Neil B. Swartz, chairman and CEO of Microleague Multimedia Inc. in Newark, Delaware, is a man in a hurry.
Microleague competes in the searing hot market for interactive multimedia entertainment. And the company's primary niche, sports simulations, just adds more sizzle to the Microleague story. After all, we're talking America here, a nation that elevated sports, sports licensing and sports broadcasting into major growth industries.
In this context, Swartz's rush-rush approach is easily understood. "We want to build [market] share now so our leadership position is solidified as the market expands," says Swartz.
It's also not surprising that when it came time in 1994 to raise capital to finance two new multimedia sports simulations, one for baseball and one for horse racing, Swartz wanted to get the deal done fast. How best to do this? "Make sure investors get a fast return on their investment," he says. After all, almost anybody can put together a deal where there is no return for five years. "Engineering a quick hit for investors," says Swartz, "required some creative thinking because conventional techniques just weren't right for us at the time."
For instance, issuing straight equity in a private placement--that is, selling shares directly in the company--might have been feasible but would hardly have offered a quick return to investors. After all, it might have been years before the company achieved the size and the momentum needed to complete a public offering. In the meantime, private placement investors would simply have to hang in there. Besides, if the products failed, Microleague might have found itself saddled with some unhappy shareholders.
Getting a loan was an option, but only in theory. Given Microleague's early stage of development, it's doubtful the company could have found a lender venturesome enough to do the deal. Besides, significant debt at that stage of the game would have choked the company.
To strike the right deal--meaning one that would entice investors but give Microleague the room it needed to grow--Swartz borrowed a chapter from Hollywood. He used off-balance-sheet financing to raise the approximately $212,000 he needed to develop Sports Illustrated Presents Microleague Baseball and Hooves of Thunder.
The term "off-balance-sheet financing" is sometimes confusing, but when interpreted literally, it begins to take on more meaning. Specifically, it refers to capital that never shows up on a company's balance sheet. For instance, issuing equity makes a mark on the shareholder's equity section of the balance sheet, while issuing debt--i.e., getting a loan--can be seen on the liabilities section of the balance sheet. But off-balance-sheet financing never shows up there, or at least doesn't ever have to.
Here's how it works. A company--say, Widget Inc.--seeking capital to develop a new product sets up a partnership as a separate entity. The partnership, perhaps called Widget Partners, then raises money and either pays Widget Inc. on a contractual basis to develop the product on behalf of the partnership or lends the money to Widget Inc. Limited partnerships are comprised of the general partner, who manages the affairs of the partnership, and the limited partners, who are investors that put money into the partnership.
The limited partnership in the Microleague financing was called Interactive Multimedia Limited Partnership. The general partner was Interactive Multimedia Inc., a company 50 percent owned by Microleague chairman Neil Swartz. The investors put a total of $212,500 into the partnership in exchange for an interest payment, which was deferred, and royalties from the sale of the products the partnership was formed to develop.
It's not unusual for the limited partnership to contract with the original company to develop the product or service. After all, the limited partnership is simply a corporate entity with no personnel or operations. In addition, this arrangement can offer the original company a significant benefit. The financing not only misses the balance sheet altogether as a liability or diluted equity, but voilÃ ! it shows up on the income statement as fee income.
In Swartz's case, the partnership lent the funds to Microleague rather than contracting for services. Swartz says this had to do with tax considerations for the investors and the company. But even as a loan, it's still remarkable since there's hardly a bank on the face of the earth that would lend funds for development of a product to a company with no previous track record of sales.
The Pros . . .
Swartz says off-balance-sheet financing delivers several benefits to carefully consider.
The first, he says, is it doesn't cost the company any equity. "Most companies at an early stage in their development simply can't [get a loan]," says Swartz. "So it appears as if giving up equity is the only other alternative to get funds in the door. Unfortunately, if the company is not worth much because it's new, that equity is going to cost them a big hunk of ownership." By contrast, the off-balance-sheet technique doesn't cost any equity.
Next, says Swartz, off-balance-sheet financing diversifies risk. "For instance, if we raised substantial funds by selling lots of equity to develop these products, and for one reason or another the products failed, they might take the whole company down the drain with them," he says. But by transferring the development risk to a limited partnership, product failure takes down only the partnership. "The company stays intact."
Third, off-balance-sheet financing can compress development cycles. "The typical model for product development at many emerging companies is to sell equity, develop products, market the products, then sell more equity to develop more products," Swartz says. But with an off-balance-sheet method, a company has the opportunity to develop many products simultaneously. This is possible, says Swartz, because the company is selling investors on the potential of particular products, rather than on the company as a whole, and can have several development programs going on at once.
Fourth, Swartz notes, off-balance-sheet financing can be an easier pitch to investors on several levels. If you've ever tried to raise money, you'll quickly come to understand that the best structure for any early-stage financing is the one investors will buy.
"One of the problems companies face when they try to sell straight equity," explains Swartz, "is that it's difficult to suggest when there might be a payoff, even if the company does well." Dividends are all but unheard of in this situation, and as long as the company is private, shares are difficult to sell. Even if the company goes public, the underwriter usually "locks up" inside shareholders for two years to prevent them from cashing out. So the gains for equity investors can be elusive. "But not so much with limited partnership investors," says Swartz. "By tying their investment to how a product does in the market, they can get a return as soon as that product starts selling." In fact, if a product really takes off, the royalty payments to investors can be spectacular.
....And The Cons
Off-balance-sheet financing is no panacea, though. Like any type of financing, it carries a price. The most common criticism is that the stream of royalty payments has the effect of mortgaging a product's future. In the case of Interactive Multimedia Limited Partnership, investors were to receive a royalty equal to 10 percent of the sales of the products they financed--not much on the front end when everything is on the drawing board but a lot on the back end when there's overhead to consider.
There was another challenge Swartz faced with his off-balance-sheet deal. When he took his company public in May 1996, "[our] limited partnership investors saw that there was a lot of upside in the company that they weren't participating in," says Swartz. "Next time I do a deal like this, we'll add in a convertibility feature to give investors the option of converting their interest into common stock."
In this regard, though, Swartz and Microleague are unique. Few companies can go public at such an early stage in their development. But it was less than two years after forming the partnership that Swartz was able to pull off a $6 million initial public offering. Apparently, being in a hurry has its rewards.
David R. Evanson, a writer and consultant, is a principal of Financial Communications Associates in Ardmore, Pennsylvania.
Microleague Multimedia Inc., 1001 Millersville Rd., P.O. Box 4547, Lancaster, PA 17604-4547, (800) 334-2722, (717) 872-6567.
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