Capital Ideas

When traditional lenders aren't available, where can a small business turn?
Here are three possibilities.

By PAOLA SINGER

The bank isn't an option. Now what?

For struggling small businesses, that's often the question. The more cash and credit entrepreneurs sink into starting a business, the less likely they are to have the credit score or fixed assets a bank requires to approve a new loan or line of credit. Similarly, the inventories and receivables that banks often base lending decisions on are often at their lowest when the need for capital is greatest.

So when traditional lenders are not biting, where should a growth-stage business turn to for cash? The answer can vary according to a company's size, the stage of the business, industry and geography, among other factors.

Here's a look at three increasingly popular sources of capital for small businesses:

MERCHANT CASH ADVANCES

Michelle Roddel, owner of Beauty & the Bistro, a cafe and catering service in Corpus Christi, Texas, says she was turned down by every bank in town when she was looking for a loan to start her business. "My credit wasn't the best in the world," she says.

Undeterred, she got the business going with money from her 401(k), relatives and a loan of about $4,000 from a local Small Business Administration program.

But the business hit a slow stretch during its second year, making it difficult for Ms. Roddel to cater large events because she lacked the cash to buy groceries and pay staff.

That's when she found AdvanceMe Inc., a Kennesaw, Ga., specialist in the growing field of merchant cash advances. Companies in this industry, also known as credit-card-receivable funding, pay cash advances to small merchants who pass muster, based on their history of credit-card sales. The merchant then repays the advance—with a hefty premium—through deductions from its future credit-card sales. For example, a small retailer may receive $100,000 upfront with an agreement to pay $135,000 within six to 12 months—equivalent to a loan with an interest rate of 35%. From that point on, a portion of each credit-card sale the merchant makes is automatically routed by the credit-card-processing company to the advancer, until the amount under the agreement is paid off.

The upside for the merchants, like restaurants, flower shops, franchisees and others that sell mostly through credit cards, is that they receive the money quickly (generally in less than 14 days), don't have to put up collateral and don't have to pay late or application fees.

The downside is that, being an unregulated industry, it's very expensive money. Indeed, this type of financing is often the last resort for businesses that can't get access to a bank loan. Critics say the cash-advance industry takes advantage by charging over-the-top rates.

Industry sources say that the typical advance comes with a 35% premium, but that this rate can vary depending on the business and the amount of risk the advance provider feels it is taking.

Glenn Goldman, chief executive of AdvanceMe, a unit of Capital Access Network Inc., says his company typically charges a 20% premium and agrees to receive about 6% to 8% of sales until the advance is repaid. Potential recipients, which are required to have been up and running for at least four months, can receive $2,500 to $150,000 per location, and up to $1 million for multiple locations.

AdvanceMe has provided more than $600 million to 14,000 businesses and has grown over 200% in the past four years, its CEO says. "There's an incredible need on the part of small businesses to access working capital," he adds.

Beauty and the Bistro has received five advances of about $5,000 each from AdvanceMe, all for different purposes, from moving into a new location to preparing for convention catering. Ms. Roddel says that she has repaid all of the advances—and that she would have been out of business without them.

MICRO-MEZZANINE FINANCING

Four years after its 2001 launch, U.S. Modular LLC, a maker of memory and data-storage products, was feeling the strain of rapid growth. The Irvine, Calif., company needed a larger management team, a facility with more square footage, new phone systems and an expanded inventory, among other things.

Although the business was profitable, it had maximized its ability to borrow based on assets. Founder and President Nick Payzant spoke with a few venture capitalists, but soon realized that for him this was not the way to go. "The venture folks value your company very low and take as much equity as they can," he says. "There's a point in time where debt is less expensive than equity."

Mr. Payzant began looking for subordinated debt—unsecured debt that generally carries a higher interest rate than bank debt. Through an intermediary, he found Snowbird Capital, a Reston, Va., provider of so-called micro-mezzanine financing. Snowbird lends amounts ranging from $500,000 to $5 million primarily to companies on the West Coast and in the mid-Atlantic region.

Mezzanine financing, used generally to fund business expansions, acquisitions or buyouts, derives its name from the gap it bridges between bank debt and equity financing. There is always an equity component, but the portion sought is usually smaller than in a pure equity deal, and in some cases is partially reversible. Snowbird, for example, offers "reversible warrants," which, with varying terms, enable business owners to reverse part of an equity option granted to the firm. Snowbird negotiates performance targets that establish how much it will get to keep in warrants based on the company's results. Typically, the more successful the company, the fewer warrants Snowbird keeps—but the more valuable each one is.

