In The Rough

Growing Pains

Remarkable as the Scimitar story is, it represents a nationwide trend that's particularly strong, according to studies, in Los Angeles and Orange Counties, California. That's because gazelles, defined as extremely fast-growing companies, often face a potentially crippling shortfall of expansion capital.

According to a study recently released by the California Research Bureau, the 35,000 gazelles in Orange County face a capital shortfall of close to $5.4 billion. Nationally, the shortfall is even more staggering and potentially more crippling--since gazelles are credited with, well, the lion's share of job creation.

Despite this capital shortage, there has been relatively little information available on how to overcome it. Following are several financing techniques that gazelles such as Scimitar, as well as other up-and-comers, might do well to consider:

  • Sell the revenue stream. Many entrepreneurs fixate on selling equity in their companies to raise capital. Break out of the box. Why not sell investors what they really want: a slice of the revenue stream? That's right--ask investors to advance capital in the form of a loan, which gets repaid as a percentage of product or service sales.

What do you get? Three of the most important benefits include preservation of equity, a larger pool of potential investors who are attracted by the prospect of an immediate cash return, and likely circumvention of all state and federal securities laws, since the advance on a royalty deal is a loan, not a sale of securities. On the flip side, however, royalty financing works only for companies with high margins and strong product or service sales (or the prospect thereof shortly after financing).

  • Tap ACE-Net. ACE-Net--the Angel Capital Electronic Network--is an investor-matching service affiliated with the SBA. ACE-Net was developed after years of public policy debate about how to link the country's estimated 250,000 angel investors with the growing legions of companies looking for growth capital. ACE-Net was launched in late 1996 and today, though still in its infancy, boasts 18 offices nationwide that help entrepreneurs list on the electronic service.

The mechanics of ACE-Net are simple. Accredited (read: wealthy) investors registered with the service gain access to a list of businesses seeking capital. Entrepreneurs pay a small fee to list their companies on the system. Similar to a stock market, the uniformity of information and ease of access generate a greater flow of funds between capital seekers and capital providers.

Streamlined forms and a short application make the use of ACE-Net a no-brainer for a gazelle or any other company looking for growth capital. You can take the first step by visiting ACE-Net on the Web at http://www.sba.gov/ADVO At this site, you can also find links to ACE-Net feeder offices near you.

  • Get a loan guarantee. When you consider that banks actually lend other people's money, which they must pay back upon demand, it's no surprise that they're so conservative. In fact, commercial banking and small businesses are a lousy match to begin with: Banks need predictable cash flow above and beyond what it costs to service a loan plus good collateral to liquidate, while small businesses have unpredictable cash flow and generally little in the way of collateral. You can satisfy the bank's need for safety and still preserve the equity of your company with a loan guarantee from a third party, such as an angel investor.

The benefits of such a loan guarantee are manifold. First, unless the guarantor is an extremely hard bargainer, a loan guarantee will not cost you any equity. Second, there is a larger pool of investors that will guarantee a loan for, say, $1 million, than will cut a check for $1 million. Of course, if the deal goes south, then the investor will have to cut the check. But when you're romancing investors, this is secondary in their minds because they believe they can pick the winners and avoid the losers.

  • Consider a direct public offering. Customers, vendors, employees and the people who live in the surrounding community are potential sources of capital. If your company has a strong relationship with them, and they believe in your company, capitalize on it by selling stock through a direct public offering.

Consider the case of Michael Quinn of Hahnemann Laboratories Inc. in San Rafael, California. Quinn needed additional capital to upgrade his manufacturing facility so he could distribute his homeopathic medicines nationally.

"Banks said no, and investment bankers and venture capitalists weren't offering much hope either," Quinn says. But Quinn had an epiphany when he realized that if just 200 of his more than 28,000 customers invested $2,000 each, he'd have all the capital Quinn Labs needed.

"My feeling was that people who use homeopathic medicines and believe in alternative medicines might also be attracted to an alternative investment," says Quinn. He was right: Approximately 240 investors collectively forked over more than $477,000, and Quinn, now with a new manufacturing facility and 1998 sales projected at $920,000, has never looked back.

Direct public offerings are a viable option for any company that has a lot of external constituents, can easily identify and communicate with these constituents, and does not need all the bells and whistles that come with a conventional initial public offering--namely the aftermarket trading and close relationship with an investment banking firm.

  • Tap your 401(k). If you've been cut loose from corporate America with a 401(k) plan, it may hold the key to financing your new business. While popular myth suggests that 401(k) plans can only make investments in large public companies, mutual funds and government securities, it's not so, says Greg Brown of the Chicago law firm Seyfarth, Shaw, Fairweather & Geraldson. And if you tap into the money in your own 401(k) plan, it postpones the day when you'll have to get outside investors involved in your company.

Brown says one strategy involves setting up an Employee Stock Ownership Plan (ESOP) to purchase equity in the company, which is then distributed to the 401(k) plan. With this technique, he says, if over time the company grows and takes on a lot of employees, they can participate in the plan as well.

"Allowing employees to invest in their company offers a number of management, tax and estate planning benefits," says Brown. Perhaps one of the most compelling, he says, is that an ESOP provides the founders with an exit strategy, so when they're ready to retire, it can purchase their interest in the company.

Back at Scimitar, Nickell and Candell are keeping their options open. "It's a great time to be an entrepreneur," says Nickell. "There's been a tremendous amount of wealth created over the past 15 years and, as a result, lots of investors out there are looking to recycle their wealth. If we can keep our growth on track, we can help them accomplish their objective."

Contact Sources

Hahnemann Laboratories Inc., 1940 Fourth St., San Rafael, CA 94901, (888) 427-6422

Scimitar Golf USA, (714) 379-6699

Seyfarth, Shaw, Fairweather & Geraldson, browngr@seyfarth.com

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This article was originally published in the September 1998 print edition of Entrepreneur with the headline: In The Rough.

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