(FORTUNE Small Business) – How do you create a hit? Sometimes all it takes is a whim. Back in 1991, Kate Brosnahan quit her job as an accessories editor at Mademoiselle magazine and joined forces (as well as names) with Andy Spade, her boyfriend and future husband, to start a bag design venture called Kate Spade Inc. The night before a 1992 trade show that would launch her chic handbags, Brosnahan (whose name now matches her company's) had that "whim" we were talking about: She stitched the company's rectangular black labels to the outside of her sleek, boxy bags. A brand--and her signature--was born.

The fashionistas loved Spade's uniquely fresh but timeless style. Seven years later, her eponymous bags are coveted not just by Hollywood celebs like Gwyneth Paltrow, but also by legions of bagaholics from Boston to Baton Rouge. The allure? The bags combine classic lines with surprising fabrics such as zebra stripe and charcoal boucle. Think Grace Kelly's naughty younger sister. Staying true to that design concept has helped the Spades cement their position in the high-end handbag niche. Spade style, you see, doesn't come cheap: The bags range from $125 to $500. But the fact that women bought tens of thousands of them last year anyway is partly what prompted Neiman Marcus to pony up $33.6 million for a 56% stake in the business last February. In addition to branching out into shoes, raincoats, and stationery, the Spades are breaking into luxury cosmetics. Last fall, the company (which had sales of $50 million in 1999 and has been profitable every year since 1997) entered into a licensing deal with beauty behemoth Estee Lauder. From the Spades' sun-swept headquarters in New York City, they told us about their adventures in the bag trade. Edited excerpts:

How did you get up and running?

Kate: We just kind of felt our way along. I started out working in our apartment making prototypes with large pieces of tracing paper and glue. I was incredibly neurotic about getting them to look exactly the way I wanted them to--where the handles would go, working out their proportions. Then we tracked down a technical pattern maker and a contractor through the Yellow Pages to produce samples. For the first three years, we did everything out of our un-air-conditioned apartment, including steaming hundreds of bags when they came from the manufacturer at night.

How did you finance the venture in the early days?

Andy: We both used our savings. Kate also tapped out her 401(k). We agreed that at least one of us should keep a day job until we knew whether the business would get off the ground, so I kept working as a creative director at the New York advertising agency TBWA/Chiat/Day. At night I worked on the marketing aspects of the business. Kate handled all the design. Neither of us really took salaries--except for a few thousand dollars here and there--until 1996. Every penny we earned from the bags went right back into the business.

Did things get easier once you hit the trade show circuit?

Kate: Not really. For one thing, our first trade show in 1992 cost about $2,500 just to get a booth. Then there was the outlay, which ran into the thousands as well, for all the fabric, patterns, and labor that go into the bags themselves. To save on decorating fees, we brought everything from home--our lamps, chairs, tables, books, everything. We didn't cover the cost of doing the show, but we did get a few small orders from Barneys and Charivari. Even so, I remember thinking maybe we should quit, because it just didn't seem worth it.

So why didn't you?

Andy: We started getting small orders from the right accounts, like Fred Siegel and Bergdorf Goodman, and that kept us going. Once the stores saw our bags were selling, they started placing even larger orders. Then as the orders grew, we started to become more confident about what we were doing.

In the beginning, did you consider bringing in outside investors?

Kate: No, that was never an option. To have borrowed even $1,000 would have made it too hard for both of us to sleep at night, especially since we weren't sure the business was going to make it. We didn't mind losing our own money, but losing someone else's would have been the worst.

What about once the business became viable?

Andy: In 1995, I flew to San Francisco to see my uncle, who's a venture capitalist in Silicon Valley. We went to lunch, and I showed him our press kit. Our revenues by then had grown to about $1.5 million, up from about $100,000 two years before. He and his partners offered me a great deal of money for a small percentage of the business. That's when I realized that it was valuable and we shouldn't give any of it up yet.

Both of you come from creative backgrounds. What were some of the business realities you had to face along the way?

Andy: Within the first two years, we realized we had to make some major adjustments when it came to pricing the bags. We had just been ballparking it without really calculating all the various costs. That's when we realized we needed to formalize the process, so we brought in one partner to oversee production, and then later brought on another to help. For the first three years or so, both of them worked without salaries in exchange for stakes in the business.

In the mid-1990s, you sued Banana Republic and Dayton Hudson to stop them from selling knockoffs. How did you win out-of-court settlements against the big guys?

Kate: I'm sure they thought we didn't know a lawyer much less have one. But back in the early '90s, no one was doing square totes and no one was using fabrics such as nylon or linen. Today they are, but back then that's what differentiated us. None of the big designers had been paying attention, so we were able to establish a recognizable aesthetic identity kind of under the radar screen. So we said, let's set a precedent, and they eventually agreed to desist. We were lucky that they didn't start copying us earlier, because we would probably have been wiped out.

In 1996, your revenues reached $6 million and have more than doubled every year since. How do you guard against growing too fast and making it all unmanageable?

Andy: We've never been all that interested in growing for growing's sake or trying to stay hot. And so far that approach seems to be working. We parted ways with one of our former presidents because he wanted us to open too many stores too quickly. We currently have three freestanding stores in the U.S., as well as leases for three more. We also have ten stores in Japan. We're definitely going to open more but at a manageable pace. Our biggest fear has always been that the quality of the bags would suffer, which is why we've tried to keep the brakes on.

Given that you were originally reluctant to take any venture capital, why did you agree to sell a majority stake of your business to Neiman Marcus when you did?

Andy: We were waiting for the right partner. We wanted one that understands the value of a brand and that had the infrastructure in place to help us grow the retail end of the business. We had also reached a point where we wanted to build our management and design teams and take on several new leases without stretching our financial resources. So the decision was half strategic and half financial. As an established high-end retailer, Neiman Marcus understands how important design is and how you need to protect and invest in the integrity of the brand. Over the years, of the four or so companies that offered to buy all or part of our business, Neiman was the only one that understood that. We didn't want to become a partner with anyone who would want us to move physically into their company or would want any involvement in the creative process. Because we still function as an independent company, it's business as usual with our other clients such as Barneys or Saks. And as far as revenues are concerned, Neiman shares in our profits as any wholesale partner would.

Over the past year, you decided to start licensing the Kate Spade name for use on everything from shoes to beauty products with Estee Lauder. Why now?

Kate: Because we want to maintain creative control over everything that goes out under our name--whether we're manufacturing it or letting a partner handle production--we knew we needed strong management and design teams in place as we expand into new areas. We've been able to accomplish that thanks to the Neiman deal.

How do you choose which products are appropriate for licensing?

Kate: We won't license the name or expand into a new area unless we think we can bring something new to a category that really makes it fresh. For instance, we got the idea to do raincoats after realizing that almost everything out there was in Burberry beige. So we decided to introduce a line of them using pink and turquoise. Same with the shoes, the address books, and now the beauty products. We see the licensing as something that will be profitable in the long term. In the short term, we see it as a great way to challenge ourselves creatively while raising awareness of our brand overall.

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