Some Businesses Challenge Lenders

November 22, 2004
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GRAND RAPIDS — Outsourcing has all but become a cliché in the world of business today.

Whereas it was once a cause for concern and alarm, it is now a standard practice: When a service or product can be provided for a lower cost outside of a company, whether locally or globally, the decision to do so is easy to make.

So said Patrick Rea and Richard Temkin, of the Small Business Administration, earlier this autumn in explaining the dramatic way the SBA expects outsourcing to change the face of small business.

Rea is SBA’s Region V administrator and Temkin is the agency’s Michigan District director.

“The corporate structure is changing in dramatic ways,” Rea explained. “We’re seeing a vertical disintegration of that structure.

“Outsourcing is flattening organizations. Huge corporations that once employed thousands of people will one day be staffed by only hundreds,” he said. “They will only be employing their core competencies and the rest will all be resourced out.”

But not necessarily offshore.

Rea cited growing trends to outsource functions such as public relations, legal, human resources, and research and development to continue on to include all but a company’s core competencies.

According to a recent SBA study, “21st Century Jobs and Entrepreneurship in the Midwest,” the great majority of the economic growth of the Midwest will be found in the service sector. A 40 percent gain is expected for Midwest jobs in business services alone, while a 32 percent gain is expected within Michigan.

“What is going to happen is that we are going to have thousands of new companies emerge to provide those services that were once held within those large corporations,” Rea said.

“There is going to be a great many more businesses centered around some kind of intellectual property or even around contracts.”

Not only will many of these companies have nontraditional models, he said, but they also will lack many of the characteristics that represent a traditional brick-and-mortar business. Offices may not even be needed for some of the most agile firms, because employees can work from home or “hotel” within client companies.

He said the majority of such firms will likely be staffed by people with a great deal of expertise in their field, but few will have any track record of running a business.

“Banks have been struggling with lending to companies whose main asset is intellectual for some time,” said Jeff Bart of Macatawa Bank, who attended Rea’s presentation.

“Whether it be technique or skill or an industry contact — whatever that they have — there is a difficulty in lending because the collateral is nonexistent in most cases,” he said.

This is not a concept unique to virtual-type businesses. Conventional lenders often shy away from small business start-ups, only becoming involved when personal assets are available as collateral or the SBA is willing to guarantee the investment.

As Rea explained, the SBA at this time is as ill equipped to deal with nontraditional business models as banks, and will likely remain so until at such time a critical mass of virtual companies is reached.

“They’re risky, unknown, unproven and there is a lot of uncertainty in these start-ups,” Bart added.

“And no one in the lending business, whether banks or the SBA, likes uncertainty.”

To make matters worse, in the early stages many will practice an “evergreen” style of finance. With a constant need for capital, the lines of credit will be fully drawn at all times. Other complications arise around companies that will form around a single contract, and then possibly dissolve after the completion of that contract.

“These types of companies are going to be out of the conventional thinking of traditional lending,” said Carol Lopucki, Michigan director of the Small Business and Technology Development Center. “The closest to a lender response they are going to get will be angel investors and venture capital.”

While still an immature practice in the West Michigan area, the venture capital practices that have propelled start-ups on the east and west coasts are fast taking root here. Angel investors are actually prevalent in the West Michigan area.

“The model of outsourcing and virtual companies makes our business more exciting,” said Pete Farmer, manager of TGap Venture Capital. “In the Old World model, if you had this automotive idea and the Big Three were giving you Tier I status, you’d have a manufacturing plant growing in your mind, block grants and all of that. Now contractors can put that all together.

“All you really need to bring now is the working capital.”

He said the venture capital world has not historically been concerned with collateral, sometimes not even with experience running a business.

The leverage a venture capitalist seeks is commercial traction and growth potential. The largest concern for these investors would lie in whether a company built around a specific contract can perpetuate itself beyond that point and then diversify.

“It certainly isn’t problematic from a venture capital standpoint to back these types of companies,” Farmer said.

“They are lower-cost models and they leverage capital better than the let’s-buy-office-furniture-and-build-a-building types,” he said.

“It’s not a negative to someone that isn’t an asset-based lender. Banks don’t like to do any type of early stage or start-up business.”

From the entrepreneurial side, though, venture capital can rob many of these businesses of one of the traits they desire most: control of their own destiny.

Farmer freely admits that for a company that wants to maintain autonomy from the lender, venture capital is probably not the right choice.

On the more extreme side of these companies Rea cites an emerging society of “e-lancers.” With more than 528,000 Google entries for e-lance, these are small companies with sometimes only one or two employees and at most a dozen that sell their services via Web sites like e-lance.com and guru.com.

“When those folks apply for a business loan, it’s a completely different business model,” Tempkin said. “Lenders may need to learn to be more flexible in terms of how they’re looking at loan applicants.” 

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