Statement of Lee W. Mercer, President of NASBIC, before the Subcommittees on Tax, Finance, and Exports & Workforce, Empowerment, and Government Programs of the U.S. House of Representatives Committee on Small Business
June 26, 2001

Chairman Toomey and Representative Pascrell, Chairman DeMint and Representative Millender-McDonald, and members of the respective Committees:

Access to Capital — Introduction

On behalf of the National Association of Small Business Investment Companies, I appreciate the opportunity to testify today concerning access to capital by small businesses. Small Business Investment Companies, the foundation of one of the government's most successful finance programs, were first created in 1958 in response to a Federal Reserve Board finding that lack of patient capital for America's small businesses was an impediment to economic growth. The SBIC program became the cornerstone for the overall venture capital industry in this country and continues to play a critical role in providing debt and equity capital in the $250,000 to $1,000,000 range that is of concern at this hearing. In FY 2000, SBICs invested $5.5 billion in 3,060 small businesses in 4,639 separate transactions. The average size of investment was $1,200,000; the more important median size of investment was $250,000. The average number of employees in companies receiving SBIC financing was 125; the median number of employees was 25. Finally, 63% of all dollars invested by SBICs in FY 2000 were invested in small businesses that had been in business for less than three years. Clearly, the SBIC program is focused directly on the area of concern at today's hearing and I have provided more FY 2000 SBIC statistics as an attachment to my testimony.

Notwithstanding the success of the SBIC program, it is clear that lack of access to capital is still a major issue for hundreds of thousands, if not millions, of small businesses every year. The Bureau of Census reports that there were 5.8 million non-farm businesses (excluding the self-employed as well) in 1999. Using estimates made by SBA's Office of Advocacy (which should hold relatively true today), approximately 89% of those businesses had fewer than 20 employees. The percent jumps to 98% if "fewer than 100 employees" is used as the marker, and to 99% if the standard "fewer than 500 employees" definition is used. Given these numbers and the importance of small business to America's overall economic health, it is appropriate that Congress continually revisit the issue of access to capital.

Stating that as many as 5.75 million small businesses existed in 1999 (and the number is greater today) does little to capture the battle that is fought and lost each year by those small businesses that close their doors. SBA estimates that as many as 263,000 small businesses that described themselves as "unsuccessful" or "bankrupt" closed in 1999. Fortunately for the country, in that year, as in all but five years since 1988, more small businesses were started than closed. However, the question remains: of the unsuccessful or bankrupt small businesses that closed their doors in 1999, how many were good businesses that would have succeeded but for the lack of adequate capital? And further, what reasonable steps might Congress take to make more capital available?

Congress Can Increase Small Business Capital Availability Through the SBIC Program

One answer to the question of what Congress might do to increase the availability of capital is the SBIC program. At no increased cost to taxpayers, Congress could pass two pieces of legislation this year that would make substantially more capital available to worthy small businesses in the individual amounts of concern here today. First, we hope the Small Business Committees of the House and Senate will come to agreement with their respective Appropriations Committees on a combination of a fee increase and an appropriations amount that would make $3.5 billion in leverage available to Participating Security SBICs in FY 2002. That total would be $1.5 billion—or 75%—more than is available this year. The demand by current and aspiring SBICs that would deploy this capital exists because there are more good small businesses for SBICs to invest in than there is current capital available to invest. When coupled with required private capital, the $3.5 billion will mean $5.3 billion in investments made over the next few years by SBICs that make equity investments that have an average size of $900,000 and a median size of $500,000. Further, because equity almost always serves as the foundation for more senior forms of financing (such as bank loans) the $5.3 billion will have a substantial multiplier impact. The multiplier can be as much as 3 to 1 for a company with positive cash flow. Thus, $5.3 billion could stimulate an additional $15 billion in capital—a total of $20 billion—for small businesses. At most, the appropriation required would be the same $26.2 million appropriated last year. Few programs if any can claim this type of positive leverage and the SBIC industry strongly urges Congress to take this step.

The second SBIC-related legislative action that Congress could take to increase the size of the SBIC program, and therefore the amount of capital available to small businesses, is to pass a NASBIC-sponsored proposal that would amend the Internal Revenue Code (IRC). The amendment would declare that government-guaranteed capital (leverage) borrowed by Debenture SBICs to augment their private capital (and thus form the corpus of their investment funds) is not "acquisition indebtedness" that the IRC says creates Unrelated Business Taxable Income (UBTI) for tax-exempt investors. Debenture SBICs are important sources of subordinated debt capital for small businesses, making investments that currently average $435,000 in size, with the median size at just $150,000. Like equity investments, subordinated debt investments often are the foundation for more senior debt. The amendment to the IRC would benefit all Debenture SBICs, including the minority oriented Specialized SBICs, in their private fundraising activities, thus helping to increase the size of the Debenture SBIC program and, therefore, the amount of important subordinated debt capital available to small businesses. I have expanded on this proposal in the final section of my testimony.

BRIDGE and SUSA - Innovative Proposals That Complement the SBIC Program

Finally, and with appreciation of the creativity involved, I commend Chairman DeMint and other supporters of the proposed Start-Up Success Accounts (SUSA) Act and the Business Retained Income During Growth and Expansion (BRIDGE) Act for attacking the problem of inadequate capital at one of its earliest and seemingly unlikely events: the first time a small business has taxable income. If enacted, either piece of legislation would help self-selected successful young companies with cash flow problems associated with growth. It is perhaps counterintuitive that success, the very thing we applaud in all young companies, should lead to an early and critical need for cash that some businesses simply cannot overcome, but it is true.

