Where Southland Businesses Can Look to Find Expansion Money

Put any group of business owners in a room and you soon find them talking about their biggest problem: finding money to grow.

Wouldn’t it be nice, someone asks ruefully, if a business doing $50 million in sales could sell bonds like $50-billion companies do? Wouldn’t it be nice, in other words, if there existed a marketplace for private-placement debt instruments in which a small business could raise, say, $5 million in expansion money?

The good news is that such a marketplace does exist, though few people know about it, least of all most business owners. The bad news? The marketplace is far from national in scope, and its players tend to work specific geographic areas--Southern California not being one of them.

This doesn’t leave Southern California’s thousands of small businesses without resources, of course.

The Small Business Administration, for example, counts some 20 small-business investment companies (SBICs) in California, although only half a dozen or so actively lend to small businesses. (For a free list of SBICs, call the SBA at [202] 205-7589; for $20, the National Assn. of Small Business Investment Companies, [202] 628-5055, sells a similar list detailing the investment practices of its members, which are most of the active SBICs in the country.)

Meanwhile, under the Community Redevelopment Act, California banks must invest capital in businesses located in or serving areas of low or moderate income. And the California Department of Insurance runs a similar effort involving insurers called COIN--the California Organized Investment Network.

At best, however, these efforts satisfy only a small fraction of the demand. The businesses targeted by COIN and by banks under the Community Reinvestment Act face daunting problems, as do those targeted by SBICs. But put together, the dollars injected into the arena by all of these efforts don’t come close to meeting the huge need of small business for capital.

Big companies encounter no difficulty in financing their own expansion plans through debt instruments such as the debenture--technically, a bond giving the holder a general claim on the assets of an incorporated company senior to the claims of stockholders but junior to the claims of secured lenders like banks. Pension plans and life insurers make the biggest market for corporate debt instruments because they offer good returns with decent security; in fact, bonds make up the greatest part of the investment portfolio for most life insurers.

But it costs money to sell bonds, and the economies of scale in the marketplace work against the small business hoping to gain access to this capital.

Which is not to say that it can’t be done--and if you want to learn how, consider the experience of First New England Capital, an SBIC capitalized with $20 million pooled from a number of life insurer investors in Hartford, Conn. The company buys private-placement debt instruments from companies seeking as little as $1 million or less.

“There definitely is a market for these deals, and it is a very active one,” says Richard Klaffky, the company’s president and chief executive. “We provide not straight debt capital but subordinated debt with equity participation--a level of capital that goes beyond what a bank would be comfortable providing even in a secured loan.”

Klaffky says the debt instruments carry interest rates ranging from 10% to 14% over terms of five to seven years, and the deals come with equity “kickers”--warrants on company stock, typically for no more than a 20% interest in the issuing company. The combination allows First New England Capital to seek annual returns totaling more than 20%. Two-thirds of the company’s portfolio represents businesses in New England. It has done deals in Texas, Florida and Illinois, but not in California.

“The companies we deal with are growing, but they are constrained by bank capital and collateral requirements or they are already maxed out with line-of-credit borrowing.

“So they have to get the dollars they need from an equity source--or from a source of subordinated debt like us.”

Because a SBIC like First New England Capital is a creature of the SBA, doing business with one involves jumping through some paperwork hoops. And since SBICs generally seek total returns exceeding 20% per year, the deals don’t offer cheap financing like banks.

But unlike banks, which lend only with security--usually a personal guarantee or collateralized assets--SBICs do offer financing to companies otherwise unable to find it. And if the private sector can create a marketplace for debt instruments from small businesses in New England, surely it could do the same in California, the nation’s biggest hatchery of small business.

If that happened, business owners throughout the state would find the going easier as they plan their own growth.

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Juan Hovey can be reached at (805) 492-7909 or via e-mail at Jhovey@compuserve.com