The Private-Capital Survival Guide

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Not every Enron story ends unhappily. Late in 2001, publicly held steel-processor Hunt Co. filed for Chapter 11 bankruptcy-court protection. Most of Hunt's work involved bending steel for Enron's gas pipelines (hence the need for Chapter 11), but hidden deep within the company was a 100-person operation that turned out metal tanks used in small-scale mechanical air pumps - the kind that inflate tires, toys, mattresses, and the like. The unit's managers, well aware that prior to Enron's collapse their business generated $23 million in revenue and commanded 70% of the U.S. market for such tanks, wanted to buy the operation from Hunt and relaunch it as a freestanding private company. But they needed help to swing the deal. Ultimately, the managers tapped their savings to put up one-third of the purchase price; a venture-capital firm put up one-third, and a local engine-rebuilding business, Springfield ReManufacturing Corp. (SRC), put up the remaining third. By June 2002, the pumpmaker, newly renamed Quest Manufacturing Co., was up and running in Strafford, Mo.

Getting out from under the shadow of bankruptcy court was a big step for Quest, but its troubles were hardly over. The company needs at least $5 million in annual revenue to make a go of it, and sales for its first six months were a disappointing $600,000. At that perilous moment, one of Quest's backers, SRC, stepped forward to demonstrate that money is just one form of capital, and not always the most valuable one. SRC president Jack Stack knew that another company in SRC's investment portfolio, a packaging company called Newstream, was looking for a metal-bending outfit that could weld some steel brackets. Stack arranged the introductions, Newstream got its brackets welded, and Quest booked some much-needed revenue. More to the point, a relationship was formed that could pay off for years to come. And it wouldn't have happened without the network of business contacts that SRC brought to the deal along with its checkbook.

Such networks can be almost as useful as money to a new enterprise struggling to gain forward momentum. Angel investors and other private capitalists can put entrepreneurs in touch with potential customers and suppliers and refer them to lawyers and accountants. They can offer counsel based on years of experience with early-stage businesses. They can be there with advice, patience, and a well-thumbed Rolodex at that delicate moment when a business makes the transition from adrenaline-fueled improvisation to professionally managed enterprise.

Of course, these investors expect something in return for their money and contacts. They expect a lot, actually. But it may come as some consolation to entrepreneurs that expected returns have, well, returned to normal levels, after a long, crazy stretch during which investors confidently assumed they would earn 35% on their money, almost double the historical average. Even at half their boom-era highs, current returns, at 20% or so, look pretty good compared with 10-year Treasury-note yields of 4.1% and stock-market returns that can't be printed in a family publication - good enough to make private capital the investing game of choice for many well-heeled investors. "There's a revolution in private equity today," says Stack. "Even after the stock-market meltdown, a lot of people have cash, and they can't get much for it in the stock market or the bond market. Barring a wild card - a revolution in South America or a bomb in Baghdad - private-capital deals will be very attractive to investors for the next 24 months or so."

That's welcome news for growing businesses, which often find that private capital is their best - and sometimes their only - financing option. Such businesses may be too small and risky to attract the notice of banks or the public-equity markets, or like Quest Manufacturing, they may need an infusion of operating capital before they can generate sufficient cash flow to secure a bank loan. That leaves them to negotiate with sources of private capital, which usually buy equity in an enterprise at a price calculated to return 20% to 40%, annualized, in five to seven years (the average private-equity returns noted above are net of all losses and fees). Such returns sound exorbitant, concedes Jeffrey E. Sohl, director of the Center for Venture Research at the University of New Hampshire, until you consider that loss rates for early-stage investors average about 80%.

Maybe so, but giving up a piece of ownership is a significant step for entrepreneurs. That's why they should take care in choosing their financial partners. The value of a private-capital infusion can be multiplied by a financier's vibrant business network and well-developed business imagination. Sometimes the added value comes in the form of financial security and management independence. The sidebar on page 103, "Cashed Out, but Still the Boss," discusses how private capital has enabled many entrepreneurs to liquidate some of the equity they've amassed without giving up operating control.