Mezzanine loans usually carry an interest rate of 12% or more for the cash portion, usually with a maturity of five to seven years, plus the warrants to buy company shares. "We have more modest return expectations [than venture capitalists]," says Snowbird CEO Nelson Carbonell. "We take less risk than they do, obviously."

In July 2005, U.S. Modular closed a $1 million deal with Snowbird, to be repaid in 24 months. The interest rate is in the 12% to 20% range, says Mr. Payzant, who declines to be more specific. Snowbird holds about 3% of the business, a stake that is one-quarter to one-half reversible if U.S. Modular exceeds an annual growth rate of 40% during the two years. The company has been growing at a 40% rate, says Mr. Payzant, and expects to grow just under 80% in 2006.

For businesses that show solid growth rates, micro-mezzanine financing "is a great alternative," Mr. Payzant says.

Many experts agree. Micro-mezzanine loans "are private, unregulated, highly flexible and particularly helpful for businesses where collateral is an issue," says Vincent Constantini, managing partner at Roseview Group, an advisory firm for entrepreneurs based in Boston.

Just be forewarned, Mr. Constantini cautions: "They can charge a lot for this product, particularly if you don't have a lot of options."

SBICS

Marian Heath Greeting Cards, a Wareham, Mass., greeting-card company, was put up for sale in 2002 when the founder's daughter decided to retire and no third-generation family members were willing to take over the business.

Aaron Kushner, an entrepreneur whose family had been in the greeting-card business for several years, was looking to buy a new company. He and his business partner, Dan Steever, liked Marian Heath; it had steady 5% annual growth. But the partners lacked cash to make the purchase.

"We put together a small portion of the price with our own and friends' money, but clearly [we] were going to need an equity partner," Mr. Kushner says.

Several venture-capital groups turned them down because the business "was not 'sexy' in the technology sense," Mr. Kushner says. Some private-equity groups also passed, expressing a preference for larger deals or for buying the entire company.

Messrs. Kushner and Steever finally acquired Marian Heath with help from three partners: a senior lender, a mezzanine lender and Walnut Investment Partners LP, a small business investment company, or SBIC.

SBICs, regulated by the Small Business Administration, are privately owned and managed investment firms that use private capital and money borrowed from the government at favorable rates. The SBA typically provides a 2-to-1 match on funds raised privately by an SBIC. Congress created the program in 1958 to help entrepreneurs whose needs weren't being met by traditional financing sources.

Walnut Investment Partners, part of Walnut Group, a Cincinnati-based group of investment enterprises, originally put $2.5 million into the purchase of Marian Heath, and was later instrumental in the acquisition by Marian Heath of a major competitor. To date, Walnut Group has invested $4 million in Marian Heath Greeting Cards, says James M. Gould, managing general partner at Walnut. It holds just under a 40% stake in Marian Heath and plays an active role in managing the business, he says.

Of the 407 active SBIC firms today, most are either Participating Security SBICs (which provide equity capital), or Debenture SBICs (which provide subordinated debt financing), according to the National Association of Small Business Investment Companies, a professional association based in Washington.

Although the funds invested by SBICs grew to $2.9 billion in fiscal 2005, according to Nasbic, this program has been plagued by faltering government support. Since 2004, the Participating Security program has been closed to new licensees and will gradually cease to exist unless Congress acts to extend it. On the other hand, the Debenture program enjoys stability and government support.

"The administration, gun-shy because of losses during the recession [when Participating Security funds performed no worse than non-SBICs] has said the debt-oriented debenture program is sufficient to meet venture capital needs of small businesses," wrote Nasbic President Lee Mercer in an email. "This is absurd," he added, "because fast-growing young companies need access to equity capital."

People in the industry say small businesses particularly benefit from SBIC investments because SBICs are dedicated to companies with after-tax annual revenue of $6 million or less for the preceeding two years and tangible net worth of less than $18 million, a segment that can struggle to find private investors.

"Because of the substantial size of most venture funds today, very few non-SBICs can dedicate the resources to fund transactions below $5 million," says SBA spokesman Dennis Byrne. From 2001 to 2005, the average SBIC investment ranged from $511,000 to $1.04 million, he says.

Mr. Kushner says it is very difficult for entrepreneurs to find "a good equity partner who isn't interested in controlling the entire company or flipping in a short period of time." Unlike similar private investors, he says, SBICs want to "nurture a small business."

—Ms. Singer is an editor for The Wall Street Journal's Americas Group in Jersey City, N.J.