Master Class: Financing Strategies for Tough Times

Yes, venture capital investing in the consumer and business services sectors is down 90% from the heyday of the first quarter of 2000 and down 50% from just three months ago. But today’s environment does present certain extraordinary growth opportunities. Recent transactions present useful illustrations of financing and growth strategies available in the current economic climate. As proof, we will highlight several examples before reviewing the major sources of capital.

Example #1: first a merger, then an acquisition

Founded: 1998
Sales: $8 million
Capital sources: Venture capital firms, individual investors
Products: Personalized recognition awards and logoed merchandise
Customer file: 50,000

T. Shipley

Founded: 1999
Sales: $10 million
Capital sources: Asset-based financing, individual investors
Products: Corporate gifts and business accessories
Customer file: 100,000

Reliable HomeOffice

Founded: 1986
Sales: $13 million
Capital source: Large corporate owner
Products: Home office furniture and accessories
Customer file: 685,000

This transaction in August 2001 combined three well-positioned companies serving the corporate recognition, gifts, furniture, and accessories market. and T. Shipley, the two companies that merged, are early-stage, high-growth direct marketers that needed to achieve a larger scale. The newly merged company then acquired Reliable HomeOffice, a relatively mature unit of multibillion-dollar office supplies provider Boise Cascade Office Products, which needed to divest the business as part of a broader corporate restructuring.

Each company on its own was not large enough to attain the desired levels of profitability and adequate funds to grow. But the combination of the three businesses provides enough sales volume — roughly $30 million — to offset variances in individual performance. At the same time, combining fulfillment into one location will reduce fixed costs and leverage capacity. What’s more, the increased sales volume should significantly improve buying efficiencies. Combined merchandise sourcing and third-party customer acquisition along with customer cross-promotion can also provide benefits.

The deal was compelling enough to attract equity capital from existing investors and new individual investors and to secure new debt financing. Investors were attracted by strong management, established brands, and the modest purchase price of Reliable HomeOffice. Catalogs such as Reliable HomeOffice are typically sold for four to six times the prior year’s operating income. Being a small unit of a large corporation, Reliable HomeOffice was probably bought at the low end of this range.

Example #2: staking a claim


Founded: 2000
Sales: $3 million
Capital sources: Founders
Products: General merchandise
Customer file: 25,000

Sicompra, one of the few general merchandise catalogs in Argentina, was started with a modest amount of capital. It benefits from the lack of direct competition. Sicompra has favorable relationships with merchandise vendors and marketing partners — a large portion of inventory is drop-shipped or provided on consignment, eliminating the need to secure inventory financing. Vendors provide sufficient quantities of backup stock to ensure adequate fulfillment rates.

Sicompra offers are inserted into billing statements from a number of major credit-card providers in Argentina, including MasterCard, Diners Club, and Visa. These institutions also allow Sicompra to directly mail to a portion of their customer base. Such marketing relationships provide a relatively low-cost means of acquiring customers. And because potential customers are in effect prequalified, response rates are relatively high.

Sicompra was able to achieve rapid growth on limited capital by staking out a new market with little competition. Although the company could ultimately benefit from obtaining third-party capital or aligning with a U.S.-based strategic partner, Sicompra’s business model should allow it to continue its growth without significant additional funding.

Example #3: a dot-com relaunch


Founded: 1999; relaunched in 2001
Sales: $2 million
Capital sources: Founder, other individuals
Products: Gourmet frozen meals
Customer file: 7,000

GreatMeals began as an Internet-based marketer and, like many similar companies, spent lavishly on online customer acquisition and Web development — $6 million in less than one year. After acquiring 7,000 customers and reaching $100,000 in monthly sales, it went out of business in summer 2001. GreatMeals founder Steven Krane subsequently acquired the assets of the company for a nominal price, and he has established a strategic relationship with a regional supermarket chain.

The relaunched GreatMeals will rely on catalogs and e-mail to reactivate customers and will do only a limited amount of customer acquisition, mostly through kiosks in its partner’s stores. Because the trade name, Website, and house list were acquired at a low cost and the company is outsourcing fulfillment, GreatMeals will require only a minimal amount of capital. The company could likely raise adequate funds from a strategic partner or an individual investor.

Yes, GreatMeals was unsuccessful in its original incarnation. But thanks to a drastically reduced cost basis, minimal customer acquisition costs, and a partner to assist in product development and customer acquisition, it has a good chance of succeeding today.

Example #4: benefiting from a bankruptcy


Founded: 1818; purchased in 2001
Capital source: Strategic acquirer
Products: Bulbs and live plants

Walter Drake

Founded: 1947; purchased in 2001
Capital sources: Private-equity firm, bank debt
Products: Gifts

The bankruptcy and subsequent sale of the Foster & Gallagher catalogs this past July, although unfortunate for the company’s employees and investors, presented a significant opportunity for buyers. The multititle catalog company was sold in several pieces through a court-administered process at what appeared to be severely depressed prices.

