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Equity Financing Alternatives for Small Business: A Review of Best Practices in the United States

Executive Summary

This review of best practices of equity financing alternatives for small and medium-sized enterprises (SME) in the United States has been prepared in order to assist Industry Canada in developing public policy regarding small business financing. The review uncovered a number of programs, policies and processes in place that have allowed the United States to be the world leader in new innovation and entrepreneurial activities.

A simple framework was developed for the investment process. It consists of agents that provide equity financing at different stages in a small business' life cycle, incentives that assist the flow of this investment, programs that support the process, and systems that improve the linkages between those seeking financing and those offering it. And, finally, recent theoretical and empirical processes of the effectiveness of the various elements of this whole system are discussed.

Flow incentives are specific programs and initiatives that facilitate equity financing both in terms of individual decisions to invest and the overall amount of aggregate dollars available for equity investment. The following flow incentives were identified and reviewed:

• Small Business Investment Corporation (SBIC) Program
• Tax incentives for equity investors in small business
• Gains on qualified small business stock
• Rollover of gain from publicly traded securities
• Tax payer relief act of 1997

The SBIC program has increased the overall supply of equity finance capital. The program entices more people to set up venture capital funds. For example an investor with $10 million might receive another $30 million from the SBA to form an SBIC. These additional funds are not the only incentives for venture capitalists to form SBICs. Since 1994, many SBICs do not have to make interest payments to the SBA during the first few years of operations. As profits are realized the SBA will take up to 10% in lieu of interest payments. As a result new SBICs are not burdened with high interest payments while they invest in long-term opportunities. This recent regulation has prompted a "mini-boom" in SBICs during the past few years.^{Footnote 1}

While SBICs provide incentives for investors to increase the aggregate amount of equity investment directly available to small business, general tax incentives affect individual decisions to invest and increase the amount of funds available by reducing the tax burden on equity investors in small businesses. The tax policies and exemptions provide incentives for both individual and corporate investors to invest and reinvest in small business equities.

Flow support systems are initiatives or programs that allow entrepreneurs to access flow incentives in order to improve their chances of receiving equity financing. Support systems such as Small Business Development Centers (SBDCs), Business Information Centers (BICs), and the Service Corps of Retired Executives (SCORE) were reviewed. These support mechanisms provide much needed training in the area of business planning, financing consultation and other key management areas.

Linkage systems increase the accessibility of investors to entrepreneurs and vice versa. In addition, they increase the aggregate level of equity financing for small business. The larger the number of effective linkage systems in a given investment setting the more accessible risk capital is for entrepreneurs. Linkage systems include both securities exchanges, and also a variety of other entities fostered by innovative securities exchange exemptions.

There are a number of stock exchanges in the United States that serve small businesses. The major incentive for investors is the level of liquidity that is provided. As long as there is a secondary market for a specific stock, investors will be more likely to invest. Stock exchanges have quantitative and qualitative listing and maintenance standards and stringent reporting obligations, which are often deterrents for small businesses. In many cases, a small business simply cannot afford the costs associated with an initial public offering (IPO). However, successful SMEs with high growth potential can often finance IPO's through banks and venture capital companies.

By legislating securities exchange exemptions, many dating back as far as 1933, the US government has functioned as a catalyst in increasing the overall number of linkage systems within the entire equity capital setting. The impetus was provided for investors and entrepreneurs to develop new equity finance markets and networks beyond traditional securities exchanges. Also, many established exchanges now offer new services to small businesses as the level of demand for these investments continues to grow. It is also important to note that these government programs have been proactively adapting to new developments. In particular, Securities Exchange Commission exemptions led to an increased demand by investors for private placements. As a result, the government created ACENet to increase the level of interaction between private investors and entrepreneurs beyond the local environment. By adapting to new developments in information technology (i.e the Internet), ACEnet has provided an early model for the many online private investment networks that are now in existence and were reviewed in this report.

Key empirical and theoretical analyses are reviewed. Detailed copies of these, and other articles of potential are interest, are provided in the Appendices. The overall conclusion of these reports is that the various programs described above have been instrumental in causing a steady increase in the numbers of small businesses in the United States. In 1997 a record 842,000 new small employers opened their doors and new incorporations hit a record high for the third straight year^{Footnote 2}, and this rate of new business development shows no signs of slowing down in the future.

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