May 22, 1997

CREATIVE FINANCING FOR SMALL BUSINESS, PT. 1

Edited by Dennis Berman

For many small companies, the image is hard to forget: The uncooperative loan officer issuing a polite, but firm, "no thanks." How then, to bankroll the business? Some companies are turning to alternative financing -- through licensing, royalties, and the government -- to raise cash. This so-called creative financing was the subject of a public conference held on May 13 by the Manhattan chapter of the Massachussetts Institute of Technology Enterprise Forum, a nonprofit alumni group. Here is an edited transcript of that conversation -- the first of two parts.

CREATIVE FINANCING -- PART I
Presented by the MIT Enterprise Forum of New York City

Panelists:
Andrew Klein, president and founder, Wit Capital Corp. Founded after successful completion of the first Internet initial public offering for Wit Brewing. Assists companies in completing IPOs over the Internet.

John Trombly, executive vice-president, Royalty Capital Management, Inc. and general partner of Royalty Capital Fund L.P.I. Provides $50,000 to $500,000 to startup companies that have completed products. Instead of equity, his company earns royalties on revenues for a specified number of years. Because this strategy does not depend on a major exit [a large, final payoff] to realize a return on investment, the firm can invest in companies that do not qualify for traditional funding.

Ritchie Coryell, director, Small Business Innovation Research Program, (SBIR) of the National Science Foundation (NSF). A program initiated by the U.S. government to fund technology research and development for use by the government. Companies respond to requests for proposals for hundreds of projects each year. Proposals now must also include commercialization strategies in order to receive funding -- which is provided in three phases, from $75,000 to $5 million with matching corporate funds.

Anthony V. Lando, senior vice-president and general manager, British Technology Group USA Inc. Firm helps entrepreneurs and institutions license technology to corporations. BTG is traded on the London stock exchange and was founded to help British-based universities license technology.

Moderator: Craig Bandes, vice-president, Alimansky Capital Group Inc.

This panel on creative financing was a result of dozen of conversations with entrepreneurs. In putting this panel together, we tried to find both funding sources that were either truly innovative or not generally known to the public, and at least one company that had to find creative means to finance itself and get operating. I think we have accomplished this with the panel this evening.

Tonight will start off with each panelist speaking for approximately 10 minutes and then we will open up to the audience for questions and answers.

Andrew Klein, president and founder of Wit Capital Corp. and Spring St. Brewing Let me give you three minutes of background and then I'll turn to talking about what my new company, Wit Capital, is trying to do to help small companies raise capital. I started a beer company in 1993 after practicing corporate securities law for six and half years. After two and half hard years of selling beer -- hard years, because selling beer is certainly harder than anything I've done before or since -- I set out to find growth capital to bring our beer company, which started with about $800,000 worth of capital, to a second level, a higher level.

I found myself six months into the process with very little hope and no money. I had about $200,000 worth of cash left in the business and I was earning about $125,000 per quarter, so we weren't in any urgent [threat] of disappearing. [But] we felt very much stuck as a small beer company, short of having a solution to raise capital.

Then, I had remembered something which I experienced back in the early eighties as a college student -- that was the growth and roll out of Ben & Jerry's Ice Cream. I don't how many people know this story, but it has been pretty well reported. Ben & Jerry's, then a tiny little ice cream company in the back of a warehouse in Vermont, decided that residents in Vermont and, more particularly, people that liked their ice cream, were a great source of capital for their business. They actually raised their first significant amount of money, about $750,000, by doing this Vermont-only direct public stock offering. They actually advertised their stock sale on the back of their ice cream boxes and really did raise money from people who like ice cream. It worked well for them both in getting them capital and, perhaps even equally important, growing a base of loyal customers. Loyal customers who would not only buy their ice cream, but who were excited about owning a little piece of their company to the degree that they actually got other people to buy their ice cream. It sounded like a pretty good idea, particularly for a company that had very few options.

