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Warming Signs?

The freeze in small-business financing may be starting to thaw, as bank loans pick up and equity options proliferate.
Alix Stuart, CFO Magazine
September 1, 2012

Small businesses may occupy a warm place in the hearts of politicians, especially in an election season, but they have been feeling a big chill from lenders and investors since the onset of the Great Recession. Banks, especially the larger ones, have been accused of shutting down lending to this segment to protect their own balance sheets, while the number of companies going public has been moderate at best.

There are signs, however, that the financing freeze may be thawing. For example, small-business lending rose 12% in May, according to the Thomson Reuters/PayNet Small Business Lending Index. Although the index is volatile, that uptick was its largest since June 2009. Small-bank approval rates rose during the year, nearing 50% last June, says Biz2Credit.com, a platform that helps small businesses find funding. Even big banks have been quicker to approve loan applications from smaller businesses in the past year, accepting 11% of applications in June 2012 compared with 8.9% a year earlier, according to Biz2Credit.

Based on a series of surveys of businesses with $1 million to $10 million in annual revenue, "we've seen credit availability getting better and better over time," says Duncan Banfield, a vice president with bank consultancy Greenwich Associates. "We're starting to see pockets of availability for small business, based on industry and the health of the company, though some are still being challenged. It's a very aggressive market for middle-market companies; banks are tripping over themselves to lend to that group, so that's trickling down to the smaller end of the middle market." (The Federal Reserve's quarterly survey of senior loan officers reported that banks loosened loan standards for middle-market firms in the second quarter, while loan standards for small companies were little changed.)

On the equity front, Congress opened up new frontiers in making both initial public offerings and non-IPO equity raises easier, via the April Jumpstart Our Business Startups (JOBS) Act. Although the "Facebook freeze" stopped up the IPO pipeline after the social network's offering flopped in May, the pipeline began to flow again in the second half of July, when 11 IPOs priced.

Even if the financing freeze is beginning to thaw, however, it could be a while before any heat reaches the smallest companies. "It remains a pretty bipolar world," says Ami Kassar, CEO and founder of MultiFunding, a contingency-based financing broker for smaller companies. "If you're bigger than $5 million in revenue, a lot of banks will fight for you today, especially if you have good credit, cash flow, and collateral. If you don't meet any of those criteria, you're in the Wild West."

Big Banks, Bigger Hearts?
For the past several years, community banks have been the mainstays of smaller businesses. They tend to be geographically closer to the companies and are willing to take the time to understand them. They can lend on reputations and relationships in many cases, rather than according to a standardized checklist of ratio requirements.

Big banks, on the contrary, have won themselves a black eye with small business. They have become known for sending prospective borrowers through prolonged cycles of paperwork and review, only to serve up a "no" in the end. Today, however, some of those behemoths are taking steps to improve their listening skills. "We have seen solicitation activity tick up, with banks calling on customers far more often," says Greenwich Associates's Banfield.

Bank of America, for one, is in the process of hiring about 1,000 new bankers with expertise in small business to forge closer relationships with existing customers and attract new ones. "These bankers are charged with being out on-site at the business owners' operations and asking them, 'What keeps you up at night, and how can we help you?'" says Robb Hilson, head of small-business lending for Bank of America, a division aimed at companies from start-ups to $5 million in sales.

Not surprisingly, this team is largely focused on cross-selling customers on Bank of America's other business services, as well as personal-finance offerings through its Merrill Lynch unit. But the new closeness can carry big benefits for those seeking credit. "We haven't changed the loan approval process, but having someone who can be an on-the-ground advocate for these companies is translating into higher approval rates," Hilson says, noting that BoA's small-business lending overall was up 21% versus the same quarter a year earlier.

Wells Fargo is another giant bank that has stepped up to the small-business plate in recent years, says finance executive Harrison Turner. Turner is the former CFO of a fast-growing $7 million (in revenues) California roofing company that recently sought financing to cover seasonal cash-flow dips. Within a few months of approaching Wells Fargo, Turner had a total of $600,000 in lines of credit at his disposal. The process was relatively easy, he says. "The most effort on our side was presenting a really solid plan so the underwriters could get a thorough understanding for the brand, and what drives the business," says Turner. "They're looking for other signs of growth potential, so the more information that can be provided over and above the financials, the better chance you get."


One finance chief recently found himself in the enviable position of having to say no to one big bank because of a better deal from another. When Tarun Chopra joined Washington, D.C.-based insurance broker Clements Worldwide in August 2010, the privately held company had no debt aside from a revocable line of credit with SunTrust Bank. The insurance brokerage, which specializes in serving expat employees and international organizations, has been growing revenues 12% to 18% per year for each of the last five years, and sees more opportunities ahead, including one or more acquisitions.

