er's mid-morning coffee breaks with Banker Brown start to pay off. Based on his knowl edge of the owner and his venture, the local banker starts making short-term loans to help build inventory and to handle multiplying accounts receivable.

Such friends-and-neighbors financing can only carry a company so far. Around start-up time, the owner starts looking outside his immediate circle. Investment firms such as Small Business Investment Com. panies get interested. If start-up is success. ful, the owner moves higher up the bank ladder and secures his first long-term cor. porate loan.

As growth reaches the $10 million annual revenue level, the owner and his increasingly professional management team start considering public financing. If the initial equity offering succeeds, then sustained growth is possible and long-term capital is sought from major institutions. Around $40 million in annual revenue, the company reaches maturity and has available to it the full variety of capital-formation tools.

The SBA Task Force likened this capital flow to a pipeline. If the flow is smooth, all types of investment capital can function. Company A taps a specific capital pool for as long as necessary and then moves on to the next, thus releasing those first funds for use by the next company to come along. If a clog develops at any point, however, capital dries up all along the pipeline. Savings that can't be pulled out of one venture won't be available for another.

As the SBA Task Force found out, clogs exist at every stage in the pipeline. A consumption-minded economy has trimmed savings generally. Tax laws penalize the investor who liquidates a new venture investment, even if he re-invests the funds in another new venture. The small but vital corps of individuals who thrived on highrisk ventures is a shrinking force. Institutions have the money now, and they're increasingly prone to conservative investment practices. Most venture capitalists have adopted a policy of staying away from start-up ventures. The public securities market remains an illusive dream for virtually all small businesses.

In other words, the capital pipeline is practically dry, as far as small business is concerned. Recycling of investment funds, on which the whole pipeline depends, isn't occurring. Instead, capital remains trapped as the company stagnates and dies, or the owner gets frustrated and sells out to a larger concern, or the owner dies and his company gets consumed by estate taxes. As new capital sources come along, they see this unattractive scenario and simply skip the small business sector altogether in favor of safer ground.

TASK FORCE
RECOMMENDATIONS

What is to be done? The first thing, the SBA Task Force says, is to forget any thoughts of simple solutions. The remedies will need to be as specific and sophisti. cated as the problems. What the SBA group did was to identify specific remedies for each stage in the capital-formation

pipeline. The Task Force further recognized that there are two broad categories of small business: those that are local and probably will never need access to public financing, and those that can develop to the point where public financing will be necessary. Different remedies apply to each category.

Following are specific recommendations made by the SBA Task Force, with elaboration from their findings and from other documents. In general terms, Recommendations 1-11 apply mostly to small companies that aren't seeking access to public financing. They seek to facilitate development of internal capital, to attract institutional capital and to improve the Small Business Administration's role in long-term borrowing.

Recommendations 14-21 concern companies seeking access to public captial. These recommendations seek to make institutional funds more readily available and to improve small business' access to public securities markets.

Recommendations 12 and 13 concern the SBA's role as advocate and the development of University Business Development Centers. The Small Business Coalition believes these two recommendations also deserve consideration.

• Concerning tax laws and IRS regulations:

1. Increase the corporate surtax exemption from the present level of $50,000 to $100,000.

During the vital years of research, startup and early growth, capital must come from internal cash flow and from borrowing. Congress recognized this in principle 39 years ago when it exempted a company's first $25,000 in earnings from the full 48% tax rate. Congress raised the exemption to $50,000 two years ago, when it became clear that 429% of inflation since 1938 had made the $25,000 all but irrelevant.

The exemption still isn't adequate for modern needs, especially in view of clogs elsewhere in the capital pipeline, according to the SBA Task Force. They recommend this schedule:

• Excess over $100,000 48% Allowing small business to use a larger portion of their first $100,000 of earnings would be "the most direct and effective step that can help small business," the SBA Task Force says. The benefits would be passed on immediately in the form of new jobs and, before long, additional tax revenues for government and lower welfare and unemployment costs. Small busi. nesses grow by hiring people. Large corporations grow by buying machines and reducing employment.

N.B. The Washington Presentation Coalition recommends a surtax exemption of $150,000. Inflation has accelerated since 1975, when the surtax matter first was raised. The Wholesale Price Index now is 474% higher than it was in 1938. (The rise as of 1975 was 429%) The SBA Task Force's recommended $100,000 exemption would be outdated before it went into effect.