We had raised the initial money by going to traditional early-round providers, basically friends and family and people you could twist an arm and get a few thousand dollars from. But to go and get $2 million to $3 million for my beer company, at the time anyway, just didn't seem like it was going to happen. We crafted a stock offering circular, or prospectus if you will, prepared to file it with the SEC and chose 22 states to Blue Sky it in [registering the stock with state authorities]. We prepared a rather grassroots marketing campaign where we were basically going out and selling our stock to our beer consumers. We put little signs on the six-packs. We printed beer labels which offered people an 800-phone number to call to get an offering circular. We also went out to the bars and restaurants where we sold our beer and put up signs offering people a chance to buy stock in a beer company.

Just as that effort was taking off, I had the idea that the Internet might help us distribute some information about our stock offering. Quite simply, we created a Web site. We spent a couple of hundred dollars to do it and we posted on the site a notice that we had commenced the first ever public stock offering on the Internet. It worked, and we got very lucky.

A gentleman from the Wall Street Journal came down to our office the next day, having seen the press release that we put out. He did a little homework, went back to his office and wrote a story essentially confirming that we had, in fact, become the first company to ever use the Internet to sell stock. We had about 2,000 news stories written in the subsequent couple of months. We had literally hundreds of thousands, if not more, come to our Web site. Many of them looked at our prospectus and fortunately about 3,500 of them bought stock in our beer company. We raised $1.6 million and we're just about as happy as little beer company people could be.

A year later, after going back to the business of selling beer and very much missing the publicity we had generated, I had another idea. We had continued to see a tremendous amount of traffic on our Web site, mostly from people that had heard we were selling stock in our beer company. I figured that it wouldn't cost us very much and it might generate some more excitement if we turned that traffic on our Web site into a little stock market -- a site where people who were looking for stock might meet people who were holding stock and perhaps might find someone who wanted to sell it to them.

Again, for a very modest amount of money, we literally took out a "Teach Yourself HTML" program book and we created this little stock-matching mechanism where people could log on, post their names and e-mail addresses and indicate offers to buy or offers to sell stock on our Web site. We put out another press release announcing that we had created the first Internet-based stock market, and again we got very lucky. We wound up with literally hundreds of thousands of people coming by to look at this trading mechanism.

We wound up with a lot of publicity again. Unfortunately, a lot of the publicity was read by people down at the Securities and Exchange Commission and about two days after we started, we got a phone call from 11 lawyers at the SEC -- all on one phone call. We found out pretty quickly that although the public offering of stock through the Internet was relatively straightforward and raised no challenging legal issues, the generation of a trading mechanism or environment, in the SEC's view, violated about eleven different sections of the securities laws. We negotiated about three days with the SEC and came to the conclusion that we had very little support in the law for what we had tried to do, although we thought it was a pretty good thing and would have been good for our beer company and small companies in general. At the end of the three days, we got even luckier.

A commissioner from the SEC by the name of Steven Waldman, who had read about what we had done, and who I guess had been briefed by somebody on the commission staff, decided to take an interest in our experiment in creating an electronic stock market. He liked what he saw. Commissioner Waldman called me the week after we had started the experiment and essentially offered us a deal. If we were to stop trading our stock in the stock market, he would work with us to find a way for us, and therefore other small companies, to use the Internet and use technologies to create an alternative marketplace for stock. We couldn't pass up a deal like that.

Sure enough, two weeks later, Commissioner Waldman issued a letter to us essentially giving permission to our company to create this electronic marketplace where people could buy and sell our stock, subject to some modifications. Essentially the SEC laid out, to the shock of the whole financial community, grounds under which small company stocks could trade in what people might call today a "black box technology." Trading without market-makers or without specialists as intermediaries, but just using technology where buyers could meet sellers and trade if deals were there to be made.

As a result of the SEC's action, we generated an enormous amount of publicity. So much publicity that in April 1996, I decided to start a company with Capital Corporation, to try to take further some of the ideas and experiences we had at the beer company and try to set up a system to help other companies raise capital through the Internet, particularly, by using affinity marketing strategies that worked very well for our company. As well, we'd set up, through technology, a trading environment where small company stocks may trade under better conditions than they currently trade as small cap listings under NASDAQ.

