SAMUEL KIM, a Korean immigrant to the United States in 1972, has earned 35 patents for his innovative electronic products, the most successful of which are arcade-style games that test sports skills. Until 1995, the 54-year-old inventor licensed rights to manufacture his products to others, earning royalties of between 5 and 10 percent on the sale of each game. Sam saw an expanding market for the games. He wanted to manufacture them himself and market them directly to distributors and consumers. He had ideas for a half dozen more products he believed would be big hits if he could gear up to produce them while the market was still hot.
Up to that point Sam's company, G.L. Technology in Rolling Meadows, Illinois, was pretty much a one-man operation. In the first few years his wife helped out with the accounting; a brother-in-law and a sister-in-law also assisted in the office. Sam realized that in order to attract capital for his venture, however, he would need to create a full-fledged organization.
In typical entrepreneurial fashion, Sam made the company a "family affair," calling on two of his four daughters, both of whom had accounting degrees from the University of Illinois, to join him in the business. The oldest, Gina Cho, 28, while employed as an accountant with Coopers & Lybrand, had managed G.L. Technology's books in the evenings and attended trade shows on the weekends. In 1991 she left the Big Six accounting firm to direct the financing and marketing of G.L. Technology's expanding product line. The following year Sam's second daughter, Minna Ko, 27, left her position as an auditor with Arthur Andersen & Co. to direct office operations.
Sam Kim also realized he could no longer rely on traditional sources of funding for the business expansion he had in mind. He needed at least $2.5 million to produce and market his games, far more than he would be able to raise from family, friends, and credit cards. He would have to look for venture capital, but he was smart enough to know that he would need help in sorting out the medley of private funding sources who were likely to be interested in bankrolling his venture.
In the summer of 1995, Sam turned to Dresner Invesments, a Chicago-based investment banking firm, to advise him on his business plan and to contact and screen potential providers of growth capital. After extensive research into the industry, Dresner's investment bankers determined and justified a favorable valuation of the business based upon G.L. Technology's product line, its management, patents, and growth projections. Dresner located two different outside financing sources: a father-son investment group that had successfully built another business and was looking to repeat their success, and another investor group made up of several venture capital sources that focus on minority businesses.
Both investment groups became serious contenders to provide G.L. Technology with a financing package. Ultimately, G.L.'s decision on which group to select would be based on the fundamental issues inherent in an entrepreneurial, family owned company.
The company
Sam Kim is the quintessential inventor, a man who spins off ideas like flocks of sparrows flying from treetops. He believes in divine inspiration; the initials of his company, G.L. Technology, stand for "God led." The Kims are very involved in the Hebron Presbyterian Church in nearby Prospect Heights, Illinois.
Unlike many entrepreneurs, Sam has also had manufacturing and managing experience. As a young man in Korea, he had earned both a B.S. and an M.S. in chemical engineering, became a university lecturer, then for a time ran an electrical equipment company serving the auto industry in that country. After coming to the United States, he was employed for several years by Wico Corp., a $50 million parts supplier to the coin-operated games and consumer electronics industries in Niles, Illinois. Sam, who became an American citizen in 1977, spearheaded the development of the first trackball and joystick products for Wico. He worked his way up to senior vice president for manufacturing and R&D and supervised a production line with more than 100 employees.
When the company was sold in 1987, Sam left to start his own business. At first, he provided consulting services to other companies in the industry and his costs were modest. All the while, however, he was dreaming up and tinkering with new games at home. When the business grew into a licensing operation, costs started to mount as Sam needed to purchase tools and components for his R&D work.
His first major success was his 18-hole Putting Challenge Mini-Golf Game, which he developed, in part, to improve his own golf game. Played on a raised platform 11 by 6 feet, the electronic game has a putting surface that changes contours after each putt and returns the ball to the player automatically for the next hole. Putting Challenge comes in two models: One is coin-operated and designed for sports bars, family entertainmcnt centers, and restaurants. The other is a consumer version for the home.
The consumer version won Hammacher Schlemmer's 1993 Outstanding Personal Electronic Award, and in December of 1995, Sam and his Putting Challenge were featured on ABC's "Good Morning America." Sam scored another smash hit with a second electronic game, Full Court Frenzy, in which players toss a basketball at a hoop that is moving and rotating and measure their skill by the number of times they get the ball in the basket.
Sam licensed his sports games to manufacturers and collected royalties from their sales. G.L. Technology grew slowly — too slowly. Between 1987 and 1995, the Putting Challenge Mini-Golf Game and the Full Court Frenzy Basketball Game generated revenues of over $18 million for the licensed manufacturers and distributors. The success of the licensed coin-op games and the consumer golf game in particular, increased Sam's determination to bring both the manufacturing and marketing of his games in-house.
