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Why It’s Getting Harder, and Riskier, to Bet the House

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In March 2008, about nine months after he bought a steel-processing business, Precision Steel Services in Warren, Mich., for some $750,000, Shailesh Kumar went to two banks in search of a $350,000 loan.

He wanted to expand the business and pay off a $290,000 debt he had with the seller, replacing an 8 percent, seven-year debt with a 6.5 percent, 20-year loan. “It would have made a huge difference in terms of cash flow and growth capital,” Mr. Kumar said.

But both lenders he was negotiating with demanded that Mr. Kumar put up equity in his own home as collateral. Mr. Kumar hesitated, and then as 2008 wore on, he watched the value of his home fall to $330,000 from $425,000, wiping out all of his equity. Eventually, the banks broke off negotiations. With no cash on hand and revenue down by some 60 percent during the first half of 2009, Mr. Kumar closed Precision Steel in July 2009. Today, he runs an investment advice Web site, Value Stock Guide.

The collapse of the housing market has highlighted how entrepreneurs are routinely compelled to bet the house on their businesses. For many, taking the risk is tempting because their home may be their largest asset and loans against home equity are easier to find than business loans. Also, such loans come at lower interest rates than most alternatives. They can also allow a business owner to avoid giving equity to investors.

Using data from Barlow Research Associates, a Minneapolis company that conducts quarterly financial surveys, Scott Shane, a professor at Case Western Reserve University, estimated that from 2001 to 2006, the percentage of small business owners who tapped their home equity for business, either by pledging their homes as collateral or by borrowing against home equity, rose to 27.5 percent from 18.4 percent.

"In normal times, there would be a movement to use home equity to shore up losses and sagging sales. The problem that has occurred is that no one’s doing home equity loans, especially on marginal cases where the owner’s business is in trouble." -founder, American Management Services, George Cloutier, 

Sometimes, owners have no choice. The Small Business Administration’s 7(a) loan program, for example, “requires that if there is collateral available to make a fully secured loan, the bank lender has an obligation to get it as collateral,” said Steven J. Smits, associate administrator for the office of capital access at the S.B.A. Many lenders require owners to show that they are serious by putting up cash — often from home equity loans. “The standard in the industry is lenders want skin in the game,” Mr. Smits said, “and 20 percent is a safe rule of thumb.”

These days, however, the drop in home prices means that fewer owners have the home equity option. And while there is no way to determine the precise numbers, that drop has undoubtedly restricted the ability of owners to obtain financing to start, expand or maintain a business.

“The biggest problem is that revenues of the great majority of small businesses have gone down from between 10 percent and 70 percent,” said George Cloutier, founder of American Management Services, an Orlando, Fla., consulting firm that specializes in financial turnarounds for small and midsize companies. “In normal times, there would be a movement to use home equity to shore up losses and sagging sales. The problem that has occurred is that no one’s doing home equity loans, especially on marginal cases where the owner’s business is in trouble.”

Some worry about the impact this inability to raise capital and start businesses and hire employees might have on the economy; others wonder whether it ever makes sense to demand this level of commitment from entrepreneurs.

“Most start-ups in the U.S. economy are not suitable for venture capital finance,” said David T. Robinson, a professor of finance at the Fuqua School of Business at Duke. “So it’s probably the best system we’ve got. But it’s certainly an inefficient system, because if I have a great idea but no home, and you have a lot of home equity but no ideas,” the two sides are out of luck.

For many entrepreneurs, risking the house demonstrates a passion to succeed. Zalmi Duchman, 31, took a $100,000 home equity loan on his Surfside, Fla., condo and in 2006 used $5,000 of it to start the Fresh Diet, a gourmet meal-delivery service. (He used the rest for living expenses while building the business.)

About 18 months later he took out an additional $200,000 to match with a $900,000 S.B.A. loan that he used to buy a competitor with operations in Miami and New York. “I don’t think I would have gotten the S.B.A. loan without my condo,” said Mr. Duchman, who expects the Fresh Diet to bring in $30 million in revenue this year. “I wouldn’t have grown the way I did.”

Others see taking money out of the house as excessively risky. Philip Patrick, founder of PharmaStrat, a pharmaceutical consulting firm in Flemington, N.J., started his company in 2002 with $5,000 and says he has had a profit since its first quarter.

This year, he sold his business, which had annual revenue of $5 million, without ever having borrowed against his house. “I think some entrepreneurs, when looking for money, pitch that as a positive: ‘Look how much faith I have! I’m betting down to the last nickel!’ ” he said. “But I think that’s a negative. I don’t want to invest in someone who’s down to the last nickel.”

Betting the house can be especially uncomfortable for the spouses and families of entrepreneurs. After Rick Sanchez lost his job at a film postproduction house in 2006, he and his wife, Tara Zucker, decided to take $55,000 from a home equity line of credit to buy equipment and start their own postproduction business.

Post Haste Media of North Hollywood, Calif., did well at first, and they were able to pay off half the loan. Then, in 2008, the economy declined and they had to take out more money. “For me, it was an exciting prospect, though it was scary,” said Mr. Sanchez, 58. “For my wife, it was a lot more difficult. She’s a lot more conservative with money and worries a lot more about it than I do. It took a lot of working on those issues between the two of us.” When they paid off the loan in 2010, Mr. Sanchez said, “it was a great relief.”

Not every loan has a happy ending. In 2001, Linda Frakes, of Cumming, Ga., decided to buy a franchise in the Curves health club chain. By 2004, she owned eight. But Curves began to fall out of favor, and in 2005, Ms. Frakes refinanced her home twice to take out $155,000 in home equity and invest it in keeping the franchises running while she tried to sell them. “I was having trouble making payroll,” she said.

Ms. Frakes wound up selling her franchises for far less than the $150,000 to $200,000 she had expected to get for each of them. She eventually closed two locations and sold the remaining six in three sales for a total of $500,000. At the end, she was left with $80,000 in cash.

Laden with about $250,000 in business-related credit card debt on which she was paying $4,000 a month, a $3,500 mortgage payment, and little income, Ms. Frakes held on for about six months before she stopped making mortgage payments in spring 2008. She declared bankruptcy and then lost her home in late 2009. “I explained to my son the 15-year-old’s version of bankruptcy, and his only question was, ‘Are we going to have enough money for food?’ ”

Now 56, Ms. Frakes wrote a book about her experience and today owns Health Fairs Onsite, a company that puts on health fairs at corporate locations nationwide. It is 100 percent bootstrapped. “I don’t have any credit, you know?” she said.