For many owners of closely held businesses, the decision whether or not to sell equity is, naturally enough, a difficult one charged with the most basic of trade-offs. The money may be essential for sustaining rapid growth, but the consequent loss of control may seem too high a price to pay. Lyman Lumber Co. of Excelsior, Minn., has found a neat way around this dilemma, getting all the financing it needs without giving up so much as a share. How? By selling several issues of nonrated, or "junk," bonds.
The company, an old-line supplier of lumber and building materials to contractors in the Minneapolis-St. Paul area, happened upon its financing strategy back in the mid-1970s, when it began to run into problems that are fairly common in family-owned companies. The shareholders -- mostly older members of the Lyman family -- simply didn't want to put any new money into the business. At the time, Lyman Lumber was moderately profitable, with sales of around $8.5 million. But Tom Lowe, who had become chief executive officer when his father-in-law died, believed that major opportunities beckoned. Already, the company had three large warehouse distribution centers. With an additional $1 million or so, it could expand its inventory and increase financing to builders, and thereby become a much bigger fish in its pond.
Unfortunately, Lyman Lumber's bank was unwilling to supply anything beyond the approximately $1.1 million of shortterm credit it had already lent. "The first thing [the bankers] wanted to know was where the new equity was," Lowe says. So unless he could find a new source of money to augment retained earnings, the expansion plans would have to be shelved.
While he was looking around for financing possibilities, Lowe heard about Offerman & Co., a Minneapolis investment-banking firm. He met with the firm's president, Joe Offerman, and explained how he hoped to expand the business without selling equity. Unfazed, Offerman began to describe a financing strategy that revolved around 10-year debt -- debt that would be subordinate to existing bank loans. The vehicle would be an issue of nonrated bonds.
As it happened, Offerman's firm specialized in underwriting such issues and had salespeople in the upper Midwest who had shown an ability to sell the bonds to individuals. The latter were attracted by the bonds' high yields -- often two or more points higher than the yields available on bank certificates of deposit or other vehicles.
Over the next few weeks, Offerman studied five years' worth of Lyman Lumber's audited financial statements. He was impressed with the stability of the company's earnings and its overall track record. In addition to Lyman's strong earnings history and balance sheet (which showed a net worth of about $1.5 million), "I felt good about the management," he says. Indeed, Lyman struck Offerman as the kind of company that could meet long-term credit obligations without skipping a beat. So he agreed to draw up a prospectus and to begin selling $1 million of debt to investors living in Minnesota.
The deal went through without a hitch that summer -- an issue with a 10-year maturity, paying an annual yield of 10%. The lumber company immediately began to use the proceeds ($920,000, following underwriting expenses) to expand operations. Once the new subordinated debt was in place, moreover, Lowe found that the banks were suddenly willing to lend much higher amounts for working capital. "Because it's subordinated and isn't due for ten years," he explains, "it looks like equity to a banker." With the help of the new debt and the resulting leverage, the volume of business with contractors picked up substantially. Between 1975 and 1977, sales jumped from less than $9 million to $21 million.
So successful was Lyman Lumber's first debt offering that CEO Lowe has since gone ahead with three other subordinated-debt deals, raising a total of more than $5 million. In 1979, the company sold a second intrastate issue to Minnesota investors, which helped it acquire a local wholesale lumber business. Since then, it has sold two more issues to out-of-state investors under the Securities and Exchange Commission's Regulation A. Each of the Reg. A deals was for $1.5 million. The first, in 1981, offered an annual yield of 14 1/2%; the yield on the second, in 1983 was 13%.
To be sure, Lyman's capital-raising technique has entailed certain headaches and costs. Because the money is raised publicly, Lyman is considered a "quasipublic" company, and is required to report its financial results to its investors. Each year, it files reports with the Securities Division of the Department of Commerce of Minnesota. Paperwork aside, the company has also had to pay relatively high underwriting fees and interest expenses.
But Lowe considers such factors almost insignificant when balanced against the alternatives -- and the results. In fewer than 10 years, he says, "we've found a way to increase our sales from $8.5 million to $45 million and grow our net worth from $1.6 million to $6 million. And the family shareholders still own 100% of the business. With the bonds, they didn't have to give up anything."
If you want to know how treacherous the market for initial public offerings can be, consider the recent nightmare of another Minnesota company, Computer Depot Inc.
Last spring, Computer Depot's founders decided to take their three-yearold computer-retailing company public in order to raise the capital needed to open new outlets in major department stores. As the June offering date approached, everything seemed to be going smoothly. Company officials had spent two and a half weeks on the road, presenting their story to prospective investors in Europe and the United States. Judging by actual orders for shares, they figured the offering would net the company some $8 million in cash. The underwriters already had the checks in hand.
But then a funny thing happened. IBM Corp. announced price cuts on its personal computers. To minimize the impact on retailers, IBM offered rebates on inventory that was less than 45 days old. Computer Depot's management did some quick calculations and decided that IBM's price cuts would have no effect on their company's earnings. A few days later, however, they discovered that they had made a mistake. A portion of Computer Depot's inventory was a tad more than 45 days old, and therefore was not protected by the rebate policy. That merchandise would have to be sold at a loss. The aftertax damage was estimated at $164,000.
Steve Parker, Computer Depot's chairman and CEO, immediately telephoned the company's investment bankers at Kidder, Peabody & Co. and Dain Bosworth Inc., the co-managers of the offering. He told them about the problem and the likely consequences for the company, which he considered minor.
The underwriters were not so nonchalint. Although the company didn't see the inventory write-down as having a material effect on year-end earnings, the investment bankers explained that the investors might perceive the write-down as material. Therefore, the bankers advised Computer Depot to notify investors of the situation before the offering was finalized. Otherwise, Computer Depot might be held liable in a shareholder suit.
The question, naturally, was how best to inform the investors. For all practical purposes, the deal had already been sold; the checks were to be cashed within a few days. One option was to send stock brokers a brief addendum to the prospectus, explaining the complication. That course was ruled out because it left the company liable if investors didn't receive the addendum.
Another option was to mail all brokers extra copies of the offering documents with stickers alerting them to the changes, and then to follow up the mailing with phone calls. But this did not give investors the opportunity to reconsider purchase of the stock.
So Computer Depot and its underwriters decided to cancel the deal completely and start over again. The company offered to return the money. It spent $60,000 printing up a new prospectus with a two paragraph insert explaining what had happened. And Parker and his top managers proceeded to do a second dog-and-pony show for investors on both coasts.
There was no guarantee that the new deal would sell. At the time, the public market was soft and getting softer. But on July 12, the offering was completed at $9 a share, only $1 below the original price. The company raised $9.3 million, and this time the money made it to the bank. "It was the kind of mistake that you couldn't pin on anybody," says Parke "It was Murphy's Law at work."