Bring the Small Business Administration into the 21st century
Empowering Entrepreneurs to Remake America
1. Measure performance
Entrepreneurs made America. They can remake it, too. Unfortunately, our key agency for promoting business development — the Small Business Administration — is stuck in the past. While its programs are as varied as the World Bank, the vast majority of the SBA’s budget goes toward guaranteeing bank loans for small, largely mom-and-pop-style businesses. As noble as this may sound, such firms are simply not the engines of productivity growth and job creation in a modern economy. On the contrary, by privileging the criterion of size over alternative indicators, the existing SBA likely hinders economic development by distorting industry scale and structure.
The SBA is unlikely to change its first initial any time soon. Nonetheless, firm size definitions are sufficiently broad to enable a good deal of flexibility. All else equal, shifting SBA support to the tradable sector and manufacturing firms, for instance, is more likely to facilitate the growth of high-wage jobs. Similar preferences, including relaxation of size restrictions, could be given to businesses:
participating in Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs;
within under-represented industry classifications;
and with high average employee wages.
Targeting young but fast-growing businesses is another a promising avenue for reform. Unfortunately, the SBA does little-to-nothing to track the performance of loan recipients, much less conduct rigorous program evaluations, making it inherently difficult to triage resources in a dynamic way.
Under the status quo, SBA “job creation” numbers are an article of faith, derived from self-reports on loan applications with no verification after the fact. Basic reporting could be achieved burden-free by simply linking existing administrative data, like tax filings and financial statements, as a requirement of participation. With quarterly or annual business performance metrics, SBA programs could become much more creative. For example, businesses that demonstrate sustained export revenue growth could be prioritized over businesses that underperform against a benchmark of their local economy, building on success rather than forestalling failure. Positive spillovers could be measured, and machine learning techniques could be used to infer optimal program structures.
Successful industrial policy is as much about cutting off support for “losers” as it is identifying “winners.” Export growth is a particularly valuable indicator in this respect, although not because running trade surpluses is inherently virtuous. Rather, exporting firms are continuously disciplined by international competitors, helping separate the wheat from the chaff. As the economist Dani Rodrik notes:
conditioning subsidies on exports has the valuable feature that it ensures the incentives are reaped by winners (i.e., those that are able to compete in international markets) rather than the losers.
In contrast, by failing to collect business performance indicators, the SBA provides cheap credit to businesses both good and bad, retarding the market discovery process.
2. High risk, high reward
In addition to small business loans, the SBA promotes access to capital through Small Business Investment Companies (SBICs). SBICs are privately owned investment funds licensed to make investments in small businesses using a combination of privately raised capital and funds leveraged at below-market interest rates thanks to government backing. They are often credited with cementing America’s venture capital market and were early investors in many household names, but are not without their problems.
While SBIC funds can double or even triple their capitalization through leverage, they are immediately on the hook for semi-annual interest payments and debenture fees, with eventual repayment of principal. Debentures are unsecured debt instruments issued by SBICs that, once pooled, are sold to banks and investors in an SBA-guaranteed bond offering. This combination of debt and equity biases SBICs toward investments in low-risk, mid-to-late stage businesses with positive cash flow, undercutting a core advantage of equity financing.
In 1991, the SBA was authorized to guarantee participating securities issued by SBICs for investments in early-stage startup companies. Participating securities operate like debt but are equity-like in that interest is repayable only to the extent of earnings. After showing early promise, the dramatic losses incurred by the SBA following the dot-com bubble caused the program to be retired.
There are perennial efforts to revitalize early-stage SBICs, but so far the risk-averse orientation of the SBA has held strong. Debentures are popular with the banking industry because they provide Community Reinvestment credits and strong, certain returns, and popular with the SBA because they avoid the political backlash associated with losses. Nevertheless, there are several ways participating securities and related tools could be reintroduced while minimizing risk to the public:
Establish a companion trust fund capitalized by SBIC fees and earnings on participating securities and invested in countercyclical assets;
Enhance the SBA’s profit participation, such that it earns a proportional share of the total upside;
Expand the use of deferred interest debentures, like those currently available for “low- or moderate-income” zones and “energy saving” companies, to a broader class of firms;
Offer leverage to SBICs with revenue-based financing options for seed-stage companies.
Revenue-based finance is a particularly popular financing option for pre-cash flow startups that need a relatively small amount of capital to get off the ground. Rather than acquire ownership, the SBIC (and SBA) would make a return if and only if the company becomes revenue positive — at which point conventional SBA financing options start to look more attractive.
Building an ecosystem
As discussed elsewhere, program integration is critical to the success of economic development policy, and the SBA is no exception. Indeed, the SBA already has many of the facets of an economic development agency, but in ways that would benefit greatly from smart reform.
The SBA’s cornerstone 7(a) and 504 loan programs do little to evaluate or even measure business performance, beyond the risk of default. The SBA provides leveraged capital to private venture funds, but through a debenture and fee mechanism that is inherently risk-averse and biased to businesses with positive cash flow.
SBIR and STTR theoretically support business investments in R&D, and provide pathways for commercializing publicly-funded technologies. Nonetheless, the ecosystem of SBA programs seldom work together, making the whole less than the sum of its parts.
These are just some sketches of how the Small Business Administration could be modernized with the goal of economic development in mind. The possibilities are endless, but will only come to fruition with extensive buy-in and collaboration. The Struggling Regions Initiative is here to lead the way.