Last year Conductor Corp. faced a dilemma that is not uncommon to rapidly growing businesses. It needed money but was unwilling to give up part of the business to obtain the funds. The two entrepreneurs who owned Conductor were convinced that with additional financing they could develop a product that would change the company from a specialty-products manufacturer in the electronics industry to a mass-market producer. Under those circumstances, who would want to dilute control?
As loath as they were to give up stock in their company, the Conductor executives realized there was no alternative. Conductor Corp. -- a fictional name for a company in the Northeast that prefers anonymity -- had borrowed heavily to finance prior expansion. None of its banks would lend any more money. To finance future growth, the company would simply have to give up equity.
After reaching this somber conclusion, Conductor's executives contacted several venture capital concerns, including my employer, Irving Capital Corp., a subsidiary of Irving Trust Co. in New York City. We studied the details of Conductor's finances and after months of discussions were able to suggest an unusual deal. We proposed linking Conductor's ability to meet its business forecasts to the amount of stock the company would ultimately have to give up for an immediate infusion of cash. The plan rewards Conductor for reaching its ambitious income projections, thus making it more appealing to the founders than more conventional arrangements.
If Conductor meets its income forecasts through 1984, Irving Capital will obtain only 15% of the company. This is probably less stock dilution than Conductor could have expected from a successful stock offering. If Conductor falls short of its projections, though, Irving Capital is entitled to as much as 35% of the company's stock, depending on how far the company is from its estimates.
While this type of deal is rare for venture capital concerns -- it was Irving Capital's first attempt at such a plan -- the arrangement makes sense for fast-growth companies with cash-flow problems. Conductor Corp.'s impressive history and promising outlook made it a prime candidate for a flexible type of equity financing.
Founded in 1971 by an engineer and a sales executive, Conductor was growing by leaps and bounds. From 1977 to 1981, the company's sales increased from $300,000 to $2.2 million, a compound annual growth rate of 65%. Earnings jumped to $110,000 on sales of $1.4 million in 1980, the last year audited earnings were available, from a loss of $30,000 in 1977.
As Irving Capital looked at the company, its future seemed bright. It was in the process of developing a product that, while not entirely new to its industry, seemed to be better and less costly than anything on the market. Interviews with Conductor's customers confirmed the product's value. Even if the new product never made it to the market, Conductor's established business was sufficient to assure steady growth.
Conductor's record was not entirely unblemished. But to their credit, the company's two top managers had demonstrated their sound business judgment five or six years earlier when expansion plans went awry and the company was pushed to the edge of insolvency. Rather than file for bankruptcy, they corrected their mistakes and paid off their debts. Their handling of the crisis enhanced Conductor's reputation with customers, including a number of well-known corporations, and the federal government.
When Conductor came to venture capitalists last year, the company was heavily in debt again and had exhausted its regular credit sources. Its debt-to-equity ratio was almost six to one, reflecting its heavy reliance on borrowed funds. Banks and commercial finance companies rarely like to make loans to small companies whose ratio exceeds three or four to one. Conductor had been able to borrow so much in the past because it had dealt with a group of regional bankers who knew its executives personally. But even these sources had limits on how far they would go.
Even if Conductor were able to find new funds to borrow, it was questionable whether the company could afford more debt. It already had more than $800,000 in bank loans outstanding, for which it was paying two to three percentage points above the prime interest rate. Additional loan repayments at high interest rates would be difficult to meet, and it needed cash to develop its new product.
Gradually, Conductor began to realize it couldn't avoid giving away equity. Although it considered going public, the investment climate was not stable or predictable enough to assure successful sale of an initial public offering. Thus, Conductor approached several venture capital firms, including Irving Capital. It hadnever had a commercial banking relationship with Irving Trust's banking division. In such a situation, venture capitalists typically demand at least 25% of a company's equity in exchange for an infusion of capital. But Conductor was hesitant to give up so much. Late last year, after more than three months of negotiations, Irving Capital proposed a deal that ties the company's equity contribution to its ability to meet its own income goals.
Specifically, if Conductor meets its income projections for 1982, 1983, and 1984, Irving Capital will get 15% of the company at the end of that period. If it achieves 75% to 99% of its goals, Irving Capital will obtain 20%, and so on down a sliding scale. In the worst case, if Conductor fails to reach 25% of its projections, Irving Capital gets the maximum 35% allowed in the agreement.
In 1982, the company has some flexibility. If it fulfills 75% to 99% of its goal, the company can make up the shortfall during 1983 and 1984 and still give up only 15% of the company. But if it misses its mark by that much or more in 1983 and 1984, Irving Capital is assured of at least 20% of the stock.
In exchange, Irving Capital has advanced the company $750,000. For its part, Irving Capital is wagering that at the end of 1984, 15% of Conductor will be worth much more than $750,000, especially if it is then in a position to make an initial public offering. Still, Irving Capital is hedging its bet. The loan is in the form of floating-rate convertible subordinated debentures that will mature in 10 years. ("Subordinated" means that there is debt senior to Irving Capital's. In the event of a bankruptcy, the holders of that debt would be paid off first.)
Unless Irving Capital converts the debentures into stock at the end of 1984, Conductor is obliged to repay the debt over 10 years at an interest rate that will "float" three percentage points above the prime rate. The minimum interest rate is set at 13%; the maximum is 16%. Since the debenture is partially convertible Conductor will have to pay back a small portion of the loan no matter how well it performs. Irving Capital will get its equity in addition to partial repayment.
Apart from the special features discussed above, the terms of Conductor's loan follow those Irving Capital includes in any conventional deal. Conductor must supply monthly financial reports and audited annual statements. The company must maintain its working capital and net worth at prescribed levels, and it is prohibited from taking on additional debt or paying dividends. Furthermore, Conductor must obtain Irving Capital's permission before it takes a major step such as selling or merging the business or going public.
It is not hard to see why a company in Conductor's position would seek this type of arrangement. If it meets its income goals, the owners retain a firm grip on the company as it grows. For its sake and the sake of our shareholders, we hope that Conductor succeeds. Irving Capital would rather have 15% of a highly successful company than 35% of a less profitable one.
Is this kind of flexible deal applicable to other companies? For those that have the potential for a successful stock offering sometime in the next few years, the answer is probably yes. Venture capital firms risk money for a future payoff -- a payoff they can achieve best through a successful public offering. If Conductor can reach its income projection, we think it is an excellent candidate for going public.