Sam believed his expansion plan would allow G.L. Technology to reap the benefits of his ideas in both the coin-operated and commercial amusement game industries, as well as the growing consumer leisure market. As Gina Cho related: "A full-fledged sales company has much greater potential than an R&D licensing company. You can only invent so quickly. Royalties come in slowly. We were strapped for capital. My father had so many ideas for products that he saw would be successful, but to take advantage of this growth potential we needed a fuller product line."
Financing
Faced with the large start-up expenses and the need for working capital for launching new products, Sam realized he had to "go outside" for financing. He knew that taking on additional debt from a bank was not a viable option; the company had few tangible assets and did not have the cash-flow generating capacity to meet bankers' lending criteria. Sam was also wary of giving up an equity interest and losing control over the company to which he had given nine years of his life. Nevertheless, he turned to Dresner to find private sources of equity financing.
Dresner's investment bankers studied growth projections of the home and coin-op games industries. It did in-depth analyses of G.L Technology's product lines, its competitors, its cash requirements. During the research process Steve Dresner, president, attended a number of game conventions and spoke with many players in the coin-op industry. "The more research we conducted," Steve recalls, "the more convinced we became that Sam Kim's vision for G.L. was viable."
The confidential business plan and financing memorandum assembled by Dresner was presented to targeted investors for their review and analysis. (Based on G.L. Technology's potential as outlined in the memorandum, the business plan was selected for presentation and review by the Chicago chapter of the Massachusetts Institute of Technology Business Forum. The forum provides expert feedback from leading financial, marketing, advertising, and operations professionals from Chicago's top firms.)
Dresner ultimately selected two different equity investor groups as suitable sources of outside capital. The father-son investment team (which we will call F-S) had successfully run several consumer-oriented businesses and had many strategic business contacts. Their financial acumen and management experience appeared to be a good fit with Sam's R&D expertise and entrepreneurial vision.
The F-S proposal had these features:
The other potential investor group viewed their involvement solely as an investment opportunity. Their approach could be characterized as a passive "institutional" (PI) investor. Like F-S, PI required less than 50 percent of G.L.'s equity. They looked for favorable returns as well as a clearly defined exit strategy that would enable them to pull out their capital if the company did not perform up to expectations. The group's offer had these features:
Both financing offers required certain standard conditions to be met at closing that would ensure investors that Sam would remain committed to making a go of the arrangement. Sam would have to convey all patents, licenses, and intellectual property rights to the company. In addition, executives and key management would have to sign employment contracts with noncompete and confidentiality clauses.
The decision
In the end, similar pricing and terms were reached for both deals. Certain aspects of the pricing offer from F-S were better than the one from PI, and, in addition, the father and son were offering business experience that could be useful for an entrepreneurial venture. The big difference between the two offers lay in the amount of control the Kims would have under each.
Under the PI proposal, the investors would have a voice in all major decisions. The Kims would be held accountable for achieving performance goals, but they would be left in full charge of day-to-day operations. If the Kims went with F-S, in contrast, they would have to relinquish managerial (though not financial) control of the company.
The decision was complicated by a question of the compatibility between the two families. During the long financing negotiations, it had become clear that the Kims and the F-S team had different styles of communicating. The Kims tended to be low-key, while the the F-S investors came on strong in expressing their views.
The Kims spent approximately six weeks diligently reviewing each proposal, working out all the financing and management details and incorporating legal issues as they arose in each plan. Dresner Investments reviewed both investor proposals throughout the negotiations. The Kim family then had to weigh not only the financial implications of the two alternative offers, but each's impact on family ownership, management, and the long-term strategy of G.L. Technology.
The final decision came down to who would control G.L. Technology. The Kims ultimately chose PI because under this proposal they would maintain full day-to-day control. They believed they had enough experience to run the business themselves and preferred to go it alone. As Gina Cho explains:
"None of the investors who approached us really had a lot of experience in this specific industry. We had to educate them in what the market is like, what makes a product a hit, what the trends are.... If one of the investor groups had had that background, it would have been a definite asset. But we were afraid that having people working here who lacked it would slow everything down because we would have to respond to their questions. We are on a fast growth track right now, and felt we would be slowed down if we were not making the day-to-day operational decisions."
The future
G.L. Technology began manufacturing Sam's games last January in its Rolling Meadows plant. The company now has 16 employees. He plans to produce two new games each year on other sports themes; seven are already on the drawing boards waiting to go into production. To direct its coin-op marketing and sales efforts, the Kims went outside the family to hire a director of sales and marketing. They have also recruited a director of manufacturing and a director of finance.
This is a company in a hurry, and the pace has been hectic. During G.L.'s three-year search for venture capital, Gina had two children and she is now pregnant with a third. She and her sister have done everything they can to lift the administrative burdens from their father and free him to do what he does best — invent sports games.
