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

9. Flow Incentives in the US

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. While the previous section dealt with generic flow incentives regarding individual investment decisions, this section summarizes federal programs that provide direct incentives for equity investors to increase the amount of investment dollars* they have available to small businesses.

9.1 Government Initiatives

The United States government has implemented a number of initiatives in order to facilitate the growth of small businesses. In addition to federal programs there are a number of State programs and regulations, also known as Blue Sky laws. There is also a wide diversity of programs county and municipal level; however, only federal laws and a few State regulations will be discussed in this review. In most cases state and municipal programs are extensions or compliments to federal policies.

9.1.1 Small Business Investment Corporation Program^{Footnote 7}

In 1958 the US federal government developed a program in which public venture capital is funneled to privately owned venture capital companies called Small Business Investment Corporations (SBICs). During the past 40 years SBICs have provided $20 billion in funding to small businesses. Some of the more successful examples include Intel, America Online, Staples, Apple Computer, Federal Express, Sun Microsystems and Callaway Golf.^{Footnote 8} The SBIC uses a combination of private funds and funds borrowed from the federal government. SBICs provide equity capital, long-term loans and management consulting to eligible small businesses. Loans and securities for less than five years are unusual, while fees, interest rates, and returns are regulated by the Small Business Administration.

An SBIC may receive leverage equal to 300 percent of its private capital. In addition, an SBIC with at least 50 percent of its "total funds available for investment" invested or committed in "venture capital" may receive an additional tier of leverage equivalent to 400 percent of private capital, not to exceed $ 90 million. A private capital investment of $5 million is required for most SBICs, while $10 million is required if an SBIC intends to use securities for its capital base. In some cases SBICs issue debentures, which are guaranteed by the SBA. Pools of these debentures are formed and sold to investors through a public offering. SBA guaranteed participation certificates representing an undivided interest in the pools are provided to investors.^{Footnote 9}

In essence SBICs function similar to a venture capital firms providing financing for existing growth oriented businesses. However, it is stated in SBA literature that SBICs seldom invest in start-ups in order to limit exposure. SBICs must provide annual financial reports and are subject to onsite evaluations by the SBA. SBA regulations also control investment approval processes and operating procedures. For example, SBICs are not permitted to control any business on a permanent basis. Currently, there are approximately 330 active SBICs in the US.^{Footnote 10}

The SBIC program has increased the overall supply of equity finance capital in two ways. First, the SBIC 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. 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 11}

Second, investors (both individual and C corporations) purchasing shares of an SBIC are eligible for tax breaks and rollovers discussed in detail in the next section.

Specialized Small Business Investment Company (SSBICs) operate similar to SBICs, however, they can access additional government financial assistance by focusing their investment activities towards new ventures owned by visible minorities or "economically disadvantaged" entrepreneurs.^{Footnote 12}

Disbursements to small businesses by SBICs were approximately $1.85 billion in 1996. The increase of $630 million over 1995 came as a result of new programs to promote the formation of larger SBICs. Investment by SSBICs was $117 million in 1996.^{Footnote 13}

Further Information: http://www.sba.gov/INV/overview.html

9.2 Tax Incentives

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 following tax policies and exemptions provide incentives for both individual and corporate investors to invest and reinvest in small business equities.

9.2.1 Gains on Qualified Small Business Stock^{Footnote 14}

A qualified small business stock is a stock that meets all the following tests:

• It must be stock in a C corporation* during the time the stock is held.
• It must have been issued after August 10, 1993.
• The corporation must be a qualified small business**
• The stock must have been acquired at its original issue.
• The corporation must meet the active business test***
• Within the period beginning 2 years before and ending 2 years after the stock was issued, the corporation cannot have bought more than a "de minimis" amount of its stock from the seller.
• Within the period beginning 1 year before and ending 1 year after the stock was issued, the corporation cannot have bought more than a de minimis amount of its stock from anyone, unless the total value of the stock it bought is 5% or less of the total value of all its stock.

* A C corporation is the most common type of corporation US. Once incorporated the C corporation becomes an entity in itself and its common shareholders do not hold liability for its actions.

