madden, a former investment banker who is now a partner at the New York City office of Questor Partners Funds, a private-equity firm. "The owner came to me originally and said, 'Mike, we want to go public.' I told him, 'You can't go public. What you need is $5 million to $10 million in private-equity funds to help you bring the business to the next level. Then we'll see what your options are."
Unfortunately, as Madden learned, that kind of money just isn't available for companies like his medical manufacturer -- at least not these days. "This isn't exactly a low-tech company. It's got some sex appeal. But everyone I talked to had the same response. 'Great little company, Mike, but we don't think the market for what they do will ever allow it to grow to the point where we'll have appropriate exit liquidity.' " He concludes, "The reality is our own calculations suggest that if this company did manage to bring in the private-equity money, it could grow to about $50 million in sales. And that's just not big enough by current investor standards. All my guy can do is try to raise funds through the debt markets, or go into strategic-alliance mode if he can figure out a big company that his business could enhance."
Indeed, megagrowth has become the name of the game for all the equity-oriented investors and deal makers who inhabit the golden pole of our "bipolar" capital marketplace. "If you don't have the capability of becoming a company with $100 million in revenues within a three-year time frame and of dominating your market within 12 months, your company is probably not going to be able to attract professional investors," is the assessment of Stefania Aulicino, the founder and president of Capital Link Inc., based in Chicago, a financial consultancy that advises entrepreneurs.
That's a slight exaggeration, since Aulicino herself concedes that "there are always investors -- smaller angels -- who are fishing along the bottom." But it's undeniable that most of today's professional investors (especially venture-capital firms, leveraged-buyout firms, and other private-investment firms) are pursuing the most narrow target profile we've seen in years.
That may not seem fair to all those "noninvestment-worthy" entrepreneurs across the country who have already proved their business models and achieved growth and profitability, and who know darn well that their companies will likely outlive, let alone outperform, many of the dot-coms whose IPOs now turn them green with envy. But though it's unfair, the tech-investment frenzy has been driven by two very basic pieces of business logic: First, investment capital moves in the direction of what investors perceive as their greatest return at an accepted level of risk. Second, and perhaps even more important, savvy investors don't enter deals unless they can foresee an easy exit.
"The reason why tech deals are the ones being done right now is simple -- that's where most of the opportunity is," explains Susan E. Woodward, a former chief economist for the Securities and Exchange Commission, who now is vice-president of research and chief economist at OffRoad Capital Corp., an online private-equity firm based in San Francisco.
Woodward points out that inflation-adjusted returns on long-term treasury securities are at unparalleled highs. Regular old mutual funds are yielding mouthwatering returns. "So the required rates of return that companies need to be able to offer in order to raise new capital are astronomical," she says. "Technology companies typically are the only ones that can meet those hurdle rates." They've also become the only type of business venture that can reliably (at least for now) offer investors a profitable exit strategy. Thus, one profitable tech deal leads to another and another and another.
The more money that flows into the capital markets, the more unbalanced the situation seems to become. "Five or six years ago there was a real trend of investment funds starting up to invest in smaller deals, less-favored industries, real contrarian plays," notes Michael Madden. "But as the dot-com craze has taken over, what are the managing partners supposed to do? You might have a 30% track record, but that's not going to be good enough to attract new investors or keep your current investors happy. You've got to figure out how to put some octane in the tank. So you've got to move in the direction of technology."
The same irresistible forces have motivated investment bankers and other deal makers. "I've got one client, an investment bank in our region, whose technology bankers are working 24 hours a day. They can't handle all the business they've got," says lawyer Howard Adler. "On the other hand, the bankers who specialize in industries like real estate investment trusts can't do anything. They can't get a financing deal done. They're just sitting around. So what's happening is, a lot of those kinds of bankers are becoming tech bankers because that's where the action is."
Michael Kane, whose Los Angeles firm, M. Kane & Co., helps entrepreneurs assess their financing options and then raise funds from a variety of sources, puts it more bluntly: "I know that I'll have a better chance raising capital if I've got one of 1,500 dot-com pitches on a venture capitalist's desk than if I'm one of 200 or even fewer low-tech or nontech companies. So what are you going to do?"
As tremendous new wealth was being created and entrepreneurship flourished across the nation, two distinct tracks developed in the financing markets.
Fortunately, like every marketplace, this one has attracted contrarian investors, who can see lower risk, less competition, and appealing (if not astronomical) potential for reward where others see only an indistinguishable blur of non-dot-commers.
