Finding Cheap Capital For Your Small Business

Subscribe to BusinessWeek

Nelson Carbonell knows what it's like to be a startup entrepreneur struggling to find funding. In the early 1990s, he bootstrapped a technology company that he ran from his basement -- using his own savings and $10,000 in credit card debt to get it off the ground.



Now that Carbonell is the chief executive officer of an investment firm, Snowbird Capital, he has directed nearly $50 million in funding toward small businesses over the past two years. He spoke recently to Smart Answers columnist Karen E. Klein about various strategies that small firms can employ to find the capital they need at the cheapest cost. Edited excerpts of their conversation follow.



You bootstrapped your first company, Cysive, before taking it public in the late 1990s. What was the appeal of entrepreneurship for you?



I'm something of a lifelong serial entrepreneur, I guess. I started my first company when I was 10, selling candy from my best friend's dad's ice cream shop. I became a software engineer, and in 1993 I started a company to build a software product. We had grand designs about building the next-generation document-management system, selling it to millions of people, and riding off into the sunset. But we couldn't raise the money, so my partner and I decided to provide software services and cut deals with our customers where we would own the intellectual property on all the projects we built.



What happened was we got so busy, and got such a great reputation working for companies like Sun Microsystems (SUNW), that we never built the software. What I tell entrepreneurs now is, 'Whatever you plan to do is not what you end up doing.' That's why the people involved in a company are more important than the plan. I will invest in a mediocre plan with a great team behind it anytime over a mediocre team with a great plan.



You wound up taking your company public during the technology boom of the late 1990s, then taking it private during the dot-com bust, and eventually spinning off some bits of it and liquidating others. Along the way, did you feel a lot of the pain that entrepreneurs typically encounter with financing?



Oh sure. My partner and I started with $10,000, each putting in $5,000 of our own money. For the longest time we didn't pay ourselves, and our office was in the basement of my house, so it was free. We were as thrifty as possible, and we financed a lot of things with credit cards. We always had big problems with cash flow.



My wife was our first chief financial officer and she used to take our biggest client's check to the bank to deposit. They wanted us to wait two weeks for that check to clear, but we had a newborn at the time, so she'd go into the bank with the baby and say, 'Hey, could you clear this right away? We have to make payroll,' and sometimes they'd help us out.



Eventually, when we were doing $3 or $4 million in annual revenues, we got an unsecured line of credit from the bank. But we were always running one step ahead of the game. I still remember the year I realized we had three months' worth of cash in the bank. That felt awesome! Way better than when we had three weeks' worth.



How did you wind up starting Snowbird Capital in 2004?



By the time we finished with Cysive, I realized I wasn't a software engineer anymore. I'd spent 10 years figuring out how to start up, finance, and grow a business from scratch. A lot of people encouraged me to start another tech company, but that felt kind of like going back to high school again. I wanted to try something else.



My goal with Snowbird Capital is to focus on the kinds of businesses that I knew well. That is, those earning between $10 million and $50 million annually, that are growing and looking for ways to finance that growth, but that are not at the point where they've got venture capitalists or bankers clamoring to finance them.



Your fund specializes in what's called "subordinated debt" or "mezzanine debt." What kinds of companies can prosper with that kind of funding?



Subordinated debt lenders are looking for companies that generate healthy cash flow but may not have the collateral -- like property or equipment -- to attract a bank loan. Banks are good at loaning you your own money. So if you have tangible assets, they'll loan you a fraction of those assets. In other words, if I own real estate worth $1 million, the bank will lend me $750,000 if I put up that real estate as collateral.



The problem for technology and service businesses is that they don't typically have tangible assets like factories or equipment to put up as collateral for a bank loan. The companies we invest in are also not necessarily great targets for venture capital investors because they're probably not the next Google (GOOG).



So we do mezzanine debt deals with companies that generate enough cash flow to repay our loan and grow. For instance, if a company has generated $1 million in cash flow, it should be able to service a loan three or four times that size, and be a good investment for us.



How does subordinated debt work?



We loan the company the money they want, and we split our return into a small piece of equity and an interest payment set by the market. Right now the interest is at about 12% or 13%, which is more than the bank will charge, but less than most credit card rates. Along with that, we get somewhere between 2% and 15% ownership in the company, either in stock options or in a warrant that we can exercise. That's far less than a venture capital firm will want in exchange for its investment.



How many companies have you funded so far?



We have done nine deals, starting with fairly small deals and moving up. We're working on pulling together our second fund, which will be larger and have a broader set of partners. What we'd like to do is offer different funding methods geared towards all small businesses. So sometimes equity funding works better, and other times it's mezzanine debt that's the key.



I believe that small businesses are the engine of our economy, and that the market needs to provide the same services for small corporations that exist for the big guys, in terms of funding options. Unfortunately, what happens is that if you're doing less than $50 million in revenue, nobody in the funding community pays attention to you.



What is your fund looking for in terms of small-business investment candidates?



The most important thing is positive cash flow. Your company has to be making money. We help out companies that want to acquire another firm in order to grow, but can't get the capital to do that. We also fund companies that are resetting their ownership structure. Sometimes the founders want to move on and do something different, and many times mezzanine debt is a great instrument to make that happen.



Another typical scenario is one that happened to me when I was an entrepreneur. I landed a large customer in Silicon Valley and I needed to establish an office there, but the heavy upfront costs of expanding geographically would have generated negative cash-flow implications for us. Snowbird helps companies that want to expand geographically without encountering a dip in cash flow while they are investing in company infrastructure.



What are your criteria for company size?



We typically make loans between $1 and $5 million. If your firm needs more than that, either we're not the right place for you to look, or we can perhaps partner with another fund to accommodate you. Your company should be making a minimum of $5 million annually and have an EBITDA -- that's "earnings before interest, taxes, depreciation, and amortization" -- of $500,000 to $1 million or more. We fund companies that have a maximum $50 million in cash flow. Firms that are north of that figure will need more money than we can provide.



Another criterion we live by is the management team. We're looking for teams that really have experience doing what they're doing. We don't want to invest in a podiatrist who wants to become a bicycle manufacturer. I have all the admiration in the world for those kinds of entrepreneurs, but I don't want to give them any money until they prove themselves. When you're not driving the car on an investment, you've got to have confidence that the people who are driving know exactly what they are doing.