Make the SBA More Responsive to the Unique Nature and Needs of Startups
The Small Business Administration (SBA) administers several programs to support new and small businesses, including loan guaranty programs to enhance small business access to capital; programs to increase small business federal contracting opportunities; direct loans for businesses, homeowners, and renters to assist their recovery from natural disasters; and access to entrepreneurial education to assist with business formation and expansion. The SBA also administers the Small Business Investment Company (SBIC) program (see below).
The SBA’s Technology Program Office also administers the Small Business Innovation Research (SBIR) Program and the Small Business Technology Transfer (STTR) Program. Through these two competitive programs, the SBA ensures that the nation’s small, high-tech, innovative businesses are a significant part of the federal government’s research and development efforts. Eleven federal departments participate in the SBIR program, five participate in the STTR program, awarding $2 billion to small high-tech businesses.
Congress should instruct the Small Business Administration (SBA) to establish a formal framework for ongoing dialogue with lending institutions and startups regarding how SBA programs, products, and procedures can more clearly distinguish between existing small businesses and new, high-growth startups. The SBA should also be instructed to determine how SBA-backed lending and other programs can be tailored and made more responsive to the unique nature and needs of startups (e.g., less complex, less reliant on cash-flow and physical asset collateral). To reinforce this expanded organizational and programmatic perspective, Congress should also rename the SBA the Small Business and Entrepreneurship Agency (SBEA).
Increase the SBA Guarantee to SBICs
The SBA’s Small Business Investment Company (SBIC) program – established by the Small Business Investment Act of 1958 – is designed to “improve and stimulate the national economy in general and the small-business segment thereof in particular” by stimulating and supplementing “the flow of private equity capital and long-term loan funds which small-business concerns need for the sound financing of their business operations and for their growth, expansion, and modernization, and which are not available in adequate supply.”
The SBIC program was created in response to concerns raised in a Federal Reserve Board report to Congress that identified a gap in the capital markets for long-term funding for growth-oriented small businesses. The report noted that the SBA’s loan programs were “limited to providing short-term and intermediate-term credit when such loans are unavailable from private institutions” and that the SBA “did not provide equity financing.” Equity financing (or equity capital) is money raised by a company in exchange for a share of ownership in the business. Ownership is represented by owning shares of stock outright or having the right to convert other financial instruments into stock.
Equity financing allows a business to obtain funds without incurring debt, or without having to repay a specific amount of money at a particular time. The Federal Reserve’s report concluded there was a need for a federal government program to “stimulate the availability of capital funds to small business” to assist these businesses in gaining access to long-term financing and equity financing. Facilitating the flow of capital to small businesses to stimulate the national economy was, and remains, the SBIC program’s primary objective.
The SBA does not make direct investments in small businesses. Rather, it partners with privately owned and managed SBICs licensed by the SBA to provide financing to small businesses with private capital the SBIC has raised (called regulatory capital and with funds (called leverage) the SBIC borrows at favorable rates because the SBA guarantees the loan obligation. Some SBICs specialize in a particular field or industry, while others invest more generally. Most SBICs concentrate on a particular stage of investment (i.e., startups, expansion, or turnarounds) and geographic area. Since 1958, SBICs have channeled more than $67 billion to 166,000 American businesses across a variety of industries. Some of America’s most iconic companies have received investment capital from SBICs, including Apple, Tesla, Whole Foods, Staples, Intel, FedEx, and Costco.
As of September 30, 2020, there were 302 licensed SBICs participating in the SBIC program. SBICs pursue investments in a broad range of industries, geographic areas, and stages of investment. The SBIC program currently has invested or committed about $32 billion in small businesses, with the SBA’s share of capital at risk valued at $13.5 billion. In fiscal year 2020, SBICs were provided nearly $1.8 billion in SBA leverage and invested another $3 billion from private capital for a total of $4.88 billion in financing for 1,063 small businesses.
On June 21, 2018, the Small Business Investment Opportunity Act was enacted to modify the SBIC program, increasing the amount of outstanding leverage allowed for individual SBICs from $150 million to $175 million. While a step in the right direction, CAE is of the view that the increase of $25 million was insufficient, especially since the cap was previously raised in 2009. CAE urges Congress to increase the cap on the SBA guarantee to SBICs to $250 million.
