Choosing investment options to optimize returns for small businesses and investors
Key Takeaways:
- Small business investment companies (SBICs) are privately owned and licensed by the Small Business Administration (SBA) to provide debt and equity financing.
- Private equity partners and SBICs are popular funding sources for small businesses.
- The best funding option for a small business often depends on the level of operational and financial control sought by the business owner.
Equity investments used to purchase a stake in a private company (or the entire company) can be an attractive option for small business owners collaborating with investors as they raise funds for expansion, inventory, or capital expenditures. Small businesses can also benefit from the expertise and guidance provided by investors as they leverage their skills to maximize long-term growth.
In this blog post, we examine equity investment in small business, including traditional private equity investments and small business investment company (SBIC) options, and weigh the pros and cons of each option.
Understanding equity investment in small business
Equity is defined as a shareholder’s stake in a company, as identified on the balance sheet. Private equity (PE) firms pool capital from investors to form a private equity fund, then invest in established companies. PE partners leverage their financial resources and operational expertise to increase the value of companies they invest in or purchase outright. Equity investments in small businesses can:
● Provide capital to small companies with limited resources
● Support business development by providing marketing, operational, and financial guidance
● Establish connections and synergies with other businesses in the investment portfolio
● Reduce the stress placed on the private assets of business owners
Small business investments also carry a level of risk for investors, especially in niche or immature market segments. For business owners, the loss of financial and operational control of the business is an important consideration.
How to approach equity investments in small businesses
- Small businesses account for 65% of employment growth and make up over 99% of all businesses in the US. The variety of companies and potential investments make it imperative to complete due diligence and verify the financial and cultural prospects of the business before investing. PE partners ease the burden on individual investors by completing these important reviews. The general categories of small business investment include:
- Equity investments where monetary offerings are exchanged for a share of profits (or losses) and the part owners typically participate in business decisions. This is commonly structured as a limited partnership.
- Debt investments where a loan is provided to the small business based on a pre-established interest rate and duration, with little or no operational involvement
An equity investment in small business should be evaluated based on the financial health and market prospects of the company, perceived fit with investor values and risk tolerance, and the level of operational control sought by investors.
SBIC vs private equity: What’s the difference?
Small business investment companies (SBICs) are privately owned companies and licensed by the Small Business Administration (SBA) to provide debt and equity financing alternatives to small businesses. The SBIC program was created in 1958 to provide more funding alternatives for entrepreneurs. There are two types of SBIC funds:
● Leveraged: When the SBIC uses a portion of their own equity combined with an SBA-guaranteed loan
● Non-leveraged: When the SBIC does not use any debt, but is still registered and licensed with the SBA
Private equity partners and SBICs both provide potential funding options for small businesses, but private equity firms are not subject to the same level of government oversight and can invest in businesses of any size. SBICs can assume debt or equity positions, or a combination of both. Private equity partners are more likely to seek controlling financial interest and decision-making authority for the businesses they invest in businesses of any size. SBICs can assume debt or equity positions, or a combination of both. Private equity partners are more likely to seek controlling financial interest and decision-making authority for the businesses they invest in.
Advantages and disadvantages of SBICs
The best way to determine whether an SBIC is the right choice for your investment needs is by weighing all financing options available to you and comparing the benefits against the drawbacks and restrictions. SBICs may be more likely to provide financing options when banks and other traditional lenders won’t. Additional advantages of SBICs for investors and small businesses include:
Advantages for businesses
● Ready access to long-term, potentially low-interest capital
● Flexible deal structures including debt, equity, or a combination of both
● May be able to secure funding via SBICs when traditional lenders are unavailable
Advantages for investors
● Ability to invest in a fund with access to SBA-guaranteed funding at competitive rates
● Community Reinvestment Act credits may be available to financial institutions that invest in SBICs
The advantages of SBICs are balanced by drawbacks that stem from government regulations that dictate the terms and types of SBIC investments that can be made. These disadvantages may include:
Considerations for businesses
● Not all businesses are eligible for SBIC investment (i.e., must have at least 51% of revenue from the US, must be a small business as defined by the SBA, and must operate in an approved industry)
● Potentially high initial costs and fees
● Financing terms may be less advantageous than traditional lenders
Considerations for investors:
● Limited control of business decisions
● SBA rules and policies may change over time
● Limited to investment in small businesses
Advantages and disadvantages of private equity
Private equity investments are an extremely popular option for businesses of all sizes seeking outside capital and guidance, and investors seeking to maximize long-term value. The amount of PE capital invested now exceeds $2 trillion US dollars each year. The advantages of private equity for investors and small businesses can include:
Advantages for businesses
● Flexible investment structures
● Access to industry networks and expertise
● The ability for quick funding of capital and flexible deal terms
Advantages for investors
● Some operational control
● High potential returns
● Flexibility in investment strategy and target company profiles
To determine if a private equity investment is the right option for your investment needs, the drawbacks of private equity investments should also be considered and compared to SBICs and other small business investment options. Private equity drawbacks may include:
Considerations for businesses
● Loss of business ownership (equity) and control
● Potential changes to company culture
Considerations for investors
● Potentially high investment minimums and fees
● Investment may not be liquid
Case studies of successful equity investments in small business
There are many private equity and SBIC examples that illustrate how each option can produce a win-win for investors and small business owners under the right circumstances.
Case study 1: Apple Computer
The origin story of Apple Computer as a two-man garage operation is well chronicled, but the 1978 SBIC investment that helped launch the company into the stratosphere is sometimes overlooked. SBIC-funded Continental Illinois Bank awarded $500,000 of start-up capital to Apple to support the ramp-up of the revolutionary Apple II computer. With the requisite marketing and engineering geniuses already on board, the hands-off investment was a perfect fit for a small business in need of cash.
Case study 2: RRS Medical
When entrepreneur Jon Leonhardt decided to exit the small medical records business he had established in order to pursue other interests, he found his options limited. With no internal successor identified within his small company, Leonhardt decided a private equity partner could provide the expertise and guidance needed to grow the business, while offering him fair market value. The private equity partner oversaw the transformation of RRS just as medical records began to migrate into the digital realm, while retaining Leonhardt’s input as a technical advisor.
Case study lessons learned
Apple Computer is one of several industry giants that utilized SBIC funding to kickstart their growth at a critical juncture. While full control was essential for Apple’s founders, other small business owners see private equity investment as an opportunity to leverage more qualified experts while maximizing their financial benefit. The contrast between Apple and RRS Medical illustrates the importance of the business owners’ skill set and long-term objectives when choosing the best investment option.
References
https://www.bankrate.com/investing/how-to-invest-in-small-businesses/
https://www.forbes.com/advisor/business/what-is-limited-partnership/
https://gocardless.com/en-us/guides/posts/what-is-an-sbic-small-business-investment-company/
https://www.sba.gov/funding-programs/investment-capital
https://www.sba.gov/partners/sbics
https://www.ecfr.gov/current/title-13/chapter-I/part-107#107.720