Gina, who is vice president, has been deeply involved in business strategy and operation, in scheduling appearances at trade shows, and in juggling other marketing opportunities. She has been especially concerned with hiring decisions and building a staff of people willing to do what is necessary to sustain a fast-growing business.
In an interview, her thoughts tumbled out rapid-fire, often ending as questions, reflecting her stress-filled work day. "Each person is so important in a small business," she says. "If anyone is sick, for example, it has a big impact on the company. The other day, someone's car broke down and the person couldn't come in to work, and another employee had to leave early. Meanwhile, my father was leaving on a business trip to Japan. Crunch situations like these test employees' priorities, their commitment to job and career. We're trying to build up a sense of commitment to the company."
Does she plan to stick with her managerial responsibilities, even with the demands a growing family? "As much as I can," she says. "Sometimes I think it really would be better if I didn't. But for the time being, we're here almost out of necessity. There's a difference between a salaried employee and a family member. Either my sister or I are the first in the door in the morning and the last out the door at night. It takes time to build that commitment in other employees."
George Thompson is the director of investor relations for Dresner Corporate Services (DCS), an affiliate of Dresner Investments in Chicago. DCS provides investor relations and corporate communications programs for privately held and public companies, as well as IPO advisory services.
Different types of financing are required at various stages of a company's growth. Here are three common types of financing and what investors who provide each will look for in the transaction.
Equity. Used most often by a startup or young company that has shown the viability of its product line, management, production, and marketing. Additional financing is needed to implement a growth strategy. Investors look for returns commensurate with the risks of the transaction, which are usually high. Tough bargaining may take place over board seats, ownership percentages, registration rights (investors sometimes require the company to register stock with the SEC so it can be sold in either an IPO or a secondary offering of equity), as well as incentives and requirements for meeting revenue and profit objectives.
Mezzanine. Often sought by companies that have shown one or two years of growth. As in equity transactions, investors demand a return commensurate with risk, which is usually higher than a senior bank debt coupon plus warrants on a conversion feature to share in the upside. Mezzanine funds, or subordinated debt funds, dilute equity less, but companies seeking such financing must have positive cash flow to support interest on additional debt. These transactions are less common and tend to be more complex than equity funding. For one thing, the documentation requires coordination with senior debt, described next.
Senior debt. Used by businesses that are firmly established and have either a strong asset base or excellent cash flow or both. The company must have a demonstrated ability to handle the debt load. The debt commitment is usually geared to receivables, inventory, property, plant, and equipment. The lender may also require covenants that commit the company to maintaining certain financial parameters, such as the ratio of debt to equity, and sufficient cash flow to cover interest payments.
— G.T.
Every financing package is different and should be structured to fit the company's goals and plans. Dresner Investments recommends keeping the following points in mind when evaluating financing offers from private sources.
Equity dilution and valuation
Privately held family businesses usually want to avoid diluting equity. Many do that by assuming debt. But too much debt can lead to cash flow problems, depending on the nature of the company and its stage of development. In seeking financing from private sources, you can reduce the risk of diluting equity by agreeing to a series of performance objectives; the investor receives interest but no equity, so long as the company meets its objectives. A proper valuation, as in the G.L. Technology case, can also greatly reduce dilution of equity. The greater the worth of the company, as demonstrated by the valuation, the less the percentage stake that must be granted to investors in return for financing.
Investor participation in the business
Qualify your potential investors. Verify their track record and obtain a Dun & Bradstreet report on their previous business holdings. Evaluate the investor's familiarity with the industry and the strategic benefits he brings to your company. Determine if these benefits are the key factors you need to grow the business. Investors sometimes insist on majority interest and seats on the board of directors. As the owner, you should decide the extent of control you will exercise over day-to-day operations, research and development, and marketing, as well as the conditions under which this control would revert to the board.
Future funding
If you will need additional financing in the future, consider whether your investor will have the funds available. The structure of the transaction should allow for future financing without a restructuring of the terms of the current agreement.
Investor holdings
The investor may be able to create synergies between the company seeking financing and one of its other portfolio companies. For example, a manufacturing company might be able to sell its products through a portfolio company that has mall outlets across the country. Or the investor may be able to broker a joint venture between two of its companies. Such ventures are sometimes structured to give one of the companies the option of eventually acquiring the other.
Strategic investors
A strategic investor, in addition to providing equity or debt financing, can also bring badly needed managerial and other expertise to a company. The question of who will have day-to-day operating control often becomes a tough issue in negotiating these transactions.
Personality
The selected investor must share your vision for the company's future. A good investment banker will have two or more investors lined up so you can choose the best fit with your company's culture. If you feel uncomfortable with the investor's attitude during negotiations, there may be a good reason. The best financial structure only works as well as the personalities that must make it work.
—G. T.