** A qualified small business is a C corporation with total gross assets of $50 million or less at all times after August 9, 1993, and before it issued the stock. The corporation's total gross assets immediately after it issued the stock must also be $50 million or less.

*** The active business test attempts to prove that at least 80% of its assets in the active conduct of at least one qualified trade or business, which include:

• Services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services,
• Principal asset is the reputation or skill of one or more employees,
• Any banking, insurance, financing, leasing, investing, or similar business,
• Any farming business (including the business of raising or harvesting trees),
• Any business involving the production or extraction of products for which percentage depletion can be claimed, or
• Any business of operating a hotel, motel, restaurant, or similar business.

All corporations are eligible except:

• A Domestic International Sales Corporation (DISC) or a former DISC,
• A corporation that has made, or whose subsidiary has made, an election under section 936 of the Internal Revenue Code, concerning the Puerto Rico and possession tax credit,
• A regulated investment company,
• A real estate investment trust (REIT),
• A real estate mortgage investment conduit (REMIC),
• A financial asset securitization investment trust (FASIT), or
• A cooperative.

Note: All Specialized Small Business Investment Companies (SSBIC) are treated as passing the active business test.

Rollovers

Owners (excluding C corporations) of a qualified small business stock may be able to rollover gains tax-free or exclude part of the gain from their income under the following conditions:

• The stock was issued by a qualified small business after August 10, 1993.
• The stock must be held for more than 6 months prior to rolling it into another qualified small business stock.
• The replacement stock is purchased during the 60-day period beginning on the date of the sale.
• The replacement stock is a qualified small business stock.
• The replacement stock continues to meet the active business test for small business stock for at least the first 6 months after it is purchased.

Rollover example: If an investor makes a $10,000 gain on a qualified business stock, he can avoid capital gains taxes by investing in another qualified small business within 60 days. Only when the investors completely liquidates his investment will he have to claim a capital gain. For example, if the investor decided to liquidate his position in the second small company and made an additional $30,000 gain on the second investment and then he would have to claim $40,000 in capital gains. The incentive is delaying the gains as long as possible because the value of any gains is reduced by time. Thus, the present value of the taxes paid is reduced. In other words, the incentive for the investor lies in the fact that he can transfer gains from one investment to the next without being taxed.

Exclusion of Gains

Since 1998, sellers of qualified small business stock have been able to exclude from taxable income one-half of the gain from the sale or exchange of stock held for more than 5 years. While this exclusion is not allowed to C corporations, special rules apply when a partnership, S corporation, regulated Investment Company, or common trust fund holds the stock.

The exclusion of gains from the sale of any one stock is limited the greater of:

• Ten times the basis in all qualified stock sold or exchanged during the year, or
• $10 million ($5 million if seller is married and files a separate return) minus the amount of the excluded gain from the stock of the same issuer in earlier years.

For example, an investor sells his position in a qualified business stock held for more than 5 years for a gain of $20,000. The amount that he would have to pay taxes on would only be $10,000.

9.2.2 Rollover of Gain From Publicly Traded Securities^{Footnote 15}

A rollover of gain from publicly traded securities is a postponement of part or all of a gain from selling securities. The following criteria must be met in order to qualify:

The seller must:

• Sell publicly traded securities (on an established securities exchange) at a gain.
• Purchase replacement property within 60-days of the date of the sale.
• Replacement property must be either common stock or a partnership interest in a specialized small business investment company (SSBIC).

The amount of gain postponed is equal to the gain realized on the sale of securities minus the amount invested in the SSBIC. If the amount reinvested is equal to or more than the gain, the full amount of the gain must be used in the rollover. The limits on postponed gains per year are as follows:

The smaller of:

• $50,000 ($25,000 if seller is married and files a separate return), or
• $500,000 ($250,000 if seller is married and files a separate return), minus the amount of gains postponed for all earlier years.

9.2.3 The Tax Payer Relief Act of 1997

Prior to 1997, individuals paid tax on net capital gains at a maximum of 28%. The Tax Payer Relief Act of 1997 generally lowered this rate to 20% and created a new 10% rate for special circumstances.

The net result of these taxes incentives and other programs has been 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 16} Empirical data will be fully discussed in Section 12 later in this review.

* All figures in this document are in US dollars unless otherwise stated.