Hidden assets

Entrepreneur,  Jan, 1997  by David R. Evanson

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Neil B. Swartz, chairman and CEO of Microleague Multimedia Inc. in Newark, Delaware, is a man in a hurry.

Microleague competes in the searing hot market for interactive multimedia entertainment. And the company's primary niche, sports simulations, just adds more sizzle to the Microleague story. After all, we're talking America here, a nation that elevated sports, sports licensing and sports broadcasting into major growth industries.

In this context, Swartz's rush-rush approach is easily understood. "We want to build [market] share now so our leadership position is solidified as the market expands," says Swartz.

It's also not surprising that when it came time in 1994 to raise capital to finance two new multimedia sports simulations, one for baseball and one for horse racing, Swartz wanted to get the deal done fast. How best to do this? "Make sure investors get a fast return on their investment," he says. After all, almost anybody can put together a deal where there is no return for five years. "Engineering a quick hit for investors," says Swartz, "required some creative thinking because conventional techniques just weren't right for us at the time."

For instance, issuing straight equity in a private placement - that is, selling shares directly in the company - might have been feasible but would hardly have offered a quick return to investors. After all, it might have been years before the company achieved the size and the momentum needed to complete a public offering. In the meantime, private placement investors would simply have to hang in there. Besides, if the products failed, Microleague might have found itself saddled with some unhappy shareholders.

Getting a loan was an option, but only in theory. Given Microleague's early stage of development, it's doubtful the company could have found a lender venturesome enough to do the deal. Besides, significant debt at that stage of the game would have choked the company.

To strike the right deal - meaning one that would entice investors but give Microleague the room it needed to grow - Swartz borrowed a chapter from Hollywood. He used off-balance-sheet financing to raise the approximately $212,000 he needed to develop Sports Illustrated Presents Microleague Baseball and Hooves of Thunder.

* THE BASICS

The term "off-balance-sheet financing" is sometimes confusing, but when interpreted literally, it begins to take on more meaning. Specifically, it refers to capital that never shows up on a company's balance sheet. For instance, issuing equity makes a mark on the shareholder's equity section of the balance sheet, while issuing debt - i.e., getting a loan - an be seen on the liabilities section of the balance sheet. But off-balance-sheet financing never shows up there, or at least doesn't ever have to.

Here's how it works. A company - say, Widget Inc. - seeking capital to develop a new product sets up a partnership as a separate entity. The partnership, perhaps called Widget Partners, then raises money and either pays Widget Inc. on a contractual basis to develop the product on behalf of the partnership or lends the money to Widget Inc. Limited partnerships are comprised of the general partner, who manages the affairs of the partnership, and the limited partners, who are investors that put money into the partnership.

The limited partnership in the Microleague financing was called Interactive Multimedia Limited Partnership. The general partner was Interactive Multimedia Inc., a company 50 percent owned by Microleague chairman Neil Swartz. The investors put a total of $212,500 into the partnership in exchange for an interest payment, which was deferred, and royalties from the sale of the products the partnership was formed to develop.

It's not unusual for the limited partnership to contract with the original company to develop the product or service. After all, the limited partnership is simply a corporate entity with no personnel or operations. In addition, this arrangement can offer the original company a significant benefit. The financing not only misses the balance sheet altogether as a liability or diluted equity, but voila! it shows up on the income statement as fee income.

In Swartz's case, the partnership lent the funds to Microleague rather than contracting for services. Swartz says this had to do with tax considerations for the investors and the company. But even as a loan, it's still remarkable since there's hardly a bank on the face of the earth that would lend funds for development of a product to a company with no previous track record of sales.

* THE PROS . . .

Swartz says off-balance-sheet financing delivers several benefits to carefully consider.

The first, he says, is it doesn't cost the company any equity. "Most companies at an early stage in their development simply can't [get a loan]," says Swartz. "So it appears as if giving up equity is the only other alternative to get funds in the door. Unfortunately, if the company is not worth much because it's new, that equity is going to cost them a big hunk of ownership." By contrast, the off-balance-sheet technique doesn't cost any equity.