From the October 2007 issue of Entrepreneur

New Jersey entrepreneur Dave Harris went to Massachusetts to buy a new oven for his bagel business and came home with a financing strategy for refitting his entire wholesale bakery operation.

It was while visiting the oven manufacturer's showroom that Harris learned about a kind of low-cost financing that could fund his long-term capital needs. The vendor had used tax-exempt bonds--which let manufacturers borrow up to $10 million for equipment and facilities--to borrow funds at a considerably lower rate than conventional financing would allow.

Harris wasted no time calling his banker, who confirmed that tax-exempt bond financing could be a good option for Harris' business if he borrowed enough to make the transaction costs worthwhile.

With the tax-exempt bonds on his side, Harris bought a $1.2 million oven and upgraded other key pieces of equipment in his bakery, pushing the total price tag to $2.4 million. "The oven that we purchased is set up for 28,000 bagels per hour, but the rest of our bakery--from our packaging to our cooling--couldn't handle [that many]," says Harris, 37, who founded West Caldwell, New Jersey-based Original Bagel Co. in 1995. "We had stopgaps all over the place. Once we had the financing, we [set up] the entire bakery so that there was no inefficiency." Thanks to the equipment upgrade, Harris expects to double the size of his business within five years and projects 2007 sales of over $23 million.

Locals Only
While tax-exempt bond financing isn't new, many eligible businesses aren't aware that it exists. Here's how it works: Each state has a bond "volume cap," which controls the amount of tax-exempt bonds the state can issue. It allocates a portion of that amount to various issuers throughout the state, which, in Harris' case, was the New Jersey Economic Development Authority. Your local economic development authority is a good place to start if you're a manufacturer interested in learning more about tax-exempt bonds.

Once issued, tax-exempt bonds are sold in the open market or purchased directly by a bank or other financial institution on behalf of the borrower. Interest income earned by purchasers of tax-exempt bonds is exempt from federal and state income taxes, so the savings can be passed on to the borrower in the form of a lower interest rate. Harris, whose bank purchased the tax-exempt bonds issued for his business, has a fixed interest rate of 5.05 percent for the first five years.

Now for the bad news: The short-term costs of tax-exempt bond financing are much higher than those of a conventional loan because the manufacturer has to pay for its own bond counsel and the bank's attorneys fees; Harris' legal costs came to nearly $35,000. Because of the high initial costs of issuing these bonds, they're generally not recommended for manufacturers with modest financing needs. "There aren't very many transactions done under $3 million," says attorney Stephen Rosholt of Faegre & Benson LLP.

One of the goals of tax-exempt bond issuers is to create jobs, but requirements vary from state to state. "As part of the hearing process, the manufacturer generally must describe what jobs will be created," says Rosholt, noting that some states don't have minimum requirements. "[Some states] are just happy with the tax base and whatever jobs are created."

On his application, Harris was asked what he would do if he didn't receive financing. He said he would consider moving his business to Pennsylvania, where it would be cheaper to operate. "At some point, to be competitive," he says, "you need a break."

Crystal Detamore-Rodman is a Charlottesville, Virginia, writer who covers the small-business finance market.