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CapSource Fund trying for popular SBIC designation

Group doesn’t want piece of the pie, only some of the filling

As James Herndon and his business partners see it, the aggressive entrepreneur shouldn’t have to be penalized and lose control of their company just because they’re in a little bit of a capital crunch.

But too often, said Herndon, that is exactly the decision that many budding businessmen and women are forced to make when they head to the traditional venture capital fund or individual: trade a big chunk of the business in return for the needed capital, or simply slim down the expansion plans and fund the growth with the steady but inadequate revenues.

In that situation, many entrepreneurs simply choose the latter, unwilling to give up a piece of their hard-earned company — and their dream — to somebody they may have to get approval from every time they need to buy a copy machine or sign a new contract.

“That is a dis-incentive to the entrepreneur to give away a piece of their business, particularly for the companies in the industries we are hoping to serve,” said Herndon.

A partner with Amerimark Capital Corporation, a financial services company with offices in Dallas, Austin and Jackson, Herndon is also president of the newly-formed CapSource Fund which will provide second-stage capital for small- to medium-sized companies in an array of industry groups, including communications, energy services, health care, furniture manufacturing and computer software. The fund will be based in Jackson with a primary market of Mississippi, but also as far away as the Florida panhandle and Oklahoma.

In the discussion stage since 1993 and planning since 1995, CapSource was officially formed in 1996. Over the last two years Herndon and his partners, Bob Weatherly and Charles Martin, have been in the process of promoting the fund to potential investors and preparing documents for the U.S. Small Business Administration to become only the second Small Business Investment Company (SBIC) in Mississippi in the program’s 40-year history.

Combined, the three partners have more than 90 years of experience in the fields of corporate lending, accounting, business finance, investment banking and management of small business operations, according to their SBIC business plan.

Both Herndon, 53, and Weatherly, 53, are Mississippi natives who were roommates at the University of Mississippi. Martin, 56, is a native of Alabama and graduate of Auburn University who joined up with Weatherly in 1989 to start Amerimark.

To date, Herndon said CapSource has attracted over a dozen investors who have put up nearly $7 million to create the fund. Once CapSource receives word from the SBA that they have been approved as an SBIC — something that is expected to happen in the coming weeks — Herndon said the fund will be closed to new investors 60 days from that date. It is hoped that the fund will rise to around $10 million from private sources and with the leverage capability that comes with being an SBIC, CapSource will have lending capacity of nearly $40 million.

But CapSource isn’t going to operate like any other venture capital source. Instead of loaning entrepreneurs money for a controlling piece of the business, CapSource’s loans will be made in the form of senior secured or subordinate debt with relatively high fixed interest rates and with warrants to purchase equity securities of the borrower, according to CapSource’s SBIC business plan.

With the infusion of capital into an already sound and aggressive company, the hope, said Herndon, is that the company will do one of three things: sell out to a conglomerate; grow and absorb new businesses, repay CapSource and then borrow from more traditional sources; or thirdly, go public.

In that case, CapSource would convert the warrants they hold on the company, which they will purchase at just one cent each, into shares of stock. With a loan-period of no more than five years, and with a provision to ratchet up annually CapSource’s warrant position, the fund could amass anywhere from 5%-20% of the equity securities of the company. Because of the high interest rates, Herndon said it is his hope companies will repay the money in two to three years so that the fund can increase it’s portfolio of companies.

With loan sizes ranging from $500,000 to $2 million, and drawing on a fund of nearly $40 million, Herndon said CapSource could potentially help 20 to 40 businesses initially. But if CapSource proves to be successful, it is highly likely additional funds would be started, he said.

A former banker himself who started an award-winning small business lending program while at First Mississippi National Bank in Hattiesburg, Herndon isn’t critical of banks for forsaking the small business sector, particularly when it comes to seed, start-up or second-stage funds. He cites banking regulations, and the nature of banks having to be more conservative with depositors’ monies, for creating the difficult environment at traditional lending sources for small business.

Beyond that, Herndon said technology, a booming economy and other factors have created a ripe market for start-up and second-stage funding. While businesses even just 20 years ago where growing slow enough to finance their own success, that is no longer possible.

“The cycle has gotten so fast that thye’ve have found it difficult to get the cash they need just from operating revenues,” he said.

SBIC’s are part of the solution although even they needed some modification to really work.

Although created by Congress in 1958, Herndon said certain aspects of the legislation were turn-offs for lenders and small business borrowers. Changes in the SBIC program in 1992 and again in 1994 have made the program attractive and created nearly a stampede for groups to affiliate themselves with SBIC’s. In fact, of the 300 SBICs now operating, 111 of them have formed since 1994.

The SBIC program currently has around $15 billion in long-term financing to some 90,000 businesses across the country. Companies that are today household names, like Federal Express, Sun Microsystems, Staples and America Online, all got money from an SBIC.

One major point that Herndon believes proves the viability of CapSource is the fact that since 1994 the number of Mississippi companies accessing financing through an SBIC has increased from about four to 10 last year.

But for all the good news and opportunities, one black-eye on his attempts to promote CapSource has been the continuing fallout from Magnolia Venture. Herndon said the problems with the venture capital fund created by the state Legislature began to surface around the time he began seeking investors. Although affiliating with the SBIC program means there are very stringent restrictions on such things as how much the fund can spend on operating costs and other guidelines, selling a venture capital fund to investors hasn’t been easy.

“Falling on the heels of Magnolia made it a little more difficult,” he said.

Sadly, Herndon said Magnolia Venture would have been a big plus for CapSource because it would have taken up where Magnolia’s funding left off.

“Their success stories would have been our clients,” he said, adding that the presence of CapSource may entice both entrepreneurs and new venture capital.

“Once you get a resource here,” he said, “it will attract other resources.”

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