Grow With Private Equity

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By Jenny C. McCune

Steve V. Petracca had an objective: to raise $11 million cheaply and without risk. Every sign pointed toward an IPO. He needed to finance expansion of his computer upgrade company, Reply Corp. The six-year-old business was profitable. Its customer base was expanding. And high-tech companies were the darlings of Wall Street.

But just as he was about to take the plunge, Petracca had a change of heart. After months researching the IPO market, he decided to pursue the private equity market instead. "People thought we had rocks in our head,'' says Petracca. "But we decided against going public.''

Petracca founded Reply of San Jose, Calif., with money from friends and family and the severance pay he received when he left IBM. Its first products were low-cost PC clones. Then Compaq Computer Corp. started slashing its prices, and Reply couldn't compete. So, with lightning speed, the company switched to making computer enhancement boards for corporate clients. More and more cost-conscious companies were upgrading their PCs rather than buying new models at double the price.

Within six years, Reply was earning a profit on sales of $40 million. Petracca financed the growth with $14 million he got from five venture capitalists. But by August 1994, he'd run out of cash. He needed funds to develop new products.

Petracca began researching the public market. The potential rewards were enticing, but he couldn't ignore the risks. Many companies watched their stock prices tumble when they did not hit their earnings projections. Any hiccup could destroy the value of his stock.

The strong market didn't encourage Petracca--it worried him. Everything that goes up must come down.

He couldn't find the right underwriter. Large firms with major resources weren't interested in his small stock offering. In 1994, the average IPO raised $54 million. Reply needed only $11 million. Petracca wasn't convinced that a smaller regional underwriter could support his stock after the IPO.

Finally, the cost was exorbitant, with no guarantee of success. The price tag for the process could run up to 18 percent of whatever amount he raised. Up-front payments alone would total $500,000.

Petracca hired Prudential Securities Inc. of New York to arrange private equity financing with institutional investors. "Steve and Reply represented an attractive, high-growth opportunity,'' says Thomas S. Shatten, the firm's managing director and head of the Private Equity Financing Group. "An IPO might have distracted Steve and his management team at a time when they needed to focus on their business.'' The private equity route made sense for other reasons:

• A private equity deal is less expensive than an IPO, where expenses can run as high as $500,000.

• Private equity protects fast-growing companies from the volatility of the public market.

• Intermediate financing could position Reply for a future public offering. Private equity money would give the company time to mature.

Last February, Reply got an offer from General Electric. The company would invest $10 million from its pension fund. Reply's existing investors funded an additional $1 million.

The offer was a vote of confidence. GE Investment Corp. looks at 600 investments per year when deciding where to invest money from its $28 billion pension fund. H. Michael Mears, vice president of private placements, says the firm looks for companies with the following attributes:

• Fast growth with profitability.

• Good management. The fact that Reply changed its product line proved that its management team could respond to changes in the market.

• Maturity. GE's pension fund doesn't invest in start-ups. It wants to catch companies just before they go public, so GE can exit quickly.

• Blue-ribbon clientele. Having well-known customers boosts a company's image. Two of GE's divisions were already buying from Reply. "It made it simple to check on the company and its products and get a realistic appraisal,'' says Mears.

Petracca sleeps better at night knowing he's secured the money to grow his company. "The right answer is not always to go public,'' he says.

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