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Equity Financing Alternatives for Small Business: A Review of Best Practices in the United States
12. Summary of Empirical and Theoretical Analyses
In addition to reviewing government and private initiatives, recent empirical and theoretical analyses of small business equity finance in the US were also reviewed. All figures are in US dollars unless otherwise stated.
12.1 Empirical Analyses
12.1.1 The Annual Report on Small Business and CompetitionFootnote 23
Published in December 1998 by the Office of Advocacy for the Small Business Administration, this report details the state of small business in the US during 1996. Of particular importance is the equity financing section in which aggregate financing figures are represented for 1995. A portion of table 2.1 from this document is represented below.
In addition, the following table displays the growth in Public Offerings of small businesses with less than $10 million in total assets before the offering over the past few years.
| Number | Value (in millions) | |
|---|---|---|
| 1996 | 291 | 5686 |
| 1995 | 187 | 3129 |
| 1994 | 190 | 1975 |
| 1993 | 189 | 2043 |
12.1.2 A Survey of High Technology FirmsFootnote 24
This survey was commissioned by the SBA in 1998 and was presented in February 1999. A study of small high technology firms financing habits reveals that almost 40 percent of companies responding to the survey rely on unaffiliated individuals, most likely angels, for equity financing (see 12d). The research summarized in the tables below (12c and 12d) indicates that 56.1% of firms who used equity finance used it to provide at least 76% of all their financing requirements (see 12c). The authors also stated that, although not readily apparent in the tables below, a full 30% of those companies that relied on equity relied on equity for 100 percent of their financing needs. Table 12c reports the mix of financing for small firms between equity, short term and long term debt. It is apparent from table 12c that when small businesses require supplemental financing — that is, when the financing sought is only a small percentage of total funds available to the company — the preferred method is through debt instruments. However, when funds being sought by a small business represent the majority of funds available, the chosen method of finance is often equity .
Table 12d further summarizes activities for those who have chosen equity to finance their small businesses. The use of "Unaffiliated Individuals" (angels and type II investors) and VCs are summarized. Banks have been included to provide a comparison. In most cases bank financing is debt oriented.
12.1.3 Small Business Administration Annual Data Reports
In regards to SBICs the amount of investment has been growing dramatically since, 1994. The following table represents SBIC and SSBIC investments from 1994 to 1998.
It is interesting to note that the average investment for an SBIC in 1997 was approximately $880,000 while the SBA estimated that the average venture capital firm's average investment was $6.8 million. According to the SBA this "demonstrates the SBIC Program's success in addressing the otherwise unmet needs of American small businesses for venture capital in the $500,000 to $5 million range."Footnote 25
The data in the following tables was released in early December 1999. A survey of all SBICs was conducted to review performance over the period of October 1998 through September 1999.
| Year | Amount (Millions) |
|---|---|
| 1998 | 417.1 |
| 1997 | 439.7 |
| 1996 | 400.7 |
| 1995 | 369.2 |
| 1994 | 115.0 |
| 1993 | 86.8 |
| 1992 | 84.4 |
| 1991 | 88.4 |
| 1990 | 75.4 |
From the information in the above tables it is apparent that the level of financing provided by the government to SBICs is having a dramatic effect on the level of financing available to small business.
12.2 Qualitative - Theoretical Review
This section will summarize and review a number of articles devoted to both the key issues of small business equity financing and the general business environment in the United States that allows capital to flow freely to small businesses in high growth sectors. Sources were selected from government, academic and business periodicals and stand-alone reports.
12.2.1 Business Environment in the United States
While there have been countless articles written about the entrepreneurial culture found in the United States, the following articles were selected as important to this study for two reasons. First they are recent articles about the state of small business in the US, and second, they provide new ideas as to where the business environment is headed in the future.
The State of Small Business: A Report to the President.
Small Business Administration
1998
This report presented to President Clinton describes the excellent climate for small business growth in the United States. In terms of financing the report states: "The availability of equity financing, especially for fast-growing firms, continued to expand in the booming economy of 1996. Both initial public offerings and private venture capital reached historically high volumes. The availability of informal equity capital from accredited investors is also believed to have increased significantly".
Models for Success: State Small Business Programs and Policies
Small Business Administration
1999
Again, the fact that state and federal governments have helped to create a positive environment for small business is related; however, there seems to be an urgency to increase efforts to reduce unnecessary regulations on small business activities. Models for Success recommends specific measures for "creating an environment in which all businesses will have the opportunity to compete effectively and expand to their full potential." This comprehensive document outlines how the states can improve their regulations regarding small business growth and prosperity. Included in the report are suggestions as to how to facilitate the expansion of venture capital activities and government programs to increase the further the financing of seed and start up ventures. Many examples of successful state policies and programs are offered as guides to those states that have not yet adequately addressed the importance of accessible financing and support for small businesses to economic prosperity.
