How do you finance growth when you are already up to your eyeballs in debt? That was the challenge confronting the owners of Photogenesis Inc. of San Antonio, a $7.2-million-a-year photo and video equipment retailer that ranked #205 on INC.'s 1983 list of the 500 fastest-growing private companies in the United States. Last April, the company found itself with four bustling camera stores in San Antonio, Austin, and Midland, Tex., and plans to open at least two more. But with a debt-to-equity ratio of eight to one, the company was in no position to bankroll the expansion through further borrowings. "We needed to raise $200,000 to $300,000 to reach our near-term goals," says Roy Graham, the chairman and co-founder. "We knew that the best way to support our growth would be to beef up the equity."

As it happened, Photogenesis had raised $80,000 of equity in 1982 by selling 5% of its common stock to two key employees, but Graham and his two partners, all in their early 30s, were reluctant to go that same route again. In particular, they wanted to avoid any further dilution of either their ownership or their control.

So they came up with an alternative. They would raise the new equity by selling nonvoting preferred stock in a private offering to a group of selected investors -- their customers. "In the early days, each of us spent a lot of time behind the counter," says Graham. "We got to know several customers who were interested in our business. They bought cameras from us, and they liked to follow our growth."

A former division controller of Church's Fried Chicken Inc., Graham knew that the deal had to be structured to compensate investors for the risks involved. "We put ourselves in their shoes, we figured that the returns should be several points above money market rates," he explains.

In the end, the company decided to offer monthly dividends based on an annual rate of about 16% and, beyond that, a 3% share of net earnings, thereby allowing the investors to share in the success of the business. If an investor ever wanted to cash out, moreover, the company would "simply buy 7% of his preferred shares each month at par value," says Graham. The investor could thus liquidate his entire investment over a period of about 14 months.

Graham contacted several people about the investment opportunity last spring. Within three or four months, the company had raised $250,000 from two San Antonio investors -- a retired construction executive and a well-heeled professional in his early 30s. That money has enabled Photogenesis to pursue its expansion without a hitch. Last October, the company cut the ribbon on its third San Antonio outlet and a second store in Austin.

Graham is understandably pleased about all this. Although the costs to the company associated with preferred stock are not tax deductible (unlike interest payments on debt), the deal has filled a critical gap in financing the company's growth. "We needed a way to enhance our borrowing power," Graham explains. With the new equity, Photogenesis has access to a larger bank credit line and more liberal trade credit terms from equipment manufacturers.

At the same time, the company has carefully reserved the right to buy the investors out at any point in the future. It simply has to give them 30 days notice and pay a premium of about 20% above the amount of their investment. "This gives us a lot of flexibility if we find alternative financing sources at a lower cost," notes Graham. Down the road, for instance, Photogenesis might try to refinance the deal with a second class of preferred stock which would be tied to a less costly formula. For the time being, however, there are no such plans. As Graham puts it, "As long as we're generating in come in excess of what this money costs, we see it as a plus situation."