Restrictive Bank Terms Fuel SMB Credit Crunch

Although the growing use of credit cards has gotten a lot of the blame for the rising cost of small business credit, local banks are also a big part of the problem. Wayne M. Gatewood, Jr., president and chief executive of Quality Support in Landover, Md., is a case study of the hurdles small business owners face, and why so many owners are turning to credit cards to finance their businesses.

Gatewood appeared before the House Small Business Committee this week as part of its continuing examination of the role of credit cards in small business financing. “Cash management is an absolutely critical matter for small companies. Careful management of cash and credit may mean the difference between whether a business expands or doesn’t, and whether it succeeds or fails,” said Rep. Steven Chabot, R-Ohio, the committee’s ranking member.

After a 21-year career in the Marine Corps, including a tour of duty in Vietnam, Gatewood started his own company in December 1989. Like many small business startups, he ran his business out of his home with no lending history or track record of working with banks. He started the company with only $600 in cash and a small loan from his father. Two years later, he applied for his first loan from the Small Business Administration (SBA), but was turned down because he had no capital or line of credit from a bank. He was, however, able to get an American Express card and a Visa card.

“Throughout the early years, I used credit cards to purchase office supplies, pay for reproduction costs, pay for my travel and fuel costs, and a number of other items that would otherwise require the outlay of cash,” Gatewood said. “I knew what money I had coming in, and I used these cards with prudence.” Interest-only payments proved handy to help balance cash flow. His company, which provides support services for conferences and meetings, also needed flexible amounts of cash to meet upfront costs for hotel rooms and other services.

In 1999 the company scored a major breakthrough when it won a contract from the State Department to provide support for international conferences and meetings. To open a London office and provide the services and support the contract required, the company needed to secure a $1 million line of credit, at minimum. “We went to our bank, where we had a fairly substantial cash balance and an established track record, but this bank turned us down,” he recounted.

“Here we were with a multimillion dollar contract and a significant task order that we might lose because we would not have the cash flow to support operations,” Gatewood said. He contacted American Express, and the company extended the necessary credit line through its OPEN program for small businesses. From 1994 through March of this year, Quality Support has charged more than $8 million through American Express and expects to charge $2.5 million this year, he said.

The company terminated its relationship with its old bank, and tried once more to establish a line of credit with a much larger institution. This time the company had a solid relationship with American Express and money in the bank, and was finally able to secure the line of credit. But the terms were so restrictive that Gatewood said he was forced to turn it down. “The agreement basically ensured that the bank would generate good income, while their level of risk, in practical terms, was zero,” he told the committee.

Among the restrictions, the bank wanted Gatewood to personally guarantee the loan. The bank also wanted to put a lien on the company’s receivables and required a minimum net worth of $1.5 million for a $500,000 line of credit. “If we dipped even slightly below that mark for even a short period of time," he testified, "the bank could call in the loan immediately. Even if we were not in default of the loan terms, the bank reserved the right to call in the loan at any time, for any reason.”

The loan agreement terminated a year and a day after it was instituted, allowing the bank to either call in the loan or terminate it at its sole discretion. The bank also wanted the right to conduct field audits at any time, as often as they chose, and Quality Support would be responsible for all out-of-pocket expenses incurred by the bank in addition to a $2,300 annual fee, even if the credit line was not used. The bank had the right to debit any account to pay expenses. Finally, the credit line was limited to current operating expenses, to carry receivables, and short-term working capital.

Needless to say, the terms were unacceptable. “I have found banks to be hostile and inflexible in many ways, as was the case in 1999 when they turned us down flat when we needed them the most,” said Gatewood.

Small businesses typically pay twice as much or more for credit than large firms, according to Georgetown University Professor John A. Largay, an expert on small business lending. The current credit crunch is now affecting businesses of all sizes, but particularly small businesses, making it even more difficult for them to borrow money.

As I wrote last month, the national recovery will hinge upon the ability of small businesses to access capital and create jobs. The last recession in 2001 is a case in point. Between 2003 and 2004, as the nation emerged from the downturn, companies with more than 500 employees cut employment by 2.7 percent. But employment increased by 27.1 percent at firms with fewer than 500 employees and by 59.8 percent at firms with fewer than 20 employees, according to the Small Business Administration (SBA).

Small firms must have access to credit, at costs that allow them to earn a fair rate of return on equity. Congress is already investigating predatory credit card practices, but it needs to look at the banking system as a whole. Credit card companies couldn’t get away with some of their more egregious practices if banks were more flexible on their lending terms.