The horticulture catalogs were sold as a group in September to gardening products cataloger Gardens Alive for $10.75 million — likely a near-liquidation value. Several of these catalogs, particularly bulbs title Breck’s, appear to have significant value as ongoing businesses, and presumably the customer lists could benefit the buyer’s existing business.

Separately, investment firm Lexton Group acquired the rights to fulfill the advance orders placed by customers for fall 2001 shipment. The investor group was required to put up the capital necessary to purchase the inventory but received a healthy share of the earnings from fulfilling the order backlog. Gifts book Walter Drake, the only catalog not to be shuttered during the bankruptcy process, was sold to a group consisting existing management and a private-equity firm.

Capital sources

These examples show that despite the poor economic environment and the dearth of traditional capital, there are still significant opportunities for growth. Tackling growth in the near term will require innovative thinking and significant persistence, however.

If you need to attract, negotiate with, and partner with a capital provider, understanding the characteristics and sources of debt and equity financing is essential. Below, some details on the types and sources of capital:

  • Asset-based borrowings use the value of a company’s inventory and accounts receivable to provide financing. Borrowers use the proceeds to pay operating expenses, including inventory, printing, and postage. Lenders usually advance 50%-60% of the cost of existing inventory as well as 70%-80% on accounts receivable. Obsolete inventory and past-due accounts receivable are deducted from assets eligible to be borrowed against. Borrowers usually repay asset-based loans directly from credit-card receipts and the collection of accounts receivable.

  • Equipment and property can be financed in several ways. Many equipment vendors provide capital lease financing at discounted interest rates. Under a capital lease, the customer usually pays for a significant portion of the value of the leased equipment and can buy the equipment at the end of the lease term for a small residual value. Buildings and property can be financed with traditional mortgages or through other debt financing such as Industrial Revenue Bonds (IRBs) — tax-free bonds issued by a local governmental entity to provide funding for specific facilities and equipment. IRBs can usually save the borrower at least 1% on the interest rate, but they often require some type of credit enhancement, such as a letter of credit from the borrower’s bank, and may necessitate annual audited financial statements.

  • Cash-flow lenders provide financing based on historical profits. A lender may finance two to three times the amount of cash flow generated by a business, on average, over the past two years. Cash-flow loans are often repaid during a three- to five-year term.

  • Mezzanine lenders, with 12%-14% interest, charge about 50% higher interest rates than cash-flow or asset-based lenders, and they usually require an ownership stake in the borrower. At the same time, they are much more willing to assume significant credit risk. Mezzanine borrowings often take the form of subordinated debt, which has lower priority in liquidation than any other debt and therefore usually gets repaid last. Subordinated debt is often repaid over a five- to seven-year term and often comes with warrants that represent a certain ownership percentage in the borrower. Companies often use the proceeds from mezzanine debt (as well as from cash-flow loans) for acquisitions, to retire more-expensive debt, or on occasion, to distribute capital from the business to the owners, which is also known as recapitalization.

  • Preferred stock and common stock are ownership interests in a business. Proceeds from the issuance of these securities provide the company with long-term capital. Typically, founders and management will hold common stock, which is subordinated to the value of the preferred stock, which is usually held by outside investors. Preferred stock may entitle its holders to a liquidation preference that guarantees the distribution of certain monies before common shareholders receive anything; it may also have a conversion feature in which the holder can receive a liquidation preference and then convert to common stock, receiving a “double dip,” something the investors might demand to ensure that they’ll get paid before the owner.

Preferred stock usually accrues dividends added to the liquidation value. Depending on ownership percentages, individual equity holders may require some influence over a business, sometimes taking a seat on the board of directors or having approval over certain events. Equity holders may also require antidilution rights that protect the investors from money raised at lower share prices.

Traditional banks provide most types of debt, but they often rely on their regional or national offices to underwrite more-complicated loans. Finance companies, such as GE Capital, Congress, and Foothill, are best known for providing asset-based loans and equipment financing. Certain individual investors will also provide asset-based financing. Equity capital can be provided by private-equity firms (venture capital and leveraged buyout funds), institutions (insurance firms, investment banks, university endowments), angels (wealthy individuals), and strategic partners. Private-equity firms and institutions with experience in catalogs include American Securities Capital, Brentwood, Chase Capital, Patricof, HIG Capital, Wand Partners, and Winston Partners.

There’s no question that these are challenging economic times, and many catalogers may need to seek funding to weather the storm. On the upside, the uncertain climate has created ample opportunities for financing and strategic partnerships if you know how to seek them out.

Malcolm P. Appelbaum is president of AppleTree Advisors, a New York-based catalog investment firm.

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