From the April 2006 issue of Entrepreneur

About six years ago, MedHelp Inc.in Baltimore needed new software to upgrade the billing and medical assistance qualification services it provides to hospitals and physicians' practices. For financing, MedHelp's software supplier suggested a local finance company with which it had worked on other deals. Though MedHelp had a well-established relationship with a bank, the company's partners felt certain their bank would have misgivings about financing this particular asset. "I doubt very seriously we could have gotten funding for the software from the bank because software loses value so quickly," says Ian Johnson, MedHelp's vice president for operations.

One big perk of not getting financing from a bank: Johnson and his partners would not have to personally guarantee the loan. "Banks tend to want everything to [secure] a loan," he says. "The bank would have wanted mortgages and everything else."

Since that initial transaction, the $1.8 million company has turned repeatedly to the finance company for funding, including recently when it needed a $50,000 loan to buy discounted computer equipment from Dell. "Dell offered a price for high-end servers that was good for only a couple of days," Johnson, 36, recalls. "We wound up saving $10,000 [on] the purchase of those servers because [the finance company] was able to get the funding in place within 24 hours."

Small Firms Are Big Business
MedHelp's financing habits are hardly unique. A recent study sponsored by the SBA's Office of Advocacy found that finance companies are indeed big backers of small businesses, ranking as the second-most important institutional suppliers of credit to small firms. According to the SBA study, vehicle and equipment loans and capital leases are especially popular finance company offerings.

Their willingness to fund specialized equipment and offer longer lease terms and flexible payment plans is a primary reason for their appeal. At the same time, many small businesses have turned to finance companies because of dissatisfaction with the banking industry--the megabanks in particular--according to business growth strategist Andrew Sherman. "There isn't the loyalty to large commercial banks that there used to be. [With] all the mergers and acquisitions and the drop in customer service, many small businesses feel ignored," observes Sherman, co-founder of Grow Fast Grow Right Enterprises LLC, a Rockville, Maryland, training and education company for rapid-growth and middle-market companies. "These commercial finance companies have stepped in and tried to provide great customer service."

It's an opportune time for entrepreneurs to tap this growing capital source, adds Sherman. "More and more of these finance companies have popped up over the years," he says, "and that has made market conditions more competitive. And when market conditions are more competitive, that usually favors the borrower."

In addition to wooing small businesses with personal service and competitive financing rates, many of these so-called "nonbanks" now offer streamlined paperwork to ease access to financing. "The whole process just seems to go faster," Sherman says. "And if it can go faster, that can make a big difference for small-business owners."

MedHelp's lender, Butler Capital, can usually give businesses a credit decision in one to three days for transactions up to $500,000, while "a bank could [take] two to three weeks," says Joe Serio, executive vice president and COO of the Hunt Valley, Maryland, financing firm. "Because we understand the industries that we [lend to], we're considerably faster than your typical bank."

Perhaps most important, finance companies on the whole are more willing to finance "capital equipment, cars and other things that banks either won't finance or won't finance as [readily]," Sherman says. "Typically, it takes time for [banks] to cultivate relationships, and they would rather chase the larger borrowers."

What's more, Serio notes, banks often get hung up on what they're lending against: "The credit could be very strong, but they won't lend to that company because it's [buying] software," he says. "[If] the underlying credit is strong, what's the difference whether we would take back office furniture or computer software? It's the ability of the customer to pay back the obligation [that matters to us]."

Fewer Strings Attached
Along with being more open to certain types of transactions, finance companies are less likely to pressure borrowers for an additional piece of their credit business. Banks, on the other hand, are more interested in cultivating a long-term relationship with borrowers whose use of supplementary financial products, such as investment services, makes the lending relationship more profitable for the bank. Many banks even demand the business's deposits in return for financing. "If [the business uses] a finance company that only offers that one thing, there is less pressure to interrupt other relationships that may be in place," says Sherman. "You can walk in and do a stand-alone transaction without feeling pressured to do more."

Flexibility, of course, does have its costs. While commercial banks are one of the cheapest sources of capital for entrepreneurs, typically charging just one to two points above prime for small-business loans, financing companies charge higher rates. "We're higher than a bank," acknowledges Serio, whose interest rates can range from as low as 8 percent to more than 10 percent on larger transactions. "But with a bank, it [takes longer] to get the deal done."

For Johnson, however, the higher financing costs are a small price to pay for access to quick, convenient funding. "I have never looked at it from a financial charge [standpoint]. Butler [Capital] has been willing to go the extra mile to get it done, so we're more willing to pay a little bit more for that type of service. It's another option that's out there."

In addition to the higher credit costs, bear in mind that while there are many finance companies to choose from, not all are reputable. "Be really careful regarding due diligence," Sherman warns. "Find out their track record. Find out what they're going to be like if there's a default. Make sure you're not [doing business] with a shifty character that's been reported to the Better Business Bureau. Some of them are very, very good and have great reputations, but some of them just got started yesterday and may be a little shadier in their practices."

Serio concurs: "Whenever possible, you should talk to other clients that the finance company has done business with."

Micro-Cap Mania
Sometimes good things really do come in small packages. Take micro-cap stocks--stocks with a market cap of between $50 million and $500 million--which went up a whopping 72.3 percent over the past five years. It's easy to see why they're gaining investor attention.

Until recently, interested investors had to settle for purchasing individual micro-caps or a handful of mutual funds that play in the micro-cap arena. These are risky and high-priced options, respectively. But no more: The past six months have seen the launch of three exchange-traded funds, or ETFs, that make buying a basket of micro-caps both cheap and accessible. With expense ratios of 0.6 percent (vs. 1.58 percent and up for mutual funds), the iShares Russell Micro-cap Index fund, the PowerShares Zacks Micro Cap Portfolio, and the First Trust Microcap ETF each track a micro-cap index and employ stock screening to create a pool of 250 to 450 micro-caps.

Zacks Investment Management Inc., which licenses its micro-cap index to Powershares Capital Management, sees these ETFs as a valuable diversification tool for investors seeking a broad equity exposure. "Because there aren't as many institutional investors buying these stocks, their price movements are not as correlated with larger cap stocks," says Mitch Zacks, vice president and portfolio manager. "So they reduce overall risk in your portfolio."

Investors who've bought micro-caps individually in the past should consider an ETF, he adds. "When you buy into a $50 million market cap company that may only trade 100,000 shares a week, your purchase can actually move the market. [So] volatility can be huge, and liquid-ity can be an issue," explains Zacks. "If you put that same money in a micro-cap ETF, you can easily get in and out. Yet you're tracking the entire group, which should outperform the index over time."

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