Help for Firms With Big Growth Potential

Randy Zurbach has a three-word answer for those who consider it impossible to round up capital for small business in Southern California:

“Sure you can.”

Zurbach founded Pinecreek Capital, an Irvine-based small- business investment company, two years ago to finance small businesses with potential for high growth in Southern California. His company does mezzanine deals, a sophisticated capital financing technique described in this space recently, with several twists:

* The deals are small--as little as $500,000.

* Unlike most mezzanine deals, Zurbach’s involve mostly debt at first, not equity capital. The deals give Pinecreek Capital rights to buy stock down the road, not upfront, because Zurbach believes a debt-heavy mix best serves the needs of small businesses struggling to find capital to grow.

* The deals get commercial banks involved too, with lots of loan money in the package.

As detailed in this space last month, mezzanine financing allows small businesses to raise capital from institutional investors such as pension funds, insurance companies and banks in much the same way as big businesses.

In a typical mezzanine deal, a small business raises up to $20 million, part of it as debt and part as equity. Put another way, you borrow some of what you need and you raise the rest by selling a minority interest in your company, usually not more than 20%, to your lenders.

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As a rule, mezzanine deals start at $10 million, where certain economies of scale kick in. A few investment banking houses do deals at $5 million, a handful at $2 million. Smaller deals don’t register on the radar screens of most investment bankers because they cost as much to do as big deals--and if a $500,000 fee takes the same work as a $50,000 fee, why do it?

But deals of $500,000 and up are Randy Zurbach’s specialty. That makes his clients small businesses indeed. Pinecreek Capital likes businesses that are at least 3 years old and have revenue exceeding $4 million and strong cash flow. So far, Pinecreek Capital has done seven deals totaling $8 million; it doesn’t specialize in any given industry.

“The hardest capital to find is capital for a company that makes money, has good management and needs to grow,” Zurbach says. “Such a company might have no collateral and need anywhere from $500,000 to $2 million to grow--and it has nowhere to turn for that money without giving up control of the business.

“Venture capital funds look for home runs. We’re patient capital; we look for singles and doubles. We want to ramp a company up to the next level, and there are very few players doing what we do.”

Zurbach learned business banking during a 23-year career with Union Bank, Wells Fargo, Security Pacific and Bank of America. He founded Pinecreek as a small-business investment company under the aegis of the Small Business Administration because, he says, the SBA gives him access to cheap capital--key to his ability to do mezzanine deals.

Pinecreek holds $12.5 million in private capital from seven investors. It commands the use of another $38 million in 10-year interest-only debentures underwritten by Chase Manhattan and guaranteed by the SBA. Pinecreek Capital taps this fund as needed, paying interest at 1.5 percentage points over the 10-year Treasury note rate. T-bills draw about 5.5%, so Pinecreek borrows the greater part of its capital at about 7%.

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That’s cheap money indeed. Pinecreek doesn’t pay much for its own capital, so it can afford the fixed costs of doing small deals.

“My investors want a return on their investment somewhat north of 25%,” Zurbach says. “So we put money out at 5 or 6 points over the T-bill rate, and we take warrants for 5% to 40% of the company, triggered in the event of a sale, recapitalization or public offering.”

In a typical deal, Pinecreek lends, say, $1.5 million at 10% to 12% and takes warrants giving it the right to buy stock in the borrowing company in the future--usually when the company goes public, undertakes a new round of financing or sells out.

In this way, like other mezzanine financiers, Pinecreek earns interest on the capital it lends and enjoys the prospect that it will win big should the value of the company go up. Unlike other mezzanine financiers, Pinecreek only holds the right to buy stock in the borrowing company; it doesn’t buy into the company from the get-go.

A typical Pinecreek deal brings in additional capital in the form of bank loan money, sometimes as a one-year revolving line of credit, sometimes as a term loan payable over five to seven years. Like other mezzanine lenders, Pinecreek subordinates its debt to that of a participating bank.

But because banks see subordinated debt as equity, a deal involving both senior and subordinated debt often induces a bank to open its wallet a bit more than you might expect, Zurbach says. Thus, if Pinecreek offers $1.5 million in subordinated debt, a commercial bank might offer another $3.5 million in senior debt, for total financing of $5 million.

To be sure, that can make for a heavy load, so the borrowing company must enjoy good cash flow and rosy prospects for growth, Zurbach says.

“If the business can get money from a bank, it makes no sense to talk to us,” Zurbach says. “But banks want collateral. And if you’ve got no collateral--no receivables, no inventory, no equipment--but you can show good cash flow and a strong potential for growth--well, that’s our business.”

Next: How an Orange County vocational training school used a tailor-made mezzanine financing deal to propel its growth.

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Freelance writer Juan Hovey can be reached at (805) 492-7909 or by e-mail at jhovey@compuserve.com