Banks and investors aren’t helping small businesses enough. Funds like these could fill the gap

Over the course of five days in August of 1965, five days of protests in the Los Angeles neighborhood of Watts gave way to violence. The upheaval gave vent to feelings of injustice, but also devastated many of that community’s small businesses. Unemployment soared, and families had to move or even break up to find jobs. 

Governments—whether local or federal—were unable or unwilling to rebuild the warehouses, barbershops and restaurants that had been damaged. Neither was private capital rushing into Watts. So a group interested in helping rebuild Watts approached the Internal Revenue Service, with a request that they be granted Section 501(c)3 tax exemption status in order to attract patient and appropriate capital to invest in the businesses that made Watts a community. 

The IRS granted the investment group this status, as long as the group maintained redeveloping Watts as their primary goal. An entity was established which used a grant from the U.S. government, leveraged 3-to-1 by private capital, with the objective of relieving poverty and unemployment in Watts. And the entity went on to make over $30 million of investments in the area and created thousands of jobs. 

The federal government recognized then that rebuilding small businesses in Watts—and in underserved markets more generally—was not something the government was well suited to do. Yet it also recognized that those underserved communities weren’t likely to attract capital from more conventional asset managers interested only in making the highest profits and as quickly as possible. 

Almost 25 years later, in 1989, our organization, SEAF (the Small Enterprise Assistance Funds), was established based on the same ruling—but with a mission to invest into, and grow, small businesses in underserved emerging markets. SEAF knew that the most effective way to rebuild the countries of Poland and Romania after socialism, and Afghanistan and Colombia after conflict, was to invest in entrepreneurs who provided the business services, local grocery stores, pet food, neighborhood pharmacies and restaurants that would employ people and provide stability. To date we have done this across 31 countries and deployed more than $650 million directly to more than 400 entrepreneurs, creating or maintaining more than 60,000 jobs. 

But we did not do this by providing straight debt, in the form of bank loans, or by taking equity stakes the way private equity or venture capital firms would. We offer entrepreneurs patient investments which do not saddle them with debt, and do not pressure them to expand at Silicon Valley-style rates. We now need to adopt this model far more widely in the U.S.

Small and medium-sized businesses, left behind

The economic consequences of the COVID-19 lockdown have been clearly disproportionately hard on America’s small businesses. Even more recently, many small businesses across this country have regrettably been damaged by looting and vandalism that coincided with demonstrations against the tragic killing of George Floyd. Unemployment has reached levels not seen since the Great Depression and a great uncertainty exists as to whether past business models will be able to continue as before. 

Small and medium-sized enterprises (SMEs) with 500 or fewer employees, especially those outside the concentrated, capital-rich markets of Silicon Valley, New York and Boston will find it hard to find financing to rebuild and reposition themselves. Banks are unlikely to be helpful—the PPP program exposed the limitations of banks and their inability to reach many small businesses. Those businesses will also not be helped by the mainstream VC and private equity firms, which do not focus on Missouri or Alabama or Maine, or on the everyday SMEs which generate nearly two-thirds of all new US employment. 

In a sense, the economic damage caused by recent events can be said to have brought out the underlying reality that our great financial system has a significant flaw—it is not reaching solidly managed businesses in the vast majority of regions in our country. The ordinary SMEs—which can double or even triple in size, but will never qualify as a “unicorn”—have been left behind. Money and jobs have been developed for the elite and in the elite areas; however, for the rest of America, businesses had to rely largely on debt from banks and possibly Small Business Administration lending programs. These businesses now have high debt levels and either have few prospects for growth or none at all.

It is clear that if we want to see a broad-based recovery we need to restore strong local businesses. We need resilient and energy-efficient local construction companies, local food processing companies, local lumber yards, specialized hospital cleaning companies, and last mile internet service providers. Instead of debt, these “Heartland Businesses” will need more flexible “growth” financing to (re)start and flourish. With the appropriate capital and management support, these businesses will achieve the growth that will generate sustainable jobs and create wealth in the regions in which they are located. 