To secure the necessary capital, Chopra reached out to a number of banks, including SunTrust, local community banks, insurance industry-focused InsurBanc, and JP-Morgan Chase. To his surprise, he says, it took him almost a year to get any concrete offers from the banks in the form of term sheets. While all three larger ones eventually came to the table with line-of-credit offers that could cover a near-term IT investment for Clements, none would fund an acquisition, on the grounds that insurance-related assets would be intangible and therefore riskier than physical collateral.

In the end, Chopra wound up having to choose between lines of credit from JPMorgan and SunTrust. He picked an increased (and committed) line of credit from SunTrust that offered somewhat more flexibility than JPMorgan's offer, though "even that took a lot of convincing, despite the fact that we had a long-term relationship with them," he notes. Chopra is quick to add that Clements hopes to do business with JPMorgan in the future, as both of their businesses evolve in specific geographic areas.

Chopra learned a lot along the way about persuading a big bank to loosen its purse strings. For starters, he had a banker make a presentation to his management team, to better understand what metrics mattered most to the bank. To illustrate his commitment to transparency, Chopra brought the head of sales into meetings when future revenue projections were discussed. That strategy surprised the bankers to some extent, he says, but it "gave the forecast a lot more credibility, because they were talking to the expert." He then convinced the banks' relationship managers to let him talk directly with the banks' underwriters, which he believes was to his benefit when it came time for the two functions to push the decision up a level.

"At the end of the day, it's not the relationship manager or underwriter who makes the decision on your loan; they all go to a credit committee," Chopra notes. "The better I could equip the team to explain our business, the better they could make a case."

JOBS Prospects
Bank loans aren't for every company, of course. Many smaller companies are expecting — or at least hoping — that equity will become a more viable form of capital thanks to the JOBS Act. Like so many mammoth pieces of legislation, the results of the new law are trickling in over time, with many not yet apparent.

In a nutshell, the JOBS Act makes it easier for companies to raise equity in a variety of ways without registering with the Securities and Exchange Commission. Those include raising up to $1 million in a 12-month period from a large group of people through online crowdfunding platforms, and marketing unregistered Rule 506 and 144A offerings more broadly to accredited investors through a relaxation of solicitation restrictions.

For "emerging growth companies" (defined as having less than $1 billion of total annual gross revenues in their most recent fiscal year) that still wish to brave the IPO market, the law offers further help. It creates a secret passageway to the public market, thanks to the new option of keeping initial S-1 filings confidential, and lessens the filing requirement from three years of audited financials to two years (see "IPO Confidential," CFO, June). It further softens the landing for newly public companies by allowing analysts to publish research immediately after the IPO, and by giving the companies a five-year grace period from complying with some of the most onerous rules of the last decade, including Section 404 of the Sarbanes-Oxley Act and many provisions of the Dodd-Frank Act, such as mandatory say-on-pay.

But crowdfunding is the aspect of the JOBS Act that has captured the biggest share of the public's attention. Done right, anybody and (almost) everybody could get in early on the next Facebook, not just those in the inner circles of finance. As for companies, crowdfunding seems to be as close as it gets to free money.

"If you go to the crowd, you give up a little bit of equity, but your business is worth more and you don't have debt on your balance sheet, so it's kind of a wash," says Maurice Lopes, CEO of EarlyShares, a nascent crowdfunding platform. Lopes says that more than 600 entities have completed preliminary registrations on the EarlyShares site so far. Of those, about 200 are mature companies, one with as many as 150 employees and $5 million in annual revenues, he says.

"Besides the money, from your investors you also get a brain trust, a market gauge, and very often, a customer base," adds Lopes. But there are potential drawbacks to crowdfunding, too (see "Joining the Crowd" at the end of this article).

Secret IPOs
For those who are still setting their sights on adding an IPO to their résumé, the ability to file an S-1 confidentially "is one of the biggest, if not the biggest, advantages" of the new IPO-related laws, says Thomas J. Murphy, a partner at McDermott Will & Emery who specializes in capital markets. That's because it removes the risk of divulging company information long before a company gets any money, he explains. That privacy, along with myriad other comforts afforded newly public companies, has already convinced some clients to file an S-1 earlier than they expected, says Murphy.


