Hidden Assets

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.

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This article was originally published in the January 1997 print edition of Entrepreneur with the headline: Hidden Assets.

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