It was the summer of 1987, just four years after our founding. Our company was still called Springfield Remanufacturing Corp. back then, and our main business involved taking worn-out diesel engines -- or cores -- and remanufacturing them so that they ran almost like new. Every engine core that we brought into our plant in Springfield, Mo., came with a component known as an oil cooler, whose function was to keep the engine from overheating. Unfortunately, most of the coolers leaked so badly that we had to replace them.
That was costing us a lot of money. We were paying about $50 each for the leaking coolers as part of the overall price of an engine core. Whenever we threw a cooler away, we replaced it with a brand-new one at about $100 a crack. All told, we were spending more than $275,000 a year on an item that I believed should have been costing us about $60,000 -- in effect squandering almost 20% of our profits.
The situation was driving me crazy. I kept bugging our engineers about it, and they kept telling me that they were too busy to focus on it. They didn't have time. They had other things to do that were more pressing.
That just got me more angry and frustrated. I bitched and moaned, but our vice-president of manufacturing told me I was wasting my energy. He didn't think that, given our overhead, we'd actually save money by remanufacturing our own oil coolers. I didn't buy it. I thought there had to be a way. I believed we simply weren't trying hard enough. We were looking for excuses. Finally, I said, "Screw it. Let's settle this thing once and for all. We'll take the damn oil coolers out of our factory, set up an independent company, and give it the oil-cooler business. We'll get other people to fix the problem for us."
So a small group of us got together and started a business, Engines Plus, to remanufacture oil coolers for SRC. As it turned out, our experimental new venture would teach us a set of homegrown rules we would use to transform our company and make innovation an integral part of the way we would run SRC from then on.
Our plan was to start Engines Plus with a small amount of equity and a large amount of debt. There was, of course, a practical reason for limiting our up-front investment: we didn't have much money. But we were also curious to see if we could harness the power of leverage.
RULE #1: Use leverage when you can.
I'm referring here to the principle that the more debt and the less equity you use in financing a start-up, the greater will be the initial rise in the company's value if you're successful. We'd already had one dramatic demonstration of leverage with SRC, which we'd launched with $100,000 in equity and $7 million in debt, thereby fueling a 15,500% increase in our stock price in the first four years. But that had been an accident. At the time, we were just trying to get the company started any way we could, and the deal we wound up with was the only one available.
With Engines Plus, we deliberately applied the leverage principle. A small group of us put up $1,000 of our own money as an equity investment. Then we arranged a $50,000 line of credit from SRC. Engines Plus thus began with a 50-to-1 debt-to-equity ratio -- not quite as steep as SRC's, but close.
RULE #2: Protect the mother ship.
It's important to understand that the new business was an experiment. We didn't know for sure that the people we brought in would be able to develop a process for remanufacturing oil coolers or that the coolers they produced would meet SRC's specifications. We certainly didn't know whether they could run the business profitably.
So we made sure that this experiment wouldn't have negative repercussions for SRC. We didn't take people out of SRC to work on it. We didn't use SRC facilities or equipment. We'd didn't put SRC funds at risk. If things fell apart, SRC would be able to recover whatever capital it had advanced either from the assets of the business or from the partners.
The point is that we'd never done anything like this before, and so we wanted it to be a separate deal, at least until we had a better sense of the risks involved. Then we could modify our approach accordingly.
RULE #3: Find the right leader and strike the right deal.
We figured we would recruit someone to head up the venture, give him or her a significant equity stake, and devise a valuation formula that would encourage bootstrapping. As luck would have it, we had a strong candidate. His name was Eric Paulsen, and he was a vice-president at one of our competitors. We knew Paulsen was looking for a new opportunity, and he met all our qualifications. He had a good track record in business, with experience in accounting and in sales and marketing, and he could put together a start-up team. We also thought he'd be able to diversify the company once he got it up and running. Among other things, he had started a parts-distribution business for our competitor. We believed he could eventually start one for Engines Plus.
RULE #4: Find a cash-flow generator.
By that, I mean a customer who has a specific need and is willing to pay to get the need taken care of. In this case, it was SRC, which needed to stop wasting money on new oil coolers.
There are actually four things that will help ensure positive cash flow in the beginning: long payables (good terms from suppliers); a bimonthly payroll (good terms from employees); short receivables (fast payment from customers); and minimum inventory. Because SRC was both supplier and customer, it was able to help Engines Plus on three of those counts. To begin with, SRC could provide oil-cooler cores on consignment, allowing Paulsen to obtain most of his raw materials without actually spending any money on them. In addition, we could set up a line of credit with SRC at minimal risk. After all, the start-up would have a guaranteed market for its products, at least its initial ones.