That's what we've been developing for a year now -- for companies just a year old who are about three years away from launching. The first deals we do will be exactly that. They will be public offerings of securities for early-stage companies that have some affinity group, some identifiable investors who we believe, and the issuers believe, are likely interested backers of the companies.

Jumping into what I think is an important conclusion, no one that looks at what we did at the beer company should draw the conclusion that the Internet is the solution to the challenge of raising capital. We keenly understood that we were able to raise money for the beer company because the media provided us with a forum to reach out to hundreds of thousands of prospective investors. I would highly recommend people who have a company with some logical affinity group to contemplate reaching out in a comparable way to them. But don't underestimate how expensive and difficult it can be to market the security absent the windfall from someone like the Wall Street Journal or CNBC, which we benefited from.

John Trombly, executive vice-president, Royalty Capital Management Inc. and general partner of Royalty Capital Fund L.P.I.

I think that if Andy could figure out how to give samples over the Internet with all the financial information, he'd really have something! Talk about a completely different form of capital that is starting to become popular. I think that any entrepreneur in the audience that has tried to raise capital has probably come to the conclusion that there are two worlds out there. There is the equity world where people will invest and purchase a piece of your company for stock, and then there is the debt world, where people will loan you capital and secure it by assets that the company or you have personally. For many entrepreneurs, those two choices are really not very optimum for a variety of reasons.

When we started out about four years ago, both my partner and I, who are entrepreneurs ourselves, had been through the process of building a company and raising a lot of equity capital; in the process wondering if there was a way that wasn't as hostile to the entrepreneur. We decided there ought to be a form of capital that would be more flexible given the business conditions of the individual company. We looked around at the different strategies. We were familiar with licensing, particularly in the engineering area.

Many of you may have heard the way in which licenses are developed in publishing, for example. An author will license the book to a publisher and the publisher will receive a royalty based on the number of units sold. In the engineering field, frequently freelance engineers will develop a product, patent it, and then license that technology to a larger firm that then sells it. The developer-inventor receives a royalty for the units that are sold under those patents.

Similarly, it's possible to create a financial entity where in exchange for an investment, the venture capital firm receives a royalty on the company's cash receipts. This is the entity that we have developed. We call ourselves Royalty Capital Fund and we invest primarily in early stage companies in the range of $75,000 up to $300,000 per company, in exchange for a fixed royalty on the company's cash receipts. That royalty is determined up front during our analysis of the business plan.

In analyzing the distribution channels and the company's customers, we develop our own concept of what we think the company is going to do in the next couple of years. It's often based on the company's own projections. From that, we determine what we think is a reasonable royalty in order to recover our investment in a period generally less than two years. By that I mean we would like to recover our principal investment in a period of under 24 months. We set the royalty rate so on average we achieve that.

A typical example: Let's say a company is at a revenue level of $500,000 a year and it thinks that it can increase or double that in the following year to about $1 million. Let's say they need about $100,000 for a marketing program that they want to launch. If we believe those numbers, we would apply a royalty rate of somewhere between 7% to 10% against that company's cash receipts, with the idea that we would recover our $100,000 investment under a two-year period. If the company happened to do better than its projections, then we would get our principal investment back earlier. Conversely, if the company's growth is slow, then it takes longer for us to recover our initial investment. The royalties, unlike the typical royalty arrangement of an invention license, are capped, i.e., when a certain multiple of the investment is returned to us, then the royalty ends and the investment is over from our perspective. That cap is usually five times the invested capital.

When you compare a royalty investment to equity, the major difference, of course, is with an equity investment. By definition the entrepreneur, at the time he (or she) receives the equity investment, is agreeing with his investor that he (or she) is going to provide a liquidity event: In other words, an opportunity for that investor to sell his shares and that's usually done in one of two or three ways. It's done either through a sale of the company to a larger firm, or it's done through a public offering, or in some cases and less frequently it's done by the company itself repurchasing the shares of an investor. By far, the most common event, if the company manages to stay in operation and grow, is that it sells itself to a larger firm. When that happens the environment changes dramatically for the entrepreneur.

