Every day I speak with small business owners and one thing is overwhelmingly clear to me – the system for financing and creating the expansion of small business and new jobs is broken. We all know that
small business is the number one piston in the U.S. economic engine and right now the piston – is stuck!
I have had several discussions with regional and community bank executives; and many banks’ existing capital for small business lending is still being tied up by an increase of capital reserves needed under the new regulation for commercial real estate loans. The regulation changes force the banks to allocate and increase capital held in reserve for each commercial real estate loan. This serves to “crowd out” money
that could have been used to finance smaller growing businesses. The real estate lending frenzy and the subsequent crash is still burdening the workhorse of our economy: “the small business”. In many
ways, I view current small business banking as having terms that resemble “modern loan sharking.”
Today’s small business loans are 50% or less, loan to value; they are short term; and who knows if credit
will be there to refinance when the year is over. Additionally, when you include loan costs and amortize those costs over the short term of the loan, it makes the money very expensive.
Small business growth finance needs precise planning and stable financing, as there is typically not a lot of
room for mistakes, the current loan terms make both of these key factors very difficult. This example of government regulation is one of many barriers that currently inhibit growth of small businesses in the United States. These include: decreased access to capital for small business, growth of government regulation that unfairly weighs on small companies, and money sitting on the sidelines due to uncertainties in the economy and government actions. Let’s focus in this article on the diminishing access to the capital markets and the high cost of capital that companies may be able to access through private equity.
What has happened to cause decreased access to capital? I believe it is a case of a paradigm shift in the
way such companies are financed. During the great bull markets of the 90’s and the earlier part of the last decade, small companies were able to successfully finance growth of their business and allow their initial seed and angel investor to find an exit strategy through an initial public offering. CFO magazine
in October of 2009 cited a Grant Thornton report discussing the IPO Market. The Authors of the report
utilized data from Dealogic and Capital Markets Advisory and they reported that:
From 1991 to 1997, nearly 80% of IPOs were smaller than $50 million. By 2000, the number of IPOs smaller than $50 million had shrunk to 20% of the market. More recently, toward the end of the lastdecade, “represents the worst IPO market in 40 years,” according to the report, which adds that “the trend that disfavors small IPOs and smallcompanies have continued.”
IPOs historically allowed the founders and the entrepreneurs who built these companies — at tremendous cost of time, personal financial sacrifice and effort — to keep a nice equity stake in the business
if they so wished. Fast forward to 2011: a financing on Wall Street of less than $50 million is unattainable due to legal and accounting fees required to meet increased regulations and reporting requirements. Due to the cost of going and remaining public, Wall Street’s doors on small business financing are closed.
Distinguished Professor of Law Stephen Bainbridge of the UCLA Law School stated earlier this year in his blog that:
“SOX-related costs do not scale well. As a result, the costs tend to be proportionately higher for smaller firms. Sarbanes-Oxley thus has become a barrier to entry protecting large entrenched firms.”
In March of 2011 CFO Magazine reported that:
“At the end of February, there were 5,091 companies listed on major U.S. exchanges, a 2% drop from 5,179 companies at the end of 2009 and a 42% decline from the peak of 8,823 in 1997.”
This void caused by regulation, placed venture capital and private equity in the driver’s seat, and what’s worse, they know it! Private Equity and VC Firms have filled only a portion of the void for small business growth capital that Investment Banks used to provide. They are one of the few and main sources of capital today for small companies that cannot get the growth capital from traditional banks.
The current situation goes something like this: Ernie Entrepreneur, who has a world-beater idea for a new solar cell design needs $15 million dollars to begin production and distribution of his patented new device. Ernie has put in seven years of his life and all of his energy into this project, along with a few
angel investors who have put over a $1 million dollars total into this venture. Now that it is time to take
this product to market – there really is no access to Wall Street through an IPO, as the amount required to raise just really does not justify financially (in the Investment’s Banker’s mind) their time or energy. Ernie’s regional bank wants 50% down and will only loan on hard assets, so he would have to somehow produce more than $7.5 million in equity, which is non-attainable. So Ernie presents his idea to a Smart Money VC firm (could also be Smart Money Private Equity) that loves the idea…but HERE is the catch – they will gladly fund Ernie’s concept as long as he gives up 70 – 80% of his equity in the deal.
Now Ernie will get paid a salary and to be fair, if he works REALLY hard over the next five years, he and the original founders, back when it was a startup, MIGHT get a combined extra 5-10% (but if thebusiness is successful there will be further diluted by an options pool demanded by the VC firm for future employees). However, their equity dividends will be net of all monies and interest that has been repaid to the VC lender, plus all VC management oversight fees and expenses. This effectively makes the hard driving entrepreneur, who raised the company from nothing, into not much more than an employee with options and very little dividend income. Compare that to Bill Gates and Paul Allen, who after their 1986 Microsoft IPO, STILL OWNED 70% of the company – where would their drive and passion have been had they been offered the current going rate in equity?
I firmly believe that this current model creates employees out of visionaries and stifles the creative energy and entrepreneurial drive that’s needed to build great companies! The long-term effect is not that entrepreneurs won’t exist any longer; it’s that they won’t be in the United States! Entrepreneurs and innovation are going to follow the capital and the environments susceptible to creating business.
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