WSJ: Pepperdine University showed that 64% of start-ups were turned down by banks when seeking loans.

By ROBBIE WHELAN

Keith Mullin’s start-up snack-food company, Gamer Grub, needs cash to become a player.

The San Diego company, which makes bags of high-energy snack food for videogame fanatics, recently struck a promotional partnership to sell its product at stores across the U.S. as part of the launch of “Call of Duty: Modern Warfare 3,” the country’s top-selling videogame. While more than 3,000 stores have agreed to sell the snacks, Mr. Mullin can’t get the funds he needs to hire workers and launch a marketing campaign.

In prior years, Mr. Mullin tapped his home-equity line of credit to inject cash into the business. But the credit line was canceled by his lender after the value of his home plummeted. That set off a chain of events that ended in Mr. Mullin losing his home. Now his business can’t find the funds to grow.

“On one side of the coin, things are great,” he says. “But on the back side of the coin, it’s fire and brimstone, and it’s just totally brutal.”

It is well known that the housing bust has taken a devastating toll on American families, nearly three million of which have lost their homes to foreclosure. Less known is the impact that the housing collapse is having on owners of small businesses, which have often relied upon home-equity borrowing to finance the early stages of growth and development.

American business history is packed with stories of company builders, from Wal-Mart Stores Inc.’s Sam Walton to Sam Adams beer brewer Jim Koch, who got key early funding from their homes. Nearly one in three small-business owners has borrowed against the equity in his or her home, or used the home as collateral for a loan to fund the business, according to a 2009 survey conducted by Gallup for the National Federation of Independent Business.

In recent months, there have been some signs that the housing market is bottoming out. That included three straight months of gains in single-family home construction, and a report in January showing that the inventory of for-sale homes is at its lowest level since 2006. But home prices, which need to rise briskly to revive home-equity lending, fell again in November, tumbling 1.3% from the previous month, according to the S&P/Case-Shiller index released Tuesday. They are likely to fall further over the next year. The balances of home-equity lines of credit and second mortgages have tumbled 27.5% since the end of 2007.

That leaves cash-strapped small businesses in a jam. Without the ability to borrow against their home, thousands of potential entrepreneurs will sit out the recovery. Most don’t have enough cash flow to get a traditional business loan from a bank. A recent study from Pepperdine University showed that 64% of start-ups were turned down by banks when seeking loans.

Mark Zandi, chief economist at Moody’s Analytics, estimates that small-business owners extracted around $75 billion from their homes to fund their businesses in 2006. That has fallen to as little as $20 billion now, and isn’t likely to rise much through 2012, he predicts.

Mr. Zandi took out a $40,000 business loan using his home in suburban Philadelphia as collateral in 1991 to start a predecessor company to Moody’s Analytics. These days, it would be difficult for others to follow in his footsteps, he says. “That is one more reason to be nervous that small businesses won’t be the source of job growth they have in past economic recoveries,” he says.

The situation could get worse. Owners of start-ups are believed to have taken out risky mortgages at a higher rate than typical homeowners, putting them at a higher risk of losing their homes and their businesses over the next couple of years. Samuel Bornstein, an accounting professor at Kean University in New Jersey, and private consultant Jung Song have done research that suggests 3.7 million small businesses took out exotic loan products such as option-adjustable rate mortgages and interest-only loans. They estimate more than 500,000 are at risk of defaulting in the next few years as their monthly mortgage payments spike after these loans reset and require both principal and interest payments.

Adrian Pelkus, a San Marcos, Calif., business owner used home-equity loans to fund at least six start-up businesses in the past 15 years. He started his flagship company, A Squared Technologies Inc., which makes circuit boards for electronics manufacturers, with a $10,000 loan against his home in 1985.

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