Welcome to the other, less glitzy pole of today's capital market. Money doesn't grow on trees here, and company founders don't become paper billionaires before they reach the age of 30. Still, the good news is, there are financing opportunities for entrepreneurs who are willing to live by an older, stricter set of business guidelines. For those of you who have been in business long enough to remember, it may remind you of how things were back in 1996 or 1997: there is money out there and investor confidence is high, but the markets are nothing if not disciplined, and competition for capital abounds.
It's not always simple to track down potential equity backers in this end of the market. They're usually not headquartered in New York or California, and they seldom get quoted in the national business press. But they do exist.
Wind Point Partners, a private-equity firm founded in 1983 in Chicago, is a good example. "We're currently investing our fourth fund, which has $350 million from state pension funds, Fortune 500 pension funds, and funds from other institutions," says Jeffrey Gonyo, a managing director. He goes on to explain: "Historically speaking, we have a Midwest focus, and industry-wise we have been -- and continue to be -- generalists. We've invested in telecom deals but also in consumer products, institutional food companies, a bicycle importer, all kinds of deals."
Just like all the investors chasing after dot-coms, Gonyo and his colleagues are focused intently on their exit strategies, which might include an IPO (if they're lucky) but also might take the form of a leveraged buyout by management or a strategic sale to a larger corporation. What's different about Gonyo and company, though, is that they're not looking to run out the door on a deal almost as soon as they put their money on the table. In fact, their investment horizon hasn't changed much from what it was when the firm first opened its doors.
"We're patient investors. We don't have to earn our payout in a year or two, which is what many venture-capital and private-equity firms are now looking for," Gonyo says. "We're willing to make a commitment of three to seven years and to stay with a company for long enough to be sure that management has time to execute its growth strategy. We believe that over the long run our investors will be well rewarded for helping companies build that kind of value."
Entrepreneurs competing for funds from contrarian investors like Gonyo need to recognize, right from the get-go, that the standards they face are much tougher than anything a tech company now comes up against. "In this financing arena, cash is king. It's the world as we used to know it. Strong cash flow is absolutely essential to get investors interested," notes Robert Koenig, president of Woodbridge Group Inc., an investment-banking firm based in Woodbridge, Conn. "The reality is, people look at those kinds of deals not in terms of a company's revenues but in terms of its EBIT" -- earnings before interest and taxes.
For low-tech companies with strong financials, good growth potential, and a well-thought-out exit strategy, the right investor may well be out there somewhere. But as Gil Menna, a partner at the Boston-based law firm Goodwin, Procter & Hoar LLP, emphasizes, their owners will need to be creative, as well as relentless, to get deals to happen. "I'd pitch my company to private-equity funds as a great hedge to all those high-tech investments they've already made," he says. " 'After all,' I'd say, 'I've got a great story and I've already got revenues and profits. I'll give you the diversification you need.' "
It could happen. But for low-tech business owners with limited cash flow, a money-losing operation, or other unfavorable financial trends, the chances of successfully wooing a professional investor are nil. Unfortunately, that's also true for many otherwise strong contenders that are simply too small or too specialized to capture anyone's attention in these highly competitive times. "You have to be seen -- you must be visible on the landscape, and that ain't easy these days," emphasizes Madden. "Everyone is competing for a share of the mind of investors. For a lot of smaller companies, it's almost impossible to get them to notice you."
Sad to say, the difficulty of distinguishing your company from the competition for capital is just part of the problem. The other roadblock for small money-hungry businesses is that many just don't need enough funding to make it worthwhile for even contrarian investors to take a gamble on them. In a way, that's the most perverse side effect of the recent bull market. Private-equity firms, leveraged-buyout funds, and venture capitalists have made and raised so much money in recent years that the threshold keeps getting higher when it comes to deal dynamics.
As Michael Kane explains: "It used to be that a $300-million fund was a big fund. Now $500-million, $750-million, $1-billion funds are much more common. And with all that money to be deployed, investment firms want to put more money into a deal, because they figure their investment is going to take the same attention to watch whether they put in $1 million or $5 million or $25 million."
David Freschman, the president of Delaware Innovation Fund, an early-stage-venture-capital firm based in Wilmington, Del., agrees. "Now that many investment funds have gotten so large and are setting their deal sights so high, there's a real capital chasm that's occurred for businesses trying to raise up to $1 million or so in equity funds. The only options that most people have are seed-capital funds like ours or angel investors -- if they can manage to attract them."
Ah yes, angels. Is it any surprise that within a capital universe that has shifted -- and polarized -- as dramatically as this one has, the nation's angel community has undergone its own major transformation?
For one thing, it's gotten bigger, although its size is easier to estimate than to quantify. Thanks to the raging bull market, the M&A boom, and the growing ranks of stock-option-enriched executives, there are more would-be angel investors than there have ever been. Angels are better-heeled than ever, too. And that can be only good news for capital-starved entrepreneurs.