The New Economy is Stronger Than you Think
Sahlamn, William A
Harvard Business Review
Nov/Dec 1999
Sahlman states that the American economy is stronger than ever and more likely to continue its dominance in the world economy. The reason that the United States has continued to not only prosper from, but also to create the New Economy is it admiration for entrepreneurs and its extremely high tolerance for failure. In what he calls "the American Way", the author argues that Americans' "love affair with entrepreneurs" has created a culture in which failure is not only expected but has become considered by many to be "good experience" for future endeavours. As result, capital flows very easily to new ideas, especially entrepreneurs starting up companies in high growth, high tech areas.
Bringing Silicon Valley Inside
Hamel, Gary
Harvard Business Review
Sep/Oct 1999
In 1998 Silicon Valley produced 41 IPOs with a collective market capitalization of $27 billion. Hamel argues that in the New Economy newcomers are responsible for creating much of the wealth in most industries. Entrepreneurship is beginning to take precedence over stewardship as the primary characteristic of running a business. Silicon Valley's success should not be attributed to a group of intelligent business people with skills well beyond those found in other regions. The success of these companies should be attributed to the region's business model. He argues "in Silicon Valley ideas, capital, and talent circulate freely, gathering in whatever combinations are most likely to generate innovation and wealth". In 1998 each worker in Silicon Valley created $54,000 in new wealth. Although the main theme of the article is how larger companies can "bring Silicon Valley inside", its exploration of the innovative and entrepreneurial characteristics of Silicon Valley is an important piece of recent research into the New Economy and how companies (and governments) can adapt. The article is especially important for policy makers as they may take some of the lessons prescribed to big business and project them onto their own circumstances. Understanding the re-emergence of entrepreneurs as the dominating force in business is important for effectively developing policies directed at facilitating a new model of freer flowing capital.
A Push for Small Companies
Business Week
May 31, 1999
This short article contends that for the US to maintain its dominance, it must continue to facilitate open markets and loose regulation. Open markets increase competition and give rise to new ideas and new successful businesses. The US culture is one that rewards entrepreneurs, while the lack of government regulation is the primary cause for the rapid expansion of small business. These are also the reasons that capital flows more freely to small businesses than anywhere else in the world.
Social Capital and Capital Gains in Silicon Valley
Cohen and Fields
California Management Review
Winter 1999
In short, social capital is the set of elements found in a vibrant civil society that evolve over time due to the interaction of different parties within the systems. On page 2 of the article the author states: "In Silicon Valley, social capital can be understood in terms of the collaborative partnerships that emerged in the region, owing to the pursuit by economic and institutional actors of objectives related specifically to innovation and competitiveness." The author argues large amounts of social capital are being amassed in Silicon Valley through the productive interaction between:
- Research Facilities
- US government Policies
- Venture Capital
- Law Firms
- Employee Stock options
- Labour markets — specifically high turnover is a valuable quality, recruitment from a global applicant pool, and good people who leave big companies to form start-ups are deemed "heroic".
- Business Networks " leaders of most the cohorts above (law, VC, government, etc) all know and interact with each other.
- The Nature of the Industry — Silicon Valley embraces intellectual property and the employment contract, while industries such as steel embrace unions.
The key to any well performing region, particularly those focused on new economy activities such as information technology, is the establishment of a performance-focused trust between its citizens.
Power to the People
Nocera, Joseph
Fortune
Oct, 1999
The author argues that the proliferation of a 'culture of investing' has been the primary cause of the "Bull" market throughout the 1990s. Investing in stocks and trading salaries for stock options has been a part of the entrepreneurial culture in America for a long time and is one of the major reasons why capital is so easy to access in the US. Although the article simply describes the author's experience in a Rhode Island town, it clearly displays the attitudes of regular citizens towards investing and the business environment.
Other Notable Articles on the business environment in the US are:
High Velocity
Hormats, Robert
Harvard International Review
Summer 1999
Helping Small Business Succeed: SBA Financial Plan 2000
US Small Business Administration
1999
Financing Small Business
Small Business Administration
Forthcoming in 1999 or 2000
12.2.2 Understanding the Financing Process
Various topics from direct private placements to formal venture capital are summarized.
Why do Business Angels Say No: a case study of opportunities rejected by an informal investor syndicate.
Mason and Harrison
International Small Business Journal
Jan-Mar 1996
Although the article is a bit dated (1996), it drew on earlier research of angels in the United States. While Angels have a much higher acceptance rate than VCs, they reject the majority of opportunities they investigate. They are different than the type II investor discussed in this review as they are "generally experienced investors that have a fair degree of financial acumen". Angels tend to invest in sectors in which they have a deep understanding and are motivated first and foremost by high capital appreciation. In the beginning of the investment process the attractiveness of the industry takes precedence, while the focus towards management competency becomes dominanat as the relationship proceeds. The top three "deal killers" are: 1) inability of management team; 2) inappropriate marketing plan; and 3) a suspect financial plan.