On the other side of the investor avenue there are a variety of companies that will provide an investment in exchange for a debt-based investment generally secured by assets in the company. For many entrepreneurs that's not a very good vehicle to begin with, because frequently the company doesn't have any assets to secure the investment. Usually the entrepreneur's spouse doesn't agree with securing the company's assets with equity in the home, for example, or perhaps securing it with the parent's trust fund, or the parent's retirement fund. All those methods, believe it or not, some entrepreneurs use as a form of security. I certainly wouldn't recommend it. The risk of failure is too great to end up with having to be thrown out of your house or having your parents have to come up with the initial funds.

With a royalty-based investment, those issues don't exist because the royalty that's paid to our firm from our company's portfolio is fixed throughout the period of the investment, generally at a rate between 5% and 15%. Whatever it is, it is determined up front as part of the agreement. If the company's revenues decline, the payments to us are always a small fraction of that revenue and it can't put the company in the position of a debt investment: where a fixed payment is required every month, principal and interest, regardless of the company's ability to pay that debt.

Some of the criteria we look for when we make an investment: We don't invest in research and development. We look for companies that develop products and are essentially ready to go to market with the product. We prefer companies that have some revenue, although it can be quite small, and the reason for that is we want to be able to talk to customers and get a good feeling for their product and service satisfaction. We also look for companies that have good distribution channels or the potential for good distribution channels. We don't like to invest in consumer-product companies whose game plan is to sell their products to Wal-Mart, for example. It's extremely difficult to get a product into that kind of a channel. We look for companies that have distribution channels, for example, industrial products where they're very dispersed, where there are many different distributors and it's a lot easier to get the product into the marketplace.

Some of the things we don't look for in an investment is that we don't necessarily have to see rapid growth in the company, since we're investing a relatively small amount of capital, in the range of $35,000- $300,000 per company. The investment works for companies that may only expect to grow to $3 million to $5 million a year in revenue. We don't require an exit event, i.e., we don't require that the company have a game plan to sell itself or go public, because our return on capital is built into the royalty stream.

Questions for Andrew Klein

Q. Critics are saying that companies going public through the Internet probably wouldn't be ready to go public through other sources, what do you say to that?

A. I think it's a challenge to us to distinguish what we're trying to do from the companies that have, like my beer company, just gone out on the Web and generated a tremendous amount of excitement without a clear understanding about what's at issue. What we're trying to do on the Web is offer individual investors a new opportunity to participate in venture capital. Our company is building an investment banking team, some say a venture capital staff, to go out and actually do the things that are necessary for due diligence, the deal structure, the valuation, discipline, that will make our brand and our company's stamp of approval on a deal meaningful. That means looking, as any venture capitalist would, at the management, potential track record and valuation. What we're trying to do differently is use the Web and the low-cost distribution it provides to offer individual investors a chance to participate at the very early stage.

More importantly, we're going to be selling to the public stocks that are actually illiquid, much like a venture capitalists would invest in an early stage company and not expect there to be liquidity. We think there will be a market out there for individual investors to put small amounts of money into early stage companies without a focus or expectation that there will be a liquidity in the short term, but rather to try to find investors who are interested...in being a small scale, venture investors.

You identify a big challenge. Simply by putting a stock out in a public offering doesn't mean that the company's ready to go public. A great many people are going to try to sell stock to the public in the wake of what our beer company did and what some of the other people on the Internet are now trying to do. It's not something we at Wit Capital are trying to create; which is a new model for venture capital, what we like to call public venture capital, where the individual investor gets a chance to put up $2,000 or $10,000 at a very early stage. By design, the company is going to limit trading in its stock through a contractual arrangement with investors. Even though the stock is being sold to the public it's not going to be a public offering.