But there's another trend worth mentioning: today's angels are also more sophisticated than ever. Many of them made their fortune by working or investing in the technology sector. And that's where they intend to back new ventures.
Before he began funding other entrepreneurs, Bill Jensen was one of the cofounders of Rodel Inc., which manufactures systems for polishing silicon surfaces. He thinks of the old doctor/dentist/retiree model as "fools and angels," while describing the new, business-savvy breed he identifies with as "archangels." "We don't just provide money, but we're capable of bringing profound knowledge and experience to the companies that we invest in. And that's the kind of angel that dominates today's marketplace in terms of successful investments."
Since tech deals are more capital-intensive at all stages (including the earliest, seed rounds), angels, too, are finding themselves making bigger investments than ever, often in the realm of $100,000 to $1 million. According to Freschman, they're looking for deals "the same way that venture capitalists and private-equity investors are looking for them -- in fact, often side by side with them at events like venture-capital fairs."
Thanks to angel-oriented Web sites, it's now easier for small companies to shop their business plans around or advertise for potential backers. Unfortunately for other types of businesses, it seems that electronic advances on the financing front still favor the technology companies. Consider OffRoad Capital's experience.
The company, which launched its services last year, aims to sell private-equity investments through the Internet, which -- in theory, at least -- should bring more potential backers to the table and increase access to investor capital for private companies in every field. But the reality is, just like everybody else, OffRoad has been raising money for tech companies. "We have to start somewhere, so we have started with the deals our customers want and understand," acknowledges Susan Woodward. "So our three financings to date have all been technology companies that just weren't quite ready for the initial-public-offering stage but, hopefully, will get there soon."
OffRoad's investors actually look a lot like typical angels -- they're just shopping through the Internet. Many have never done a private-equity deal before. Every investor must put up at least $25,000 to get a piece of the action. And each has a net worth of at least $1 million. "These are the people who probably don't live in California or New York and probably don't have the personal contacts that could get them into a great deal themselves," Woodward speculates. "So they've used the Web to find one."
But although electronic advances reinforce the migration to tech deals, you can still find contrarian investment patterns in the angel world, too. They're most prevalent in regions that are not overflowing with high-tech opportunities. Take Oklahoma. "We're not exactly Silicon Valley here," notes Bob Craine, the chairman of the Oklahoma Investment Forum Inc., a Tulsa-based economic-development organization that, among other things, sponsors an annual venture-capital forum to showcase the state's entrepreneurial companies.
As it is elsewhere across the nation, the angel community is growing in Oklahoma. "A year ago we had 5 or 10 angel groups across the state, but now there are 30 or 40," reports Craine. And while those angels probably would love to get involved with "the next eBay, they're also a pragmatic bunch," he adds. "Show them a good solid deal with the opportunity for a 25% or 30% return, and they'll probably want to get involved, whatever the industry." Show them a deal that has less growth potential but offers the chance to bring 200 new jobs to a small, struggling community, and they may jump on it as well.
At this end of the market, it pays to offer an investment angle. (And here's where the Internet can help companies conduct some helpful research.) There are angel groups, economic-development organizations, and seed-capital firms that target geographic locations, minority or female business owners, and even certain industries. And for entrepreneurs who simply cannot find any that relate to their particular set of circumstances, there's always the alternative of offering equity to a strategic partner (perhaps a supplier, a major customer, or a large competitor).
Fortunately, even though the opportunities in equity markets have narrowed in recent years, the world of debt has shown a lot of interest in serving small and midsize private companies. And business owners with no other realistic alternative may be comforted to know that borrowing options have never been better.
This is another place where the Internet has made an important contribution. Company owners can (and should) comparison-shop to find the best terms and borrowing limits among entrepreneur-friendly lenders in their region. Using the Web makes it easier to identify good prospects among the broad range of financing players, which these days increasingly include "nonbank lenders" (such as nontraditional lenders with Small Business Administration connections); small-business-oriented private banks; equipment financiers; and other specialty lenders. Some companies have already streamlined their credit or loan applications to speed up electronic approval or to permit quick online assessments of whether approval is likely. That's a trend that should snowball during the next year or so.
But there's more going on. Although bankers have waxed hot and cold on the small-business community for years now, the long-term picture is finally improving, mainly because so many different kinds of lenders have made the entrepreneurial community part of their own growth strategies. And while the biggest money-center banks do, and probably always will, lean more toward the best established and most growth-oriented private ventures, there are so many community banks, small regional banks, and (in increasing numbers) business-only banks that it's rare for a loan-worthy company to be turned down. According to the SBA, small-business lending rose by an impressive 1.3 million loans from 1997 to 1998, the most recent year for which statistics are available. The biggest increase took place in those often-difficult-to-obtain small loans, those under $100,000.