2. Allow greater flexibility in depreci

ating the first $200,000 of assets. Writing off depreciable assets is an im portant method small business can use to improve cash flow. Several suggestions have been made for increasing flexibility in depreciation. The Treasury Small Business Advisory Committee recommended to the Secretary in December that any amount up to 100% of an asset value could be written off in the year of acquisition. This, in effect, is a tax deferral and does not effect over the long run the amount of tax paid. The limitation would be $200,000 a year.

3. Permit investors in qualified small businesses to defer the tax on capital gains if the proceeds of the sale on a profitable small business investment are reinvested within a specified time in other qualified small business investments.

There has been a 70% to 100% increase in capital gains tax rates over the past ten years. Because the capital gains tax at its higher limit approaches the tax on "earned" income, the once lower capital gains tax is "so high that it no longer serves as an incentive to provide long-term investment capital." Allowing investors to defer the tax if they keep recycling their investment would attract many individual investors back to the small business sector. The SBA Task Force pointed out prece dents for such deferral in home sales, condemnation proceedings and retirement plan distributions. In terms of tax revenues, the initial cost of deferral would be more than offset by higher tax revenues paid by new and growing companies. "Small business is potentially the most rapidly growing part of the equity investment spectrum," the Task Force says.

4. Liberalize certain limits of Section 1244 of the Internal Revenue Code.

This section was enacted in 1958 to encourage the flow of new funds into small business. It provides that certain losses be on small business investments can treated as ordinary losses, not capital losses, for tax purposes. This larger tax offset makes the high risk of small busi ness investment less of a disincentive. The limits set in 1958, however, have been overtaken by inflation and by sharply increased capital costs. The Task Force recommends that a taxpayer be permitted to deduct $50,000 in Section 1244 tax loss in any one year, up from $25,000. Two key criteria for qualifying under Section 1244 should be doubled, too, thus broad. ening availability of this investment incentive. The limit of issuer equity capital should be raised to $2 million from $1 million, and the size limit of eligible financ ing should be doubled to $1 million.

A Library of Congress analyst advised Congress last year that amending Section 1244 in this way "would greatly facilitate" the ability of small businesses to attract equity capital, which is what small businesses need most.

5. Permit underwriters of the securities of small business to deduct a loss reserve against the risks inherent in the underwriting and carrying of such securities.

This change could help reserve the flight of underwriters away from small business offerings. Admittedly, the risks are high in small business securities. Also, the secondary market has been weak since 1969. Consequently, initial offerings aren't at tractive, to investors or to underwriters. This recommendation approaches the problem from the underwriter's point of view, by offering a tax incentive for handling small business offerings.

6. Revise methods by which revenue impact of tax changes is esti mated to reflect revenue gains from the business use of tax sav. ings and the stimulus to capital formation that tax incentives provide.

The SBA Task Force criticizes the method currently used by the Treasury to forecast the revenue impact of tax legisla tion. The Treasury only calculates the reduction in tax collections. It fails to con. sider how a tax measure would spur business activity, and thereby increase taxable income. Nor does the Treasury's method reflect the stimulus to capital formation and economic activity that tax incentives would provide. The Task Force urges the Treasury to review its revenue-impact methods and develop "a more accurate and balanced method."

■Concerning the Small Business Admin.

istration:

7. Provide that some portion of the guaranteed borrowing available to SBICS take the form of debt with the interest partially subsidized if the funds are used to make equity investments.

Small Business Investment Companies are an important source of long-term debt financing and equity and venture capital for small business. SBICS secure long-term government guaranteed loans and then invest in small businesses. Lately, the SBICS have swung away from equity investments and toward debt instruments. This reflects the increased costs at which SBICS obtain their funds. The swing adds to the debt burdens of small businesses, rather than providing badly needed permanent capital.

If the interest on loans made to SBICS were partially subsidized, the SBICS wouldn't be under such cash-flow pressure to recoup the interest cost through highyield debt investments. Instead, they would be able to make the equity investments that may be lower-yield to the SBIC but are badly needed by small businesses for permanent capital.

8. Permit SBICS a deduction from ordinary income for loss reserves on both the equity and debt por tions of their portfolios.

At present, SBICS may establish loss reserves only for investments made in debt securities. The Task Force would broaden that to include loss reserves for equity investments, too. This would encourage more equity investments.

9. Immediately make a substantial increase in the size standards for SBIC investments and also provide for either an annual revision of these standards or index them according to broadly accepted price indicators.

with inflation. Size standards used as cri teria for SBIC investments tend to lag be hind realities of the marketplace. Some adjustments are needed immediately, and a method for continuing revision needs to be developed. The Task Force suggests either a plan for annual revision or an indexing method that would peg the stan dards according to inflation-tracking price indices.

