Sherpa Partners in the News:

Article: Private Placements

Minnesota's investment community is a thriving source of private capital.

By Phil Bolsta

(Reproduced from Minnesota Technology magazine, March-April, 1999 by permission)

The only way Karl Groth could get a healthy bottom line was to get an injection of capital.  His medical device company, First Circle Medical, Inc., in Columbia Heights, needed cash to finish engineering work for its breakthrough product, a hyperthermia device that treats patients with AIDS, Hepatitis C and certain cancers by heating their bodies to 108 degrees Fahrenheit.

"We also needed money to complete some basic research work on hyperthermia, build some devices and cover the regulatory cost of bringing our product to market," says Groth.

Groth figured his options could be summed up in two words: private placement.

Essentially, private placement is a source of financing that does not involve a public stock exchange.  The term covers a wide variety of ways in which a person or business entity may invest in a private company.  Placements vary in how the deal is structured with regard to ownership position, exit strategy and a host of other considerations.  Perhaps the most appealing benefit of private placement is that it raises equity capital as opposed to creating debt.

Four common sources of private capital are:

• High net-worth individuals.  Commonly referred to as "angels," these experienced investors have the financial wherewithal to take a potentially risky investment position in start-up companies.

• Venture capital.  A more formal approach to raising money, venture capital firms are always on the lookout for promising new companies in which to invest.  "When you take that road," notes Groth, "you usually have to give up much more of your company.  For example, venture capitalists may demand a high percentage of ownership, right of first refusal and seats on your board."

• Strategic partners.  Some companies have an interest in a young company's technology and are willing to invest in the company to get closer to it.

• Institutional money.  Many retirement funds and other types of institutional accounts commit a percentage of their portfolio to higher risk investments.

It's important to note that private placement refers to the character of the investment's destination, not its source.  The last two options above may involve getting money from publicly held corporations but the transaction remains private as long as the investment is not registered with a public securities exchange.

Climbing the Mountain

"One of the real challenges for any entrepreneur is to manage cash flow and anticipate needs," points out Larry Arnold, a private investor who retired six years ago from the investment banking firm of Wessels, Arnold & Henderson (now Dain Rauscher Wessels).

"An entrepreneur with a good idea is going to need capital," says Arnold.  "There may be a founder's round for a small amount of capital just to get them started.  Then he or she needs to raise more serious money maybe six months later.  As a company grows and progresses, it will typically need to raise additional capital.  Before a company goes public, it's not uncommon to see three or four rounds of private investments."

Additional infusions of capital dilute the entrepreneur's stake in the company.  "By the time a company is ready to go public," says Arnold, "it's not uncommon to have the founder own less than 10 percent of the company.  But you're better off owning 10 percent of a going concern than owning 50 to 75 percent of a company that has no value."

Another compelling reason to consider private placement is the expert advice that is usually attached to the money.

"Our basic idea," says Mac Lewis, president of Sherpa Partners in Edina, "is if entrepreneurs have a vision and want to go climb a mountain, they should take along someone who's been up the mountain before."  Lewis, himself, founded a very successful Dallas software firm in the early 1980s.

He and his three Sherpa Partners associates won't even consider investing in a company unless an entrepreneur also welcomes their assistance in non-financial matters.

"We've found that the best investments are the ones we're interested in enough to get personally involved with," explains Lewis.  "It's a good gut check-- if we're not interested enough to spend time with and provide assistance to an early-stage company, why would we want to put our money in there?"

Lewis is also managing general partner of Minnesota Management Partners, a $3 to 4 million fund fully invested in 13 Minnesota companies, four of which have welcomed him onto their board.  "There are a lot of good ideas here in Minnesota and a lot of good people who can run the companies," says Lewis.  "We'll invest in the ones in which we are interested and invited to take an active role."

What Investors Look For

In order to attract investors, of course, a growing business must put its house in order.  "First, management needs to put together or update the business plan," says Jerry Okerman, who manages 3M's corporate venture program.  "Then they incorporate that as part of a private placement memorandum, which also includes an overview of their company and their vision as well as their strategy for achieving that vision.  All that would be reviewed by their lawyers and accountants and be given to potential investors, whether individuals, institutions or venture funds."

