United States

Small business: A big opportunity for investors

Private equity and other investors should look small for big returns

INSIGHT ARTICLE  | 

Private equity firms and other institutional investors that are focusing on larger, more established businesses may be missing out on potentially higher returns available from smaller, more entrepreneurial companies.

Small business is big. A March 2014 report by the United States Small Business Administration (SBA) states that small businesses (defined as an independent business having fewer than 500 employees) account for more than 99 percent of U.S. employers and have created the majority of new jobs since the end of the 2008 recession. Firms in the 20–499 employee category have lead the way.

Advantages of investing in smaller businesses

Investors have a robust selection of small businesses to choose from. According to U.S. Census Bureau data, in 2012 there were 5.73 million employer firms in the U.S. with 99.7 percent of those businesses having fewer than 500 employees and 89.6 percent having less than 20 employees.

For investors, small businesses can offer unique advantages. They are often run by creative entrepreneurs who are focused on sustainable growth and who are amenable to the insights offered by their investors. Because they are usually less bureaucratic and closer to their customers than their larger competitors, small businesses can be more nimble in reacting to market demands and opportunities. Small businesses are also often targeted exclusively in a given niche, which concentrates their focus on key market opportunities. They also generally have fewer layers of management, which increases transparency into operations and often means tighter control over costs. Investors looking at small business targets should look for companies that maximize these valuable benefits.

Small businesses also offer a variety of tax benefits for potential investors. For example, small businesses that meet the definition of a Qualified Small Business (QSB) can, under Section 1202 of the Internal Revenue Code, exclude between 50 and 100 percent of gain realized by an investor upon disposition of stock. Section 1045 of the Code allows for the deferral of realized gains if the investor rolls over these gain proceeds towards the purchase of additional QSB stock.

SBIC offers investors an edge

With interest rates at historic lows, the current availability of cheap investable capital provides a glut of opportunity to those who can sniff out a good deal. One option of interest to fund managers with successful track records is the Small Business Investment Company (SBIC) program. The SBIC program was started in 1958 to facilitate the flow of long-term capital to America’s small businesses. SBICs are privately managed investment funds licensed and regulated by the SBA that use a combination of their own capital plus funds borrowed from the SBA at very favorable interest rates to make equity and debt investments in qualifying small businesses. For every $1 raised by the SBIC from private investors, the SBA will commit up to $2 of leverage, in the form of 10-year debentures with principal due at maturity and interest payable semi-annually.

“The smaller-end of the middle market is a robust and dynamic part of the market, with a vast array of attractive entrepreneur-managed businesses in need of capital to grow their companies. The SBIC program is the ideal investment platform for this market; providing long-term, low-cost capital specifically intended to help drive growth and create jobs in these small businesses,” said Steve Berman, a partner at Argentum, a NYC-based manager of growth equity SBIC funds. According to the SBA, from 2011 to 2015, more than $21 billion in financing was invested into more than 6,400 businesses. Some notable corporations that received financing from SBICs during their early stages include Apple, Intel, Sun Microsystems and FedEx.  

The opportunity for investing in small businesses across the United States is vast. Many of the baby boomers who lead these companies are looking for exit strategies but do not have succession plans in place. This creates opportunities for investors to provide these entrepreneurs with the liquidity needed to take some of their chips off of the table while leaving these companies together. The result? Small businesses with intact innovative and competitive edges, along with the employees to grow these businesses to the next level. Small business is big. Will you be a part of it? 

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