10.

The SBA should require and encourage commercial banks to assume a larger portion of the risk in SBA loans and change its gua rantee fee from a one-time fee of 1% of the amount of the guaran. teed debt to an annual fee which more nearly reflects the value and cost of the SBA's guarantee. The Task Force recognizes a need to strengthen the financing role of the SBA, especially by putting its programs on a more self-sustaining and flexible basis. One laudable move already has been a shift in SBA emphasis from direct loans to the guarantee of bank financing. This has put loan management in the hands of local bankers, who know the customer more intimately and can supervise the loans more carefully. The government guarantee enables the local banks to extend longterm financing to risky ventures and still stay within regulatory requirements.

The recommendations would place SBA loan-guarantee operations on a more busi ness-like basis. The commercial banks would take a larger portion of the risk and would more adequately compensate the SBA for its guarantee. The recommenda tions might well induce borrowers or lenders to do without the guarantee, thus reducing the cost of the borrowing to the small business.

11. Substantially expand SBA's Secondary Market Program by creation of a "Certificate" system for the sale of SBA guaranteed loans.

Under the Secondary Market Program, banks making SBA guaranteed loans can sell them to other investors. This improves the banks' liquidity and also increases the potential pool for small business loans by making government-guaranteed, high-yield loans available to institutions and other investors. The program has worked well so far and should be substantially expanded.

A "Certificate" system would transform the guaranteed portions of SBA loans into freely transferable market securities. This would tap additional sources of capital, remove bankers' reservations about liquidity and ease bank examiners' worries over long-term loans in bank portfolios.

The Task Force urges the SBA to launch a comprehensive public information program to make small businessmen more aware of the Secondary Market Program. 12. The SBA should expand its role as a catalyst and advocate within the government for changes reflecting the concerns of small businesses.

A prime role for the SBA is that of initiator. Rather than putting out brush fires, the agency should get involved in the implementation of new regulations before they're issued. The SBA should analyze the impact changes that govern

14. Amend the Employee Retirement Income Security Act to encourage high-risk investments by pension funds.

Fiduciary standards created by ERISA have locked pension funds into blue-chip investments and fixed income securities. The pension funds control $200 billion but don't feel free to invest any of it in the high-risk small business sector. That's because fund lawyers so far have naturally and correctly interpreted ERISA regulations conservatively. To avoid liability and protect investors' liquidity, the funds are reluctant to invest in companies without strong earnings records and capitalization of over $100 million.

One key obstacle is ERISA's so-called "prudent man" standard, which establishes normal prudence as a test of fund manager decisions. So far, funds have applied the "prudent man" rule to each individual investment.

Instead, the Task Force wants it expressly stated that the "prudent man" standard applies to the portfolio as a whole. Within the standard, the policy should be to invest in a broad spectrum of companies.

In addition, the Task Force recommends that up to 5% of a fund's assets, can be set aside in a special "basket" for higherrisk investments in companies whose net worth is below $25 million or whose securities have limited marketability. 15. The development of professionally managed pools of capital should be encouraged so that pension fund managers, otherwise constrained by time and expertise, may participate in the investment in new ventures and growing small companies.

Because pension fund managers have limited time to analyze potential investments, they tend toward safe, more readily evaluated investments. A specially managed pool would get around this lack of time and experience and enable pension funds to effectively invest in potentially rewarding but admittedly high-risk investments.

The Task Force recommends that the Securities and Exchange Commission exempt these special pools from the "time

consuming and cumbersome requirements of the Investment Company Act of 1940." 16. In cooperation with the SEC and other regulatory bodies, exempt the illiquid securities of small companies from the "market-tomarket" or "fair value" account. ing treatment.

As portfolio managers now interpret accounting rules, they must frequently value their holdings of unregistered securities and report changes in value, even though no transactions take place. The result is substantial short term profit and loss impact. But the Task Force views the fluctuations as arbitrary and time consuming. Most institutions avoid the whole matter by sticking to safe investments in large concerns. The Task Force recommends that fair value accounting be waived for investments made within the 5% "basket" provision. (See Recommendation 14.)