A potential investor looks for three key factors before investing, says Okerman:  a strong management team, a proprietary position on the products (usually in the form of a patent) and the ability to achieve $100 million in sales within 5 years.

"Certainly an important part of building an early-stage company is building the team," agrees Lewis.  "We try to help by performing interim management roles and also help with building the ongoing team.  The leadership team includes the board of directors and the executive leadership, as well as the investors.  Our goal is to find the kind of investors that are most appropriate for what each company is trying to accomplish." 

It's critical that the right company gets hooked up to the right investor, adds Lewis, who relies on his extensive network to play matchmaker if Sherpa Partners decides not to invest their own resources.  "There are some very good investment banks in town that help early-stage companies," he says.  "Or it may be more appropriate for a company to look to more traditional venture capital investing.  We also help companies research the venture capital environment to determine which firms would be interested in their particular field."

Networking Works

If an entrepreneur needs financing and doesn't know where to begin looking the Internet provides a good place to start.  For example, at www.vfinance.com one finds The Venture Capital Resource Library, an extensive directory of venture capital resources and related services.

A helpful local source of information is The Collaborative, a Twin Cities organization serving growth-oriented, emerging-market companies statewide.  "We try to stimulate growth of companies through the collective knowledge and experience of our more than 700 members, who are entrepreneurs, managers, investors and professionals," says president Dan Carr.  "Companies can gain visibility through our network."

The Collaborative offers its members 20 programs a year, a fall conference on venture finance and a quarterly journal called New Venture Review.  This way the organization offers a means by which high-potential, young private companies can gain exposure to investors and other entrepreneurs.

If someone is resourceful enough to start a company, they're resourceful enough to find investors, contends Arnold.  "Early on, people usually tap their friends and acquaintances.  Then they begin to network around town to find individual investors.  The Twin Cities are very active in that area; there are a lot of 'angels' here who have been entrepreneurs themselves and are willing to back people who have good ideas." 

When the entrepreneur moves beyond the start-up stage and has a well-thought-out business plan, says Arnold, it may be time to solicit introductions in the more formal venture capital community.  Keep in mind that a venture capital firm will only invest in a fraction of the companies that approach them.

Once your name begins circulating in the investment community, chances are good that the right person will hear it.  The Minnesota Venture Capital Association is an informal group of about a hundred venture capitalists.  They convene every other month to network and try to stay current with the issues affecting their industry, says the organization's president, Ed Spencer.  He also serves as CEO of Affinity Capital, his own Minneapolis venture capital firm.  The association includes all the major venture capital firms in the state as well as some private investors.

Another source for venture capital is MIN-Corp., an independent nonprofit organization spun off from Minnesota Technology, Inc., on July 1, 1998.  "It's an investment company that makes investments in small to medium-size privately owned technology companies in Minnesota," explains Jerry Okerman, who also serves as MIN-Corp.'s chair.  "We focus primarily on rural areas.  Our guidelines state that 80 percent of investment funds need to be invested in companies outside the seven-county metro area."

After aggressively pursuing one referral after another, Karl Groth raised $2.5 million in the last half of 1997 from more than a dozen angels and two strategic partners, Phillips Plastics, located in Phillips, WI, and Adventist Health Systems of Orlando, FL.

Prior to the private placement, First Circle Medical had six shareholders and a valuation of $9.6 million.  The company now has 20 shareholders and a valuation of $14.6 million.  Groth, who has already initiated a $6 million second round of private financing, has given up 20 percent of his company so far but hasn't regretted it for a moment.

"I love building companies," he says.  "I love the financial side, the funding side of it.  You're basically selling your company.  You're putting together a story, going out to the investment community and selling opportunity.  It's a lot of fun." 

Phil Bolsta is a freelance writer living in Minnetonka.  He covered factoring in the January-February issue of Minnesota Technology.