Both pieces of legislation are unique in that they would require no government involvement other than record keeping and no expenditure of scarce time in an application process by intended recipients. Nor would capital benefits flow to any undeserving recipients. The beneficiaries of the program would prove their merit and qualifications by actually producing taxable income. They differ in approach (income deferral under SUSA, tax deferral (with interest) under BRIDGE), with respect to the size of the small businesses that would likely benefit most from their respective provisions (very small under SUSA, much larger under BRIDGE), and with respect to whether or not a threshold level of growth should be required. However, both have as their foundation the belief that successfully growing small businesses should not be unfairly punished by rigid application of tax laws and accounting rules during the earliest stages of that growth.

Both pieces of legislation should be considered complementary to the SBIC program. Designed by the government to be profit-oriented entities, SBICs invest in only the best opportunities they are presented with. That does not mean that small businesses that do not receive SBIC financing (or financing through one of the other SBA programs) may not be deserving of support. It simply means there are more small businesses deserving support than there are sources of that support. For example, on average, SBICs invest in perhaps 1.0% of the potential investment proposals they receive, with e-mail having greatly increased the number of proposals received. Thus the 3,060 companies that received SBIC financing in FY 2000 there were likely among over 300,000 proposals (without adjustment for multiple submissions) that may have submitted for consideration in one form or another. We also know that there are hundreds of thousands of small businesses that for one reason or another do not have business plans—an absolute requirement for investment consideration. The proposed legislation would give many worthy companies in these categories financial breathing room—without the necessity of creating ill-advised capital structures to accommodate an "emergency" capital source—to prepare for professional presentations to investment professionals that will support them over time.

Further Expansion on Unrelated Business Taxable Income & Debenture SBICs

(10) INDEBTEDNESS INCURRED BY DEBENTURE SBIC. For purposes of this section, the term "acquisition indebtedness" does not include the indebtedness of a small business investment company licensed pursuant to the Small Business Investment Act of 1958 that is evidenced by a debenture issued by the small business investment company pursuant to Section 303(a) of the Small Business Investment Act of 1958 or held or guaranteed by the United States Small Business Administration.

Background and Discussion

Small Business Investment Companies (SBICs) are government-licensed, government-regulated, privately managed venture capital firms created by the government to invest only in original issue debt or equity securities of U.S. small businesses that meet size standards set by law. SBICs were created to provide venture capital needed by small businesses to create jobs and technologies that are the cornerstones of the U.S. economy. The investment limitations on SBICs differentiate them from non-SBIC venture funds, funds free to invest in any company—large or small, foreign or domestic.

To become a Debenture SBIC and gain the program's benefits—augmentation of private capital by access to government-guaranteed capital—aspiring Debenture SBICs must raise a minimum of $5 million in private capital. About 60% of private capital invested in venture capital funds is controlled by tax-exempt organizations such as pension funds, foundations, and endowments. Debenture SBICs were created to make loans to small businesses and may only augment their private capital by borrowing government-guaranteed capital through SBA. SBA-guaranteed borrowed capital is treated by IRC §512(b)(4) as "debt-financed property" which carries with it "acquisition indebtedness." This fact subjects tax-exempt investors who would otherwise be inclined to invest in Debenture SBICs to UBTI liability. For this reason, Debenture SBICs find it impossible to raise capital from tax-exempt investors. Free to choose, tax-exempt investors opt to invest in venture capital funds that do not create UBTI record-keeping requirements or taxes.

Congress designed Debenture SBICs specifically to make subordinated debt financing available to small businesses. Such loans are well suited for family-owned businesses that may never reach the growth required to "go public," or, for companies whose owners may never want to lose equity or control of their companies by the sale of large blocks of stock. These companies are often found in the heartland of America, not the "hot" locations that typically attract media attention. Nonetheless, these companies are very important to America's economic wellbeing in general and the health of their local communities in particular. They are often primary employers in the areas in which they are located.

The structure mandated by Congress for Debenture SBICs creates UBTI. Thus, 60% of private capital potentially available to Debenture SBICs is "off limits." This is in conflict with congressional intent. As found in §102 of the Small Business Investment Act, that intent is

"to improve and stimulate the national economy in general and the small business segment thereof in particular by establishing a program to stimulate and supplement the flow of private equity capital and long-term loans which small-business concerns need for the sound financing of their business operations and for their growth, expansion, and modernization…provided, however, that this policy shall be carried out in such a manner as to insure the maximum participation of private financing sources." Emphasis added.

There should be no tax revenue loss associated with the amendment. Tax-exempt investors allocate only a finite percentage of their capital to the class of investments represented by venture capital funds. Allowing Debenture SBICs to compete for such funds on even terms with equity-based venture capital funds will not increase the capital allocated to that class of investments. The government is receiving little if any tax revenue attributable to Debenture SBIC UBTI since tax-exempt investors invest their allocated amounts in equity-based venture capital funds that do not produce UBTI.

That concludes my prepared testimony. Thank you once again for the opportunity to share my views on the important subject of small business access to capital.