How to Finance Anything
Andresky Fraser, Jill Inc.
March 1999
The author argues that the state of the capital markets is not all positive. She argues that the age of entrepreneurs receiving easy money is gone and although she offers such terms as "overheated" and "dried up" to describe the capital market in the US, she offers 20 tips on raising money. Although this authors of this review disagree with Fraser's assessment of the capital markets. she makes some good comments and provides a different view of venture capital. As a result of new found reluctantly to invest in "anything dot com". Venture capitalists and Angels are scrutinizing their investments more closely than before. The result has been better deals for venture capital as entrepreneurs compete with each other for less funds. Fraser contends that the VCs will likely continue this process and that it will become internalized into the industry. Included in her 20 tips to raising capital are guaranteed loans from the SBA, private equity from friends and family, private equity from Angels, online equity markets, corporate investors, international investors, and others.
SCORE's Impact on Small Firms
Broome Jr., JT
Nation's Business
Jan 1999
The Service Corps of Retired Executives (SCORE) has a network of 389 chapters with over 12000 active volunteers. The impact on small businesses has been dramatic. The article offers a few testimonials in which SCORE mentors have not only readied entrepreneurs to open for business but have assisted them in acquiring financing.
Financing for Do-It-Yourselfers
Reynes, Robert
Nation's Business
May 1998
Small Company Offering Registrations (discussed in section 11.2.4 in this review) have become more popular after their slow start in 1990. SCORs take advantage of Rule 504. The author argues that affinity groups, groups with similar interests, should be the target market for SCOR marketing. Such groups include customers, suppliers and others. In many cases the SCOR can function as a Direct Public Offering (DPO) or can become the catalyst to a much wider DPO through other newly forming channels.
Fragmentation in the Market for Venture Capital
Fiet, James
Entrepreneurship Theory and Practice
Winter 1996
Although it is an older article is it relevant to the current review as it outlines the concept of competition between Angels and VCs for equity investment opportunities. The article recognizes that there is a lack of market intermediaries responsible for: 1) documentation of investment opportunities; 2) introducing entrepreneurs to investors; and 3) providing and aura of fairness and responsibility to the investor (screening and credibility). It is interesting to note that the article was written in 1996 and that these intermediaries have been growing in number due primarily to improvements in information technology. Traditionally, VCs received the best investment opportunities because they have the best information systems. However, angels are now improving their information channels and are gaining access to better opportunities. Now VCs and Angles often compete for the same deals. Although the article is bit technical in its description of the two market players, its note on the importance of fragmentation to the competitive nature of equity finance markets is relevant to the topic at hand.
Easier Access to Equity Capital
Evanson, David
Nations' Business
Jan 1998
Another article discusses SCOR as a great "starter" to acquiring equity financing. SCORs are often overlooked as inexpensive methods of acquiring financing. One important point of the article is that the SCOR can provide the impetus for large scale financing. Once a SCOR has been successfully floated the stock then can be traded on various DPO markets and the NASDAQ over the counter bulletin board. If this is stated as part of the plan, investors will be more likely to invest given its increased liquidity in the future.
How Venture Capital Works
Zider, Bob
Harvard Business Review
Nov/Dec 1998
The author argues that the majority of venture capital does not flow towards new innovations but to follow up funding and technology commercialization. Venture capital firms invested $10 billion in 1997 while only 6% went to start-ups. One different viewpoint of the article is that VCs do not invest in people as much as they do in chosen industries. The article details how VC investment deals can be structured differently. He also outlines the benefits and risks for both parties of an equity finance arrangement. Because venture capital is such a small part of the over all financing picture (i.e. debt is by far the largest component) it has the potential to grow exponentially in the future.
Inside the Silicon Valley Money Machine
Warner, Melanie
Fortune
Oct 26, 1998
The article reviews the practices of the most successful venture capital firm in Silicon Valley. Kleiner Perkins was the founder of the VC industry in California and invested in early ventures such as Netscape, AOL, Amazon, and others. The relevance of the article is not the company's success in securing equity financing deals, but in how it networks all of its investment companies together to increase the likelihood of a successful venture.
Dollars from Heaven: A choir of angels bedevils the VCs
Karlgaard, Richard
Forbes
June 1998
Due to the success of IPOs and the equity markets there are now more Angels than ever before. Microsoft, for example, has created at least 5000 millionaires. Th author reports that in 1997 "angels" invested $50 billion into new ventures in the US. Family and friends invested $40 billion while $10 billion was invested by "serious" angels. The author argues that angels are most compatible with seed capital and that the growth of angel investing is creating much needed competition with VC firms. This trend is likely to continue considering the growth of the American IPO market. Angles and VCs are now vying for the best investment opportunities and are creating more efficient capital markets.