Re-structure and Re-launch the SBA’s Early-Stage Innovation Fund (ESIF) Initiative
In January 2013, the Small Business Administration (SBA) launched the Early-Stage Innovation Fund initiative (ESIF) – an offshoot of the SBA’s Small Business Investment Company (SBIC) program (see recommendation above). Whereas licensed SBIC’s invest primarily in the growth of existing small businesses, ESIF licensed firms were required to invest at least half their funds in early- and seed-stage startups. By guaranteeing up to $50 million in additional capital per licensed fund, the ESIF initiative was intended to help leverage private capital already raised by active funds, providing additional investment capacity to venture capital funds beyond the venture capital centers of Silicon Valley, New York, and Boston, which attract three-quarters of all venture capital. In announcing the program, the SBA said it planned to guarantee up to $1 billion in additional startup capital over five years at no cost to the American taxpayer.
On September 19, 2016, the SBA proposed changes to the ESIF program because as of June of 2016, the SBA had licensed only five venture capital funds. On June 11, 2018, the SBA announced that it was withdrawing its proposed rule and ending the ESIF program. According to the SBA, the initiative failed because the SBA-backed portion of ESIF-affiliated investments were structured as subordinated debt that paid quarterly interest back to the government equivalent to the rate of a 10-year Treasury bill plus 1.5 percentage points and “debentures are not well-suited to an early stage investing strategy sine many early-stage investments do not provide ongoing cash flows needed to pay the current interest an annual charges associated with SBA guaranteed debentures.” Given the importance of early- and seed-stage risk capital to startups, together with the relative scarcity of venture capital in heartland states, CAE recommends that the SBA work with the venture capital community to determine a financing structure consistent with the earnings and repayment realties unique to startup and relaunch the Early-Stage Innovation Fund initiative as soon as possible.
Raise the Cap on the Reg A Exemption (or “Mini-IPO)
The JOBS Act of 2012 sought to revive the Regulation A exemption – sometimes called a “mini-IPO” – which allows public companies to raise capital through general solicitation without the full burden of disclosures typically required of a conventional initial public offering (IPO). The Act increased the amount of capital that could be raised under the exemption from $5 million to $50 million and instructed the Securities and Exchange Commission to reevaluate the cap every two years.
In 2015, the SEC adopted final rules to implement Section 401 of the JOBS Act by creating two tiers of Regulation A offerings: Tier 1, for offerings of up to $20 million in a 12-month period; and Tier 2, for offerings of up to $50 million in a 12-month period. From June 2015 through December 2019, issuers in the Regulation A market reported raising approximately $2.4 billion in 382 qualified offerings. The vast majority of capital raised under Regulation A, approximately $2.2 billion (91 percent), was raised under Tier 2, with only $230 million (9 percent) raised under Tier 1.
In March 2020, the SEC issued proposed amendments to simplify, harmonize, and improve the “patchwork” exempt offering framework under the Securities Act, with the aim of reducing potential friction points and to make the capital raising process more effective and efficient. In proposing the amendments, the Commission noted that exempt offerings accounted for more than double the new capital raised by registered offerings in 2019 – $2.7 trillion in exempt offerings compared to $1.2 trillion in registered offerings. The SEC approved the prosed amendments on November 2, 2020, which included raising the maximum offering amount under Tier 2 of Regulation A from $50 million to $75 million.
While the increase in the Reg A cap is welcome news, companies seeking to raise more than $75 million – say, $100 million, still a small amount by any standard – must resort to the conventional IPO process and the burden of standard disclosures. With this in mind, and given the expanding importance of exempt offerings to the financing of young high-growth companies, CAE urges the SEC to raise the Reg A exemption cap to at least $100 million.
Raise the Cap on 3(c)(1) Investment Funds
On May 24, 2018, the Economic Growth, Regulatory Relief, and Consumer Protection Act was signed into law by President Trump. Title V of the legislation addresses capital formation – including a provision, “Supporting America’s Innovators,” Section 504, that had previously passed the House (H.R. 1219) and Senate (S. 444) by wide margins. The section amends section 3(c)(1) of the Investment Company Act of 1940 by raising the permitted number of investors from 100 to 250 for investment funds not making a public offering of securities that are exempt from registration as an investment company with the Securities and Exchange Commissions and from the filing of costly disclosure requirements associated with registration – provided the fund size does not exceed $10 million.