Being creditworthy, of course, is still essential. In this competitive marketplace, definitions of creditworthiness are shifting and, in some cases, broadening. But miracles in financing still don't happen here, either. As Michael Kane puts it: "Realistically speaking, you'll need to have cash flow to cover at least 1.25 times whatever your debt service is going to be. And you'll need some kind of assets, whether they're corporate collateral or personal assets."
One new trend worth watching: the "niche-ing" of loan products into specialty credit lines that make it easier for lenders to assess and manage their risks and make it simpler for companies to get the kind of money they need. A good example is ProjectLine, a $50,000 to $500,000 line of credit that Butler Capital Corp., a private lender based in Hunt Valley, Md., provides to companies that might once have had a tough time finding financing. "The typical borrower is a white-collar professional firm. Maybe its growth is tech driven, but it's probably not a dot-com," explains president Lawrence J. Butler. "It isn't big enough to attract equity capital, but it's got real growth potential if it could raise the funds to help it staff up, acquire new equipment, or maybe move to new office space. We'd sit down with a customer, help the owner figure out what kind of credit line could help the company carry out those activities, and work out appropriate terms."
Butler, who has been in small-business finance for more than 20 years, notes a trend that keeps him awake at night: more competition, even for small-business customers. "There was a time when nonbank lenders might have charged as much as seven percentage points over prime. Now rates can be as low as one or two percentage points higher."
Competition has also increased from the credit-card companies, which are aggressively trying to position themselves as something better than lenders of the last resort. American Express launched a major initiative last spring to encourage its best small-business customers to use their cards for inventory and raw-material purchases up to a monthly maximum of $400,000. Another sign of the times: Visa's new Start-up 2000 program, which will provide $25,000 in funding, as well as up to $50,000 in office products and other services, to three outstanding young companies, soon to be selected from a national search.
Three companies out of the hundreds of thousands of young companies may not seem like much, but it's an indication of the new focus on small businesses that more and more banks, credit-card companies, and specialty lenders are now taking. Those developments can only work to your advantage.
Jill Andresky Fraser is Inc. 's finance editor.
"I believe in the future, but I can't believe in the valuations I see in deals these days in technology companies. They leave me shell-shocked. There will have to be a correction. But when it comes to the rest of the world -- all those Main Street, America, deals -- there's no frantic mania that's been driving this market. Valuations have been stable -- similar to the level they've been at for the past few years. I don't foresee a correction at this end. This part of the world has been functioning fine and should continue to do just that."
Robert Koenig is the president of Woodbridge Group Inc., an investment- banking firm in Woodbridge, Conn.
Susan E. Woodward
"We envision eventually creating an online secondary market for private-equity deals, which would not trade daily like the stock market but could trade quarterly or semiannually. That could represent a tremendous improvement, because it would create liquidity, which could make some kinds of investment deals easier to do.
"I can imagine this kind of Internet trading market enabling the owner of a very large car dealership to sell a private equity stake in his or her company to an investor, which right now could be a very difficult thing to do. Ultimately -- maybe 10 years from now -- there might be as many as 25,000 private companies whose shares are trading in this type of Internet market. They won't necessarily be very little companies. But they might be companies that could otherwise never have attracted private-equity capital."
Susan E. Woodward is the chief economist and vice-president of research at OffRoad Capital, in San Francisco, an online marketplace for private equity.
Howard B. Adler
"What would restore what we think of as sanity to the capital markets? It would take a jolt in the equity markets. But it would have to be a very big jolt. After all, there are many people who have earned so much more money in today's technology deals than in any other kind of investment that I don't think a 20% drop, say, would change anything. People have grown to accept tremendous volatility as part of what these markets are like."
Howard B. Adler is a partner at Gibson, Dunn & Crutcher LLP in Washington, D.C.
"There's a mentality now that bigger is better. You see that in the equity markets and the kind of companies people want to invest in, and you see it in banking -- where many banks think they need to get bigger and bigger, even though they may do a worse job of serving their customers. All of those trends may make it harder for smaller companies to raise capital these days.
"I don't know if anything will change here, but there's one thing I do know. Debt is much less expensive than equity. If entrepreneurial companies could recognize this -- and could concentrate on getting financing from lenders who really do understand the risks and rewards of smaller businesses -- they'd be better off. And it won't matter that their only options are debt oriented. They'll still be able to finance profitable growth."
Tom McAuliffe is the chairman of Commerce National Bank, a small-business-oriented bank in Worthington, Ohio.
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