The Private-Capital Survival Guide

Even with both the economy and the stock market sputtering, private-capital deals are more appealing than ever. Why? Because well-heeled investors still need a place to stow their cash. But it's not just about the money.

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Not every Enron story ends unhappily. Late in 2001, publicly held steel-processor Hunt Co. filed for Chapter 11 bankruptcy-court protection. Most of Hunt's work involved bending steel for Enron's gas pipelines (hence the need for Chapter 11), but hidden deep within the company was a 100-person operation that turned out metal tanks used in small-scale mechanical air pumps -- the kind that inflate tires, toys, mattresses, and the like. The unit's managers, well aware that prior to Enron's collapse their business generated $23 million in revenue and commanded 70% of the U.S. market for such tanks, wanted to buy the operation from Hunt and relaunch it as a freestanding private company. But they needed help to swing the deal. Ultimately, the managers tapped their savings to put up one-third of the purchase price; a venture-capital firm put up one-third, and a local engine-rebuilding business, Springfield ReManufacturing Corp. (SRC), put up the remaining third. By June 2002, the pumpmaker, newly renamed Quest Manufacturing Co., was up and running in Strafford, Mo.

Getting out from under the shadow of bankruptcy court was a big step for Quest, but its troubles were hardly over. The company needs at least $5 million in annual revenue to make a go of it, and sales for its first six months were a disappointing $600,000. At that perilous moment, one of Quest's backers, SRC, stepped forward to demonstrate that money is just one form of capital, and not always the most valuable one. SRC president Jack Stack knew that another company in SRC's investment portfolio, a packaging company called Newstream, was looking for a metal-bending outfit that could weld some steel brackets. Stack arranged the introductions, Newstream got its brackets welded, and Quest booked some much-needed revenue. More to the point, a relationship was formed that could pay off for years to come. And it wouldn't have happened without the network of business contacts that SRC brought to the deal along with its checkbook.

Such networks can be almost as useful as money to a new enterprise struggling to gain forward momentum. Angel investors and other private capitalists can put entrepreneurs in touch with potential customers and suppliers and refer them to lawyers and accountants. They can offer counsel based on years of experience with early-stage businesses. They can be there with advice, patience, and a well-thumbed Rolodex at that delicate moment when a business makes the transition from adrenaline-fueled improvisation to professionally managed enterprise.

Of course, these investors expect something in return for their money and contacts. They expect a lot, actually. But it may come as some consolation to entrepreneurs that expected returns have, well, returned to normal levels, after a long, crazy stretch during which investors confidently assumed they would earn 35% on their money, almost double the historical average. Even at half their boom-era highs, current returns, at 20% or so, look pretty good compared with 10-year Treasury-note yields of 4.1% and stock-market returns that can't be printed in a family publication -- good enough to make private capital the investing game of choice for many well-heeled investors. "There's a revolution in private equity today," says Stack. "Even after the stock-market meltdown, a lot of people have cash, and they can't get much for it in the stock market or the bond market. Barring a wild card -- a revolution in South America or a bomb in Baghdad -- private-capital deals will be very attractive to investors for the next 24 months or so."

That's welcome news for growing businesses, which often find that private capital is their best -- and sometimes their only -- financing option. Such businesses may be too small and risky to attract the notice of banks or the public-equity markets, or like Quest Manufacturing, they may need an infusion of operating capital before they can generate sufficient cash flow to secure a bank loan. That leaves them to negotiate with sources of private capital, which usually buy equity in an enterprise at a price calculated to return 20% to 40%, annualized, in five to seven years (the average private-equity returns noted above are net of all losses and fees). Such returns sound exorbitant, concedes Jeffrey E. Sohl, director of the Center for Venture Research at the University of New Hampshire, until you consider that loss rates for early-stage investors average about 80%.

Maybe so, but giving up a piece of ownership is a significant step for entrepreneurs. That's why they should take care in choosing their financial partners. The value of a private-capital infusion can be multiplied by a financier's vibrant business network and well-developed business imagination. Sometimes the added value comes in the form of financial security and management independence. The sidebar on page 103, "Cashed Out, but Still the Boss," discusses how private capital has enabled many entrepreneurs to liquidate some of the equity they've amassed without giving up operating control.

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