The increase in the number of permitted investors is a welcome change that will facilitate the formation of angel investor funds and smaller venture capital funds. However, the fact that the cap on qualifying funds was not raised will limit the value and impact of the increase in permitted investors. Moreover, because institutional investors prefer funds of at least $30 or $40 million, the $10 million limit means that fund managers are generally unable to attract institutional investors to smaller funds.
With these problems in mind, CAE recommends that the cap on funds exempted from registration as an investment company be raised to at least $50 million – and potentially to $100 million, which would be consistent with the recommendation immediately above regarding capital raises under the Reg A exemption.
Mobilize More Angel Investors Through a Federal Tax Credit
In recent years, “angel” investors – wealthy individuals who invest in young promising companies – have become a major source of startup capital in the United States. Like venture capitalists, angels invest in new, high potential companies in exchange for an equity stake in the business. As with venture capital, angel capital is recovered and returns realized when financed firms either go public or are bought by another company.
Many angel investors – particularly those who are current or former entrepreneurs – also provide advice, mentoring, and other support to the management team of the new businesses in which they invest. Perhaps for this reason, research has shown that angel investment significantly increases a startup’s chances of success. A study conducted by William Kerr and Stanislav Sokolinski of Harvard University and Antoinette Schoar of MIT found:
“Startups funded by angel investors are 14 percent to 23 percent more likely to survive for the next 1.5 to 3 years and grow their employment by 40 percent relative to non-angel funded startups. Angel funding affects the subsequent likelihood of a successful exit, raising it by 10 percent to 17 percent. Having angel funding also seems to matter significantly for the ability of a firm to obtain follow-on financing.”
Angel investors also differ from venture capitalists in significant ways. For example, unlike VCs, who invest institutional capital in amounts of $1 million or more, angels invest their own money, typically in amounts between $25,000 and $250,000. Despite smaller individual investments, aggregate angel capital rivals that of venture capital. In 2019, angels invested a total of $24 billion in 63,730 companies. For every new company that receives venture capital, nearly 20 others receive angel capital. Amazon, Home Depot, and Uber are just a few of the thousands of companies launched with angel capital.
Perhaps most importantly, whereas venture capital is typically invested during a later growth phase after initial financing has helped create a viable company, angel investors have emerged as the principal source of outside “seed” or early-stage funding critical to the formation, survival, and growth of new businesses – providing 90 percent of such capital once entrepreneurs have exhausted their own resources and those of family and friends.
According to the Center for Venture Research (CVR), there are currently about 335,000 active angel investors in the United States. According to the Securities and Exchange Commission, another 12 million American households meet accredited investor criteria. Most are likely unaware of what angel investing is and of the opportunity to potentially participate in financing the next generation of great American companies.
To be sure, angel investing is risky and not appropriate for every accredited investor. More than half of all angel investments lose money, and just 7 percent of all investments generate 75 percent of returns. But given the importance of angel investors to startups – and the importance of startups to economic growth and job creation – the formation and commitment of angel capital should be responsibly incentivized. If only 3 percent of the 12 million additional potential angels chose to allocate a portion of their financial portfolios to promising new companies launched in their cities and towns, the number of active angel investors would double to 650,000 – and, presumably, the amount of capital invested would double to $50 billion annually.
In CAE’s view, this objective can be best achieved by way of a federal tax credit, coupled with relief from taxes on any gains in the value of angel investments held for at least five years. Twenty-six states have enacted tax credits to incentivize angel investing. Details vary from state to state regarding the size of the credit, limits per investment, caps on total investments, and qualifying businesses. Most states offer credits of between 25 and 35 percent.
And the evidence to date is clear – tax credits work. For example, after Ohio created its Technology Investment Tax Credit in 1996, the program was used by 4,800 angels to invest more than $160 million in 668 companies through 2013, according to the state economic development agency. Similarly, after Wisconsin enacted a 25 percent tax credit in 2005, total angel investments jumped more than 10 times and the number of angel investor groups in the state increased from just four to more than 20. Other states have experienced similar success.
A federal tax credit equal to 25 percent of investments in startups would lower investment risk to angels by providing an immediate return. While tax credits encourage investment, the majority of the angel’s money remains at risk, preserving the investor’s incentive to carefully examine potential projects and ensuring that scarce investment capital will be directed to only the most promising business ideas.
