THE WALL STREET JOURNAL

The Journal Report: Small Business

Lessons From a Lender

How a small-business investment company decides where to put its money

By David Enrich

Last spring, George C. Kenney paid a visit to Hoag Hospital in Newport Beach, Calif., to do some research. He wanted to learn more about an amenity being offered to patients: interactive bedside entertainment consoles equipped with high-speed Internet, premium cable channels, on-demand videos and meal services.

Mr. Kenney ducked into patients' rooms and asked what they thought of the contraption, made by Skylight Healthcare Systems Inc. "It got very good reviews," he says. Then he quizzed some nurses. "They were very happy. So were hospital administrators."

Mr. Kenney, founder of Shepherd Ventures LP, a San Diego-based small-business investment company, was weighing whether to invest in Skylight. His visit to the hospital helped convince him of the company's potential, and Shepherd eventually decided to put "a reasonable amount" of money into San Diego-based Skylight, Mr. Kenney says. He won't disclose how much, but Shepherd generally invests $2 million to $3 million, with the understanding that more may follow.

The hospital excursion is an example of the lengths to which Shepherd and other small-business investment companies -- or SBICs -- go as they mull whether to shell out millions of dollars for a stake in a company. It's a decision that takes place after a painstaking, months-long courtship. And for all of the time that a company devotes to wooing Shepherd, there's no guarantee that it will win the investment.

"Typically, of all the companies that come to us, we might fund one in 100," Mr. Kenney says.

The U.S. government established the SBIC program in 1958 to encourage private-equity funds to focus on small businesses that don't catch the attention of standard venture capitalists. To qualify for funding from the Small Business Administration, an SBIC must raise at least $5 million in private capital and cater to businesses with net worths of less than $18 million and average after-tax earnings for the prior two years of $6 million or less. SBICs, which generally provide funding in increments of $250,000 to $5 million, pumped $2.9 billion into about 2,300 companies last year, according to the SBA.

Setting Out

Mr. Kenney founded Shepherd in 2000 with about $10 million from private investors. For years he had worked as an electrical engineer at companies including Sony Corp. and Philips Electronics Ltd. Then he did stints as an IT executive at prominent Wall Street brokerage firms. Armed with that expertise, he says, he decided to launch his own fund.

Today Shepherd manages about $80 million, some two-thirds of which came from the SBA. The rest is from a combination of banks such as Wells Fargo & Co., pension funds, such as the Colorado Public Employees' Retirement Association, and wealthy individuals. About $60 million of the funding already has been invested in companies or set aside for future rounds of funding in the 13 companies in Shepherd's portfolio. Investors have committed to provide the other $20 million or so once Shepherd is ready to use it.

Other than their SBA funding and exclusive focus on small companies, SBICs operate similarly to venture-capital firms. When there are profits or proceeds from a sale or initial public offering of a company in which the fund has invested, Shepherd and its partners get a cut in the same percentage as the fund's stake in the company. Shepherd first returns the original capital that the SBA and private parties invested. Then Shepherd divvies up the profits. The SBA automatically gets 10%, and Shepherd pockets 20% of what's left after that. The remainder is divided among the private investors according to how much they contributed.

Shepherd caters to businesses in the information-technology and life-sciences fields -- industries in which Mr. Kenney and his colleagues have expertise. But unlike firms that provide seed money to help get business concepts off the ground, Shepherd specializes in companies with established products, customer bases and revenue streams. The firm hunts for companies possessing "unfair advantages" that create high barriers of entry to potential rivals, Mr. Kenney says, such as unique, patent-protected products. Strong management teams also are a must; he says he subscribes to the mantra, "Bet on the jockey, not on the horse."

Screening Process

Shepherd subjects each potential investment to rigorous screening. Mr. Kenney and his three fellow managing directors gather every Monday morning to discuss potential investments as well as the current roster of companies. For each serious prospect, one director is assigned to investigate. Then, at each weekly meeting thereafter, that person reports on his progress probing the company.

Personal connections are the most common way Shepherd learns of investment opportunities. The directors regularly meet with lawyers who like to pitch ideas, hoping to score work drawing up investment agreements. Other Southern California venture capitalists, especially those that provide seed funding, also pass along tips about companies that are ready for later-stage financing.

Seemingly parochial ties can prove fruitful. That's how Shepherd connected with Digital Orchid Inc., a San Diego-based company that designs and manages cellphone ring tones and other wireless applications for brands such as Nascar and the National Hockey League. Last year, Digital Orchid was looking for funding to help it expand overseas. The company's chief executive, Daniel Daou, happened to have a neighbor who was a former venture capitalist and knew Tom W. Siegel, one of Shepherd's directors. The neighbor arranged for Messrs. Daou and Siegel to meet over breakfast one morning last February. They hit it off. About four months later, Shepherd wrote a check to Digital Orchid. The company now has offices in Argentina and Mexico.

"It's all about the network and navigating your way through the relationships," Mr. Siegel says.

It didn't hurt that a major San Diego telecom player, Qualcomm Inc., previously had invested in Digital Orchid. The company's executives realized that the financial backing from Qualcomm conferred extra credibility on Digital Orchid and its management team. "It gives you, from a financial perspective, more of a stamp of approval," says Bobby Betros, Digital Orchid's chief technical officer.

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