Three Keys to Obtaining Venture Capital
PricewaterhouseCoopers LLC
http://www.pwc.com/moneytree
This is an important document for entrepreneurs to review when seeking venture capital. In order to effectively tap VC funds, entrepreneurs must first understand the process.
Other exceptional articles regarding the investment process in the US are:
Angels in the Valley
Malone, Michael
Upside
Apr 1997
Another Face for Venture Captialism?
Fox, Loren
Upside
Oct 1999
Small Wonders: Many of today's hot growth companies received early financing from SBICs, "the best kept secret in Washington".
Korn, Donald
Fiancial Planning
Aug1, 1999
Capital Ideas for Financing
Nelton, Sharon
Nation's Business
Sep 1996
12.2.3 Newly emerging Forms of Venture Capital
Private Equity Turns Inside Out
Korn, Donald
Financial Planning
Nov 1999
The article reports the new trend by the mass market of investors to invest earlier than the IPO stage to take advantage of massive returns being accumulated by VCs. "Online private equity marketplaces" are being erected at an alarming rate where informal (yet accredited) investors not previously involved in VC or Angel activities, are now getting more involved in the equity financing of start-up companies. This new development in equity finance in the US is primarily a result of analysts forming online networks where people can buy directly into SMEs. By providing quarterly valuations of the private stock, not only do investors receive more information than ever before, but the stock also become eligible for IRA investments, which is the equivalent of RRSPs in Canada. In effect, this new trend is bringing private equity investing to the masses of accredited investors who would otherwise only be active in public markets.
Community Development Venture Capital: creating a viable business model for the future.
Jegen, David
Nonprofit Management and Leadership
Winter 1998
Community Development Venture Capital firms (CDVC) are a rapidly growing trend in the US. These companies must balance financial and social returns in their investment activities. In effect, the nonprofit sector has borrowed a successful model from the private sector. By making profit oriented decisions investments in communities can be self-sustainable in the long term. In 1998 there was approximately $299 million in CDVCs. Most target their funds towards particular geographical areas, while other target primarily minorities. The investment challenges of 9 CDVCs are chronicled. Although it is apparent that CDVCs do not get choose from the more attractive opportunities, they are filling an important role by providing profit oriented equity finance to undeserved areas.
BankBoston Development Co. Strikes a Chord in Urban America
Lau, Deborah
Venture Capital Journal
May 1999
This article details how one Bank's venture capital fund has been successfully addressing the policies of the 1997 Community Reinvestment ACT which encourages banks to invest in the communities in which they operate. This bank is employing traditional venture capital techniques while seeking traditional venture capital returns. This "no handouts" type of investment has been quite successful to date. For those businesses that do receive funding and have high growth potential there is an immediate link between the Bank owned VC and it's larger partner The Bank of Boston.
Venture Capital
Duffy, Tom
Computerworld
Oct 11, 1999
The article outlines the new trend of large corporations to enter into the VC market. Not only are they looking for the high returns found in the industry, but more importantly they are looking to secure access to new technologies. There are approximately 500 VC firms in the US managing over $330 billion worth of investments. Notable large companies to recently enter the market are GE capital, Motorola, and the Central Intelligence Agency (CIA). The author points out that most VCs want to provide more that just investment dollars, and as a result must have a local presence in the economic cluster of choice.
Can Big Companies Nurture Little Companies
Fazio, Regina
Harvard Business Review
May/Jun 1999
The author argues that new corporate VC "units" are a welcome addition to the venture capital industry as yet another equity finance option for is available to entrepreneurs. The study reviews the success of corporate venture capital and compares it to traditional firms that are smaller and more flexible. She concludes that corporate VCs have fewer but lengthier review process, deeper managerial experience to transfer to the new venture, and better networks to ensure initial success of its investments. Entrepreneurs who use large corporate venture capital must be aware of these factors and the likelihood of the business being acquired in the future.
12.3 Summary
The preceding empirical and theoretical review examined not only some of the results of various government and private initiatives but also reviewed some of the US's top academic opinions regarding these policies and the state of small business. The general opinion is that the United States has developed an environment that provides ample equity investment funds for growing small businesses. Although the existence of the numerous programs and policies summarized in this review has allowed small businesses to flourish in the US, there also seems to be a continued demand to see even more policies that facilitate freely flowing funds from investors to small business with little or no government intervention.
While access to financing is one of the most important factors in determining the success of small business growth in any country, equity financing is arguably the most important form of funding for businesses with high growth opportunities. A direct result of its entrepreneurial business culture, the United States has been extremely proactive in developing policies that facilitate the flow of equity financing to small businesses. The continuous high growth in both the numbers of small businesses and their contributions to employment, GDP and the tax base in the US has provided ample proof that SMEs are thriving south of the border.