Indeed, ServiceSource CFO David Oppenheimer, who led his firm's IPO in early 2011, says he felt "a little pang of jealousy" when he learned of the new IPO changes, "because they will certainly make the process less painful for companies." Besides the benefits of confidential filing, Oppenheimer notes that reducing the number of years of required audited financials from three to two will take out some audit costs, while allowing research analysts and investment bankers to be in the same meetings (under the watchful eye of an attorney) will save time. Now that analysts can publish research right after the IPO, "you could see some dampening of post-IPO volatility, too, because the analyst research often helps clarify things for investors who may be trying to figure out the story," says Oppenheimer.

Still, like many, Oppenheimer is skeptical that such changes will radically alter the number of companies going public. "If I were filing today, would I take advantage of the JOBS Act? Certainly yes. But would it have hastened the process for us? No, because the health of the business is the key thing." The investment community is the ultimate arbiter of the viability of a business, and it remains to be seen what demands will be placed on companies, if not from the SEC, then from the banking and investing community.

Big companies might have a voice, too. "Most venture-backed companies have to prepare for two possible exits, the IPO path and the sale of the company to a strategic acquirer," notes Gary Vilchick, CFO of Veracode, a venture-funded application security software company. Since such acquirers typically have expectations that the business they acquire will have robust systems and controls, Vilchick and other finance executives he has talked to are skeptical that taking the easy route will be a real option.

What's clear is that the money is out there. As Kassar of MultiFunding puts it, the good news and the bad news is this: "We can find [financing] for almost anybody today — it's just a question of whether the business can afford it." Indeed, David Keepes, a finance executive with American Credit Card Processing Corp., says his firm is in the process of securing $10 million from investors for the purpose of lending it out in the form of merchant cash advances or advances on credit-card receipts. Although these loans are among the highest-priced in the alternative credit market, he says demand for them is booming. "We could do another $10 million easily," he says, with a healthy dose of sympathy. "The companies receiving the advances are creditworthy customers — they just cannot get bank loans, or get them quickly enough for their purposes."

While the capital markets sort themselves out, though, finance executives can take consolation in at least one thing: the harder it remains to get external financing, the more necessary finance chiefs are to privately held companies. "The fact that my firm had a CFO definitely helped our case" with Wells Fargo, notes Turner. "These days, not having one makes a company seem underdeveloped."

Alix Stuart is a contributing editor at CFO.


Joining the Crowd

The ability to raise up to $1 million a year by selling securities over the Internet (via a registered broker or funding platform) may appear as an oasis in the funding desert to credit-thirsty companies. But experts caution that crowdfunding, while not a mirage, is likely to be both expensive and messy. For one thing, there are a number of costs associated with it, including auditing and valuation services, as well as the fee to the platform itself. How much liability the platforms will bear and whether or not they must be licensed and regulated are yet to be determined.

At an extreme, "when you get all done, it looks to me like for every $1 million you raise through crowdfunding, you're going to be taking home $600,000 or $700,000," estimates Thomas Murphy, an attorney with McDermott Will & Emery who specializes in capital markets. "That's not a very efficient money-raising mechanism."

Then there is the issue of how to handle a proliferation of investors, both now and in the future. "I've closed a few deals recently with 10 or 12 or 13 angel investors, and procedurally, it's an incredible burden for the company," notes Edwin C. Pease, a partner with Brown Rudnick LLP. "Getting 20 people in at $10,000 each is a pretty frightening proposition from a corporate-law and bookkeeping perspective." Looking ahead, he says, "how are those up-front $10,000 investors going to be treated when the company grows and is ready for a $3 million venture round? For individual investors, it's probably going to be a pretty bad idea."

Maurice Lopes, CEO of crowdfunding platform EarlyShares, has solutions to those hypothetical problems, solutions that just might work. For one, he says the portal (which is itself venture funded, and non-revenue-producing at the moment) will take a small fee off the top of any successful offering, and in fact is hoping to take part of its fee in equity "because we really believe in this model." The portal will then function as the primary communication medium, shielding entrepreneurs from dozens of investor phone calls each day. When and if a company makes it to a bigger funding round, the entire group of original crowdfunders will aggregate their stakes within a separate legal entity to be considered as a single shareholder.


How crowdfunding will play out is anyone's guess at this point, since the Securities and Exchange Commission hasn't officially sanctioned the practice yet and is still in the process of detailing necessary rules. Meanwhile, some of the amendments to lesser-known forms of equity financing could be significant, experts say.

"If I really thought crowdfunding would work, why wouldn't I do a 506 offering [private placement]?" asks Murphy. "There I can advertise myself, run the offering myself, and raise as much money as I want, without all these restrictions." Indeed, about the only constraint on the offerings now is that they are sold solely to accredited investors, a newly broadened term that includes a large universe of people.

"Lots of private companies say they want to raise money but don't know the right people," says Murphy. "Now you don't need to know the right people; you can advertise." — A.S.




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