Exempting any returns on investments in startups held for at least five years from federal capital gains tax would maximize the pay-off on any successful investments. And since total capital gains tax revenues have historically represented less than 5 percent of federal tax revenues, exempting gains on angel investments from taxation would have almost no impact on federal tax revenue while having a potentially dramatic effect on new business formation and growth. And because most angel investors reinvest most or all of their returns into the next generation of innovative new companies, exempting such gains from federal taxes would have the further benefit of increasing the amount of seed capital available to startups.
Pass the New Business Preservation Act
CAE supports the immediate passage of the New Business Preservation Act, the purpose of which is to incentivize continued and more equitably distributed venture capital investment in America’s most innovative startups. The Act was introduced in the Senate (S. 3515) on March 18, 2020 by Senators Amy Klobuchar (D-MN), Chris Coons (D-DE), Tim Kaine (D-VA), and Angus King (I-ME), and was introduced in the House (H.R. 6403) on March 26, 202 by Reps. Dean Phillips (D-MN), Terri Sewell (D-AL), Ro Khanna (D-CA), and Tim Ryan (D-OH).
Despite their unique economic importance, startups are also extremely fragile because they are new – with half of all startups failing within their first five years. Because of their risk profile, many startups are unable to secure bank financing like existing small businesses and instead rely on venture capital, which has been a major source of financing for young innovative companies since the late 1940s.
Venture capital firms are long-term investors that provide early-stage capital – raised from institutional investors like pension funds, insurance companies, university endowments, and foundations – to new and rapidly growing companies in exchange for an equity stake in the company. Venture firms also assist in the management and professionalization of the young companies in which they invest, typically taking seats on the board. Venture capital has helped finance thousands of American companies, including Intel, Federal Express, Apple, Microsoft, Google, Cisco, Home Depot, and Starbucks.
At present, venture capital in the United States is highly concentrated, with 80 percent of venture capital raised and invested in just three cities – San Francisco, Boston, and New York. Moreover, the coronavirus crisis poses a major threat to this vital source of startup financing. A research note issued on March 31, 2020 by Pitchbook, the leading source of venture capital data and analysis, predicted “a decline in total venture transaction volume over the next few quarters,” with the greatest impact expected in “ecosystems outside of the major investment hubs” of Silicon Valley, New York City, and Boston. A paper released by the National Bureau of Economic Research (NBER) in May showed that early-stage venture capital investment dropped by 38 percent in March and April.
The New Business Preservation Act would address this threat to the nation’s startups by establishing a program, administered by the Treasury Department, which would allocate $2 billion in federal dollars ($1.5 billion initially, and $500 million in follow-on investment) to the states on a straightforward population basis to attract private venture capital by offering a 1-to-1 match of federal dollars with venture capital investment in promising startups, particularly in states outside the major venture capital centers.
The legislation is modeled on Israel’s “Yozma” program of the late-1990s, which successfully incentivized U.S. venture capital firms to invest in promising Israeli startups, and builds on other successful federal-state partnerships to support small businesses, such as the State Small Business Credit Initiative (SSBCI).
Importantly, the legislation is carefully structured so that the federal government will not “pick winners and losers,” but rather will rely on private entities to source and manage investments in promising early-stage companies in every state. All investment decisions will be based entirely on private investor determination of the economic prospects of the new companies receiving equity capital. Finally, the program authorized by the Act is intended to be “evergreen,” with any gains from investments following exits to be used to incentivize future rounds of private investment in heartland startups.
Pass the IGNITE American Innovation Act
To respond to the capital needs of new and small businesses amid the Covid-19 pandemic, Congress created the Paycheck Protection Program (PPP) in March of 2020 and the Federal Reserve Board later established the Main Street Lending Program. Unfortunately, due to their unique financial and funding circumstances, thousands of fragile startups have been shut out of PPP and the Fed’s lending facility, with many forced to lay-off employees or close their doors permanently.
With these realities in mind, CAE strongly supports the immediate passage of the IGNITE American Innovation Act, introduced on August 5, 2020 by Rep. Dean Phillips (D-MN) and Rep. Jackie Walorski (R-IN). The legislation would amend the U.S. tax code to permit pre-revenue startups to “monetize” tax assets on their balance sheets – principally net operating losses (NOLs) and research and development credits – as a means of getting badly needed capital to promising young companies as the pandemic continues.