A win-win

If the picture for broad-based growth in the U.S. is bleak for SMEs, neither is the picture rosy for investors. With Treasury bills offering negligible fixed interest rates, cap rates on real estate likely to fall, defaults to increase, and public equity markets closed to IPOs of all but the rare few companies, the vast majority of investors have a menu of very low interest rates and improbable equity opportunities to choose from. 

Yet there is a solution to these problems, one that flows from lessons SEAF has learned from its investment around the world over the past 30 years.

The time is right to offer investors “impact investment” instruments that would provide them with reasonably safe, high-single-digit returns, while providing Heartland Businesses the ability to grow their operations and their employment in ways not possible with pure debt-based or venture capital. SEAF has been using such instruments around the world in underserved markets, where IPOs and active markets for private equity are mostly a theoretical possibility, like Macedonia, Estonia, Colombia and Bangladesh. We should now use them in the many U.S. states that have largely been left behind by private equity.

Specifically, we believe that revenue-based or profit-sharing instruments are especially suited for growing small businesses. These instruments usually tie repayment to the growth of the business, by paying investors a percentage of revenue or profits of that business. For Heartland Businesses, these instruments permit growth without immediately having to amortize financing costs. These alternative investments furthermore better align the interests of the investor or fund with the entrepreneur, as both seek to grow the business successfully, in order to benefit from sales- or profit-based royalties as well as the equity kicker. And while the standard terms may occasionally miss out on some of the upside of a particularly high-performing individual investment, the speed at which these agreements can be negotiated (without lengthy valuation discussions) and the protection on the downside of at least a portion of the company’s assets tends to compensate for such misses. Instead, this instrument delivers medium level returns at moderate risk for what will remain in all likelihood a small local business—exactly what the United States economy requires to rebuild. 

The kinds of investment instruments we recommend offer growth capital instruments with a blend of the following characteristics:

• A relatively low interest rate with some (probably partial) collateral coverage, but no amortization of principal;
• A royalty-based participation in the increased revenues generated after the investment;
• A notional minority equity investment, with automatic dividend rights and a buyback clause enabling the entrepreneur to buy our shares back at some affordable multiple after completing the repayment of the loan.

In our model, all payments to the investors are capped after the company receiving funding has paid back roughly 2.5 times the amount of the original capital invested.

This kind of capital is much more appropriate to help businesses recover and grow than traditional financing. Bank debt, in the form of straight-line loans, is extractive because the business has to pay back no matter how it is doing at a given time, and venture capital pushes for exponential growth, next valuation and a quick exit—not a path most Heartland entreprenenurs would choose to take.

A call to action

Investors concerned about economic growth and recovery in their regions should strive to invest in small businesses, and should do so via funds which offer these investments as instruments which both deliver reasonable returns AND allow Heartland Businesses to grow. These instruments emphasize growth over collateral, partnership over collection procedures, and a reasonable sharing of the benefits of growth. We have been using these instruments for 30 years and have been able to not only successfully return capital to investors, but to have developed lasting small businesses who have been and are a key part of the economic growth in their countries.

What is also important is that these instruments be deployed via investment vehicles fit for this purpose. As with the rebuilding of Watts, investment managers should be able to establish 501(c)3 entities or other-impact led investment vehicles, blend commercial and philanthropic dollars, and be judged not only based on their financial returns, but also on the impact they create in the communities where they place their capital.

We believe that the above approach is mostly missing in the U.S. today, and that it is vital that it be added to the mix of investment instruments to support small businesses. It is time for investors to join in the rebuilding of ALL of the nation, and to realize that the more equitable distribution of economic opportunity and job growth will restore not only business and the economy, but also a more equal,more just and more prosperous United States. 

Bert van der Vaart is a co-founder and CEO of SEAF, a global investment fund manager focusing on small and medium enterprises. Agnes Dasewicz leads the Capital Access Lab at the Ewing Marion Kauffman Foundation, and sits on the board of directors of SEAF.

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