•Concerning securities laws and regula

tions:

17. Increase the small offering exemption from $500,000 to $3 million.

To keep small ventures from being shut out of public securities market entirely, the SEC created "Regulation A." It facilitates offerings of less than $500,000 by exempt. ing them from the costly and time consuming process of full registration. The limit of $500,000, however, provides insufficient capital for a growing concern in today's business world. Moreover, most Regulation A offerings need to be underwritten. The SEC calculated that only 35% of Regulation A shares offered in 1972-74 actually were sold. Underwriters won't touch an offering of less than $3 million.

For both reasons, the SBA Task Force recommends the $500.000 limit on Regu lation A be substantially increased to $3 million.

18. Enact the limited offering exemp tion as proposed in the American

Law Institute project to codify securities laws.

Also exempted from costly regulation procedures are certain private offerings. However, recent administrative and court decisions have undercut this useful exemp tion. The decisions seek to protect investors from fraud, by enabling them to de mand return of their money simply be cause the stock was unregistered. Such protection from fraud already exists under Rule 10b (5).

The chief effect of the decisions has been to subvert the original purpose of the private offering exemption, which was to facilitate very small financings. Congress should restore the full breadth of the private offering exemption.

19. Retain and simplify Rule 146. The SEC issued Rule 146 in 1974 in an attempt to provide a safe harbor for private offerings that claim the private offering exemption and do not register. The SEC was seeking to clear up difficulties caused by the administrative and court decisions cited in Recommendation 18. Rule 146 specifies criteria for qualifying for the private offering exemption. It requires that the issuer exercise "reasonable care" to insure that buyers have sufficient knowl edge and experience to evaluate the offer. And the rule indicates the kind of information that should be provided to potential buyers.

The Task Force would amend the rule so that only material information would need to be provided, rather than the moun tain of data that the Rule now seems to require. Also, the Task Force wants it made clear that a buyer who has been properly informed cannot later demand a refund simply because the stock was unregistered.

20. Amend Rule 144 to make volume and time limits less restrictive and thereby facilitate small offerings.

Rule 144 governs the resale of accurities purchased by investors in transactions exempt from registration. The Rule seeks to insure that such offerings don't become simply a conduit for sale of unregistered, not-fully-disclosed securities to the public. Thus, a purchaser must hold the securities for at least two years. When he decides to sell, he may sell in any six-month period no more than 1% of the total shares outstanding or an amount equal to average weekly trading volume, whichever is lesser, in the case of an exchange-listed stock. For an over-the-counter security, the limit in six months is 1% of total shares outstanding.

As applied, Rule 144 has proved to be overly restrictive. Venture capitalists say the severe limits impair investors' ability to liquidate investments and thus free up capital for other investments.

The Task Force recommends, as a first step, that the time limit be shortened to three months, rather than six months, and that the limit on volume be set at 1% of outstanding shares or the average weekly volume over a four-week period, whichever is higher instead of whichever is lower.

Eventually, the Task Force would like the quantitative limits eliminated altogether or at least enlarged further. The Task Force applauds the SEC for initiating a re-evaluation of the need and justification for the limits on resale of unregistered securities.

21. Develop procedures under which small companies could develop and promote a good market for their stocks.

Rule 144 currently prohibits solicitation. This works against small-company issues, which need to be promoted in order to attract a sufficient market. The Task Force recommends that, under SEC supervision, small companies be allowed to engage in the active selling necessary to develop a market for their securities.

In the plant of Asbury Industries, Inc., Murrysville, Edward Asbury, right, answers

a question on the surtax exemption from Leo McDonough.

HEINZ PRAISES DEDICATION OF SMC MEMBERS

U.S. Sen. H. John Heinz, III, in a statement printed in the May 23 Congressional Record, gave high praise to the Smaller Manufacturers Council.

The statement, which included the main points of the printed Small Business Presentation, noted: "The week of May 22-28 is National Small Business Week, a time to pay welldeserved tribute to the people who make the country moveour small businessmen and

women.

"It is easy enough to pay tribute on this occasion and I hope most of us will do so. It is more of a challenge, though, to take a careful look at the problems of small business today and what needs to be done to solve them."

Pointing out that the SMC and four other small business groups had been in Washington May 18 for the annual Presentation, Heinz said:

"The Smaller Manufacturers Council is an organization I have come to admire and respect for its members' hard work and dedication, both to their own businesses and to furthering the interests of all small businesses, and I have great confidence in any study SMC has been a part of."

COVER:

President Carter, right, listens to one of the presentations at the Small Business Meeting in the White House Cabinet Room March 29. SMC Presi. dent Alex T. Kindling is fourth to the left of the President and SMC Government Relations General Chairman Ralph W. Murray is on President Kindling's right.