When Selwyn Yosslowitz and his two partners started Marmalade Cafe & Catering Co. in 1989, they financed their company the same way as most new-business owners: They mortgaged their homes and ran up their credit cards.
But after using bank loans and company earnings to bankroll six more sites over the next 15 years, they realized they could expand much faster by taking a different tack.
In February, the three partners sold a large stake in their Santa Monica-based chain to a private equity firm. They plan to use the infusion to grow to 22 sites by 2010.
"It was a smart way to hook up with someone who could complement our business and provide a source of funding," Yosslowitz said.
Southern California is home to scores of fast-growing small companies, and private equity firms are taking notice. These investment firms gather money from institutions and wealthy individuals and plow it into promising companies capable of outsized returns.
A large investment from a private equity firm can significantly speed up a company's growth. Private equity investors also can supply managerial know-how and strategic vision that entrepreneurs may lack.
To tap into that money, business owners should make sure to have excellent accounting and recordkeeping systems in place several years before approaching a private equity firm, experts say. And it's usually smart to have an intermediary such as an accountant or attorney approach potential investors. That lends an air of credibility that may be absent when owners are hawking their own businesses.
Entrepreneurs also should be wary of the trade-offs that typically come with accepting private equity money.
The firms often demand majority ownership stakes in companies in which they invest. Company founders continue to run day-to-day operations, but must square big decisions with outsiders -- a shock for entrepreneurs used to calling the shots.
What's more, private equity investors seek big payoffs within three to five years. That often means selling a company to a bigger player or doing an initial public stock offering.
"The business can become more valuable sooner with a private equity partner than it could on its own," said Jed Johnson, managing director at Parallel Investment Partners, which teamed up with Marmalade.
"Their big payday is when we altogether build a company to a level where we sell it or take it public," he said.
The trade-offs didn't bother Eugene Inose and Jeffrey Louie.
The high-school friends and custom-car hobbyists started a specialty auto parts business in 1989. They launched Pro-Motion Distributing Inc. with a $5,000 bank loan, and eventually notched 30% to 40% annual growth rates without borrowing another dime.
Would-be investors approached them over the years, but the men rebuffed their overtures.
"We figured this was our baby," Inose said.
But as the City of Industry-based Pro-Motion approached $25 million in annual sales, growth throttled back. The two founders decided they needed professional guidance "to go to the next level," Inose said.
At the prodding of their accountant, they sold a large stake to a pair of private equity firms last month and raised almost $10 million more by securing "mezzanine" financing, which refers to capital typically obtained by companies seeking to expand.
"Five years from now I want to be running a $50-million company," Inose said. "Ten years from now I want to be running a $100-million company."
Private equity firms troll Southern California for opportunities.
Parallel is based in Dallas but has an office in Century City. Of the firm's 17 investments since 1999, more than one-third have been in Southern California-based businesses, Johnson said.
Pat Haden, a former NFL quarterback who is now a partner at private equity firm Riordan, Lewis & Haden in Los Angeles, invests only in promising local companies.
"There are thousands and thousands of these in California," he said.
The downside for entrepreneurs is that private equity firms are extremely choosy. Each firm invests in only a few businesses at a time.
Haden's firm has investments in eight companies at the moment and typically has no more than 11, he said. Parallel studies about 400 companies a year, of which it invests in two to four.