Q. How do you ensure integrity and distribution to the investors?

A. Again, what we're trying to do is build a company that, deal by deal, will develop a reputation for quality just as any investment bank that is reputable has investors coming back again and investing in their deals because they have a track record and they've done well. We can't build that instantly. But by doing one good transaction at a fair value in a quality company and then another and another, we hope to build a channel to investors who see in the Internet what we call public venture capital, a way to participate in venture capital investing that doesn't exist today. The only way to do it is to pick good companies and put fair prices in front of people and work with companies, just like venture capital firms do, to make sure that after the deal is done the companies build successful businesses.

We're hoping to build a track record in part by having our own investment banking group and in part by having partnerships with pre-eminent investment banks and venture capital firms. To some extent, we're going to be able to trade on the reputation of some of our partners getting access to quality deals. What we're really trying to do is build a channel to the public small investor that's interested in small cap stocks and offer them something that doesn't really exist today: a real opportunity to buy small pieces of very early-stage equities of a very high quality.

Q. How does Wit Capital make its money?

A. We're primarily going to rely on underwriting fees like other agents that help people raise money. We're also offering brokerage services to the investors with us. Only by opening an account with us will they be able to get access to the offerings we do. And while we build the relationship by offering unique access to securities, we're also going to have secondary trading and basic brokerage services on which we'll make commission revenue.

Q. When Wit Capital does an offering over the Internet, are they actually issuing a prospectus or can you view the prospectus on the Web page?

A. No, it will be completely paperless. You can go to the Web and look at the prospectus, download and print, or read it online. You can even look at road show presentation, audio and video material that will supplement the prospectus we think in helpful ways.

Questions for John Trombly

Q. When you make an investment, how do you secure that you're going to receive the money back in a royalty stream? Is there any other lien against cash flow or assets?

A. Our investments are secured by the assets of the company but we subordinate our position in those assets to any other debt source. Our primary interest is to maintain our position in the intellectual property of the company as the primary form of security.

Q. So cash flow comes to the company, it doesn't go to a P.O. box, it's transparent? A. Well, it depends on the company. In some cases the royalty is paid to a bank, in other cases it goes directly to us. It depends on the relationship we have with the company.

Q. How do you base your royalties? Is it on gross revenues, net revenues, and what if it's a stark startup with no track record?

A. We do invest in startups where the company has no revenue at all, although that's a small percentage of the type of investments that we do. Most of the companies in which we invest have some revenue at the time that we make the investment.

Q. How do you base your royalties?

A. The royalty is applied to the company's gross cash receipts, not profit, whatever cash receipts the company has from whatever source, although it excludes cash receipts from other investment companies. For example, it doesn't apply to an equity investment in the company or debt, but it applies to any product or service revenue the company has. It doesn't apply to the revenue that's generated in a month; instead, it applies to the actual cash coming into the company. So, in effect, part of what we're doing is providing receivables financing.

Q. How do service companies fit into the royalty funding model?

A. We've looked at a number of service companies and to date we have not made an investment in one. Our investments apply primarily to companies that have a high growth margin so that our royalty does not affect the company's ability to expand their operations and develop new products. There are certain service industries where the margins are quite high. If we were to come across one of those companies we would certainly take a look at it and evaluate them similar to the product oriented companies we invest in.

Q. What would you do if you saw that the royalty payment back to the fund was actually getting in the way of the company being successful for economic means?

A. We haven't had that problem so far. What generally happens is that if the company is growing rapidly and requires additional capital beyond what we could invest, then we invite other investors to participate. We've found that a royalty investment doesn't impede other equity or debt investors as long as the company has a good track record and an interesting product. That's one of the concerns we had at the beginning when we started making investments. We felt that we could only make investments that could get to their goals with our capital alone. What we found is that when we choose the right companies, these companies are very interesting to equity investors as well as other sources and so it really has not been a problem.

NEXT:Briefings and Q&As with the forum's two other panelists, Ritchie Coryell, director of the Small Business Innovation Program, and Anthony Lando, general manager of British Technology Group

Click here for Part 2 of this Special Report