Individual investors, once a vital source of funds for new businesses and liquidity for early investors, have been so hurt in recent bear markets that they are reluctant or unable to provide risk funds again. In addition, the incentive for individuals to risk capital in equities has been drastically reduced by a capital gains tax rate that today can run from 70 to 100 percent more than the maximum rate that prevailed as recently as 1970.

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Compliance with Government regulations tax returns, registration statements, ERISA reporting requirements, and a great variety of reports and surveys constitutes a heavy burden for the small businessman. Although highly commendable efforts to lighten this load are under way, the small business today is in grave danger of smothering under the weight and cost of repetitive paperwork.

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One of the more serious problems is the skyrocketing cost of entering the public market to seek new sources of financing. An analysis of six of the smaller offerings made in 1976 by companies having assets of less than $5 million shows the average cost of registration is $122,350, an automatic and, in some cases, insurmountable roadblock for companies interested in entering the public market.

The Life Cycle of Growing Businesses and Its Financing

The result of all these trends has been to make economic growth for smaller companies increasingly difficult. The chart on the next page illustrates the stages a company must go through to achieve maturity as a corporate entity.

The cycle of a business enterprise requires different types of capital at each stage of its life. The highly developed U.S. marketplace has spawned investors for each of these many stages. The result can be imagined as a financial pipeline along which successful companies move from start-up to maturity.

If this pipeline flows smoothly, all types of investment capital can function. If it clogs at any point, capital dries up all along the pipeline. Facilitating the turnover of initial investments to more conservative investors is critical to unblocking the flow of initial higher risk investments in smaller businesses. In fact, the Task Force believes that creating better prospects of liquidity for early investors will, in itself,

restore the flow of equity investment in the early stages of business life. Hence the Task Force focused on institutional investors and the public stock market, in addition to other sources of risk capital, internal financing and long-term debt financing.

Traditionally, businesses have used a mixture of internal and external financing for their needs. Small businesses cannot grow very fast if they have to finance themselves solely out of their earnings. In most cases external sources must provide the financing for significant growth.

As shown on the chart, however, a hypothetical company moving through the system must reach a revenue level of up to $10 million before public financing becomes even remotely possible. Moreover, it is not until a business reaches revenues of $25 to $40 million that all sources of public and private funding become, in some measure, available.

Though Government agencies provide a great deal of assistance to small businesses through agencies such as the Small Business Administration (SBA), there are legislative limitations on this agency's programs that prevent them from being completely responsive to the small businessman's needs for equity capital. Because private financial resources are at times unavailable, the small businessman is often faced either with stagnation or the sale of all or part of his company.

In addressing the financial needs of small businesses and the impediments to meeting them, it soon becomes apparent that the problem is different for:

a. the many small businesses that are local in character or so family owned and managed that they would be unlikely to have or want access to the public securities markets; and

b. those businesses that can develop so that they will need access to public financing.

There are different remedies called for with respect to these two broad categories of smaller businesses.

There is a cycle of financial events and opportunities into which new and growing businesses have to fit themselves to finance their growth and expansion. This cycle starts off with the ability to save and the will to

commit those savings in order to start a small business. Here, if public policy is to reflect the contribution new and small business can make to the national welfare, our tax system has to encourage necessary savings and the commitment of these savings to new and small businesses.

Then, after a new business is launched, the tax system should permit it to generate sufficient internal capital so that a growing equity and credit base will enable it to meet growth requirements. This can be done with some deferral of tax payments; allowing small businesses greater flexibility in charging off the assets needed to do its business; and an increase to reflect inflation in the amounts to which small business tax treatment now applies. This will provide greater revenues for the Government in the future as small businesses use this increase in internal financing to provide additional jobs and greater taxable wages and profits.

From among the new and small businesses that grow as a result of these tax revisions, a few will show a potential for generating jobs and profits that are sufficient to attract funds from private, public and institutional investors. These businesses should be able to compete for these funds on equal terms with older, larger and more established businesses. Savings will not be invested in these new and growing enterprises unless the investors can efficiently convert their investment to cash over time without undue penalty. The seed money needs of these innovative and growth-oriented businesses used to be met by knowledgeable investors found in towns and cities all over America. In the last fifteen years, a significant portion of this activity has become institutionalized and professionalized in enterprises having risk money together with experience and skill in identifying unusual business opportunities in technological developments and emerging needs.

Today however, surveys of the investing activity of leading professional venture capitalists, having total assets estimated at $1.7 billion and investing in excess of $100 million per year in venture capital situations, show an increasing proportion of their funds going to established companies. In 1975 only five percent of new investments went to startups of new ventures and two percent to first-round financings.

This represents a sharp reduction from previous years. Most venture capital firms have adopted a policy of staying away from start-ups and have put their available capital in safer and more liquid investments. The Task Force believes this steady shift towards a more conservative investment policy comes from perceived difficulty in recycling investment funds as restrictions on the access of small and growing business to the public securities markets has become more costly and difficult.

COMPANIES WITHOUT ACCESS TO PUBLIC SECURITIES MARKETS

The very small business, usually local in character, is likely to be launched on the personal savings of family and friends by an entrepreneur interested in full ownership and attracted to the prospects of financial reward.

His primary financial advisor will usually be his local banker, who provides advice, counsel and, more importantly, short-term credit for his generally under capitalized enterprise. Local bankers are likely to go as far as conventional economic wisdom and prudent banking standards permit in granting loans on the basis of confidence and character. Certainly the banker cannot be adequately compensated for making this type of loan because of the risk and servicing involved. He, and the entrepreneur, are taking calculated risks, hoping for greater rewards -- increased deposits and profits in the future.

With these loans and private resources, the entrepreneur begins his business with a reasonable relationship between debt and equity capital. If the business prospers, he approaches his banker for funds to purchase additional inventory or to handle his multiplying accounts receivable. He continually borrows short term, being fully convinced that he will have funds to repay within the 30-day term of the loan. The banker, pleased with this progress, continues to advance funds, all in short-term notes renewed and rewritten at regular intervals. This satisfies the bank's need to adjust loan interest rates quickly and to show liquidity on its books. As this small business grows, however, the availability of this type of financing fades away as its dangers emerge. Short-term indebtedness goes up and retained earnings are unable to grow as fast as the business. Paradoxically, the more profitable the business is, the worse its financial statement looks because of the high ratio of debt to equity. As internal financing becomes increasingly difficult, the entrepreneur's external source of financing, his banker, may begin to run into loan limit problems. Moreover, as more and more local banks are absorbed by large banks, the entrepreneur may find himself faced with a more impersonal and cautious branch manager, who may not want these small business risks.

The entrepreneur begins to realize the value of long-term financing. He turns to the government for help, in most cases to the SBA. He finds that this agency's programs of direct and guaranteed loans, and equity financing through SBA-licensed Small Business Investment Companies (SBICs), may be able to provide necessary assistance. Yet this assistance, too, has its limits.