Such win-win outcomes have lured both institutions and individuals into the private-capital market, making for a high degree of liquidity. According to the University of New Hampshire's Sohl, angel investors and other informal investing groups poured an additional $30 billion into growing businesses in 2001 and at least that much again in 2002. Only about 5% of that money is start-up funding, Sohl says, with the rest going to meet the capital needs of going concerns.

Larger, more formal investing partnerships, which invest in later-stage enterprises, also have money to put to work. Thomson Financial Venture Economics reports that private-equity investors put a total of $13 billion into later-stage deals in 2001, up from $4 billion in 1997, the last year before the outbreak of Internet madness, when private investment surged, touching $16 billion in 1999 and $26 billion in 2000. (Generally speaking, later-stage financing flows to established companies with revenue of $10 million or more that are well managed, consistently profitable, and generate positive cash flow.) So great was the flood of money into new-venture financing during the gold-rush years that much of it is still waiting to be invested, says Thomas S. Shattan, whose Shattan Group, based in New York City, matches entrepreneurs with financiers. "Pension funds and other organizations," he says, "have given so much to private-equity funds over the years to invest in companies that much of it is still there." That's one reason more growing enterprises than ever have been able to arrange financing. Venture Economics reports that 1,172 companies received an average of $11.4 million in later-stage private-equity funding in 2001. In 1997, by comparison, 849 companies received an average of $4.7 million.

Angel investors, private-equity partnerships, and venture-capital firms may have a lot of cash available, but they are in no hurry to part with it. Investors in growing enterprises have repented of their boom-era zeal and incautiousness, and are now subjecting every deal to microscopic scrutiny. "In 1998 and '99," says Joseph Beninati, chairman and CEO of Greenwich Technology Partners, an information-technology consultancy, "institutions were throwing silly sums of money at new ventures. Today, $2 billion funds spend six months agonizing over $5 million investments." Even if an entrepreneur manages to locate investors willing to commit their funds, those investors may not be as knowledgeable, well connected, and energetic as Stack and SRC. "The smart money is not always as smart as you think it is," says a jaded veteran of three start-ups.

Even taking into account those qualifications, cautions, and caveats, however, private capital represents a vital resource for growing companies. It's not the first big financial step in the entrepreneurial life cycle. That first step, seed capital, comes from friends, family, savings, and credit cards and finances the earliest stages of an enterprise - the development of a prototype, say, or the rental of a storefront and equipment, or simply a market-and-feasibility study to determine whether further investment is worthwhile. Angel investors - individuals with money to spare and a taste for action - are the next link in the chain, when a business needs $250,000 to $750,000 in start-up capital. It's in the third stage of growth, when a business's capital needs are greater than most individuals can or will bear alone, that venture-capital firms and private-equity partnerships usually come on the scene. (They don't come on the scene fast enough to suit everyone. For more on one attempt to close the "structural capital gap," see "Closing the Capital Gap" below.) Private-equity partnerships, which often include both institutions and wealthy individuals, are formed to invest in growing enterprises for a fixed period of time. These partnerships often invest alongside venture capital. But private equity tends to be more patient than venture capital, investing in five- to seven-year blocks, compared with the three- to five-year life span of most venture-capital partnerships.

In practice, there is considerable overlap and interplay among angel investors, private equity, and venture capital; the boundaries between angel investors and venture-capital investors are particularly fluid, having mainly to do with their degree of organization and the size of their investments. For the purposes of this article, the term "private capital" will be used broadly to refer to individuals and institutions that operate outside established securities exchanges to provide equity capital to small and midsize businesses in their early stages of growth. For most of these businesses, the key to tapping this capital is in understanding who these financiers are, what drives them, how to find them, and, most important, how growing enterprises can win their backing.