Housing finance represents a key element in the capitalization and liquidity of small business enterprises (SBEs) in America. Accessing the equity in one’s home via home equity loans/lines of credit (HELOCs) or refinancing has enabled entrepreneurs and small business owners to expand operations, hire new employees, make capital improvements, and invest in research and development. Unfortunately, with the challenges, market conditions and myriad of deficiencies within the US housing finance system, SBEs now find themselves unable to avail or restructure this source of funding. And in a period of “job creation” discussions, the biggest engine of such job creation, namely small business, is mired with trials of job retention and ultimate survivability, due to the state of housing finance.
With property values eroded, loans not being refinanced, and desired access to residual equity being a non-starter, other means of capital availability need be proffered. But before suggesting alternatives, borrowing against one’s home (say HELOCs) has never been an optimal source of financing. I say this in the spirit of “match-funding” assets and liabilities. Normally, match-funding addresses pricing of the respective loans and funding source (e.g., deposits). But it also addresses the risk profile of both the source and use of capital. Investing in a higher risk venture should be done with “high risk” funds able to be lost. A small business owner invests “equity” into his business, with such equity seeking an attractive return (via appreciation or improved cash flows), however, such small business can also witness operating challenges. If the latter were to happen, by using leveraged finance (the home loan) further problems occur, as the loan remains outstanding. So, while the “asset” (small business value/health) is diminished in value, the liability remains, making the use of leveraged finance for an SBE the proverbial double-edged sword. The SBE owner not only has exhausted his business funding, but is still obligated with a significant liability, one that places his home (and personal finances) at risk.
To the main issue, there is a tremendous need to make available funding resources to the SBEs, as this is critical to the economy at large. But, the type of such funding needs to reflect the nature of the “equity risk”, which will need to be sourced from outside of the lending community. These funds will be seeking attractive returns, but positioned to absorb a loss. We subscribe to two means of appropriate funding for small business, willing and positioned to accept “equity” risk.
The first, similar to practices of larger companies, is direct equity funding from third party investors. Such investors are willing to “invest” funds in hopes of achieving returns through the capital appreciation of the SBE capital stock. The challenge today is that SBEs have limited access to equity markets, and more so, when they do, the cost of raising the limited amount funds sought given the laws and regulations involved in securities’ transactions, are prohibitively expensive. In order to effectuate this, there needs to be a framework to enable the equity fundraising in a cost effective and efficient manner. One such method would be the deployment of objective and transparent “crowdfunding” platforms, whereby SBEs could raise, say, up to $1 million in equity funds via pools of investors. Crowdfunding has been successfully used to fund creative projects, such as music, independent film, and journalism. But in these applications, the provider of funds serves as a patron to the initiative, benefiting through rewards, products and other “non-economic” elements, rather than the appreciation of share value of company stock. Online platforms, such as Kickstarter and Indie-gogo, have shown the efficacy of crowdfunding to aggregate and direct small increments of funds to enable a creative campaign to manifest. This approach can be effectively applied to the SBE community in terms of raising small amounts of equity funds, subject to the willingness of regulators to not over-burden such efforts with costs and restrictions.
The second approach is to enable funding for the SBE owner through a different method of housing finance, namely equity sharing, whereby an investor “buys” (or invests in) a percentage equity interest in the owner’s home, seeking a return from potential property appreciation. Equity sharing finance becomes a much more prudent approach to SBE financing than leveraging (and pledging as collateral) the owner’s home (the double-edged sword) in that, the owner is saddled with a liability that not only remains constant regardless of the financial outcome of the SBE, but also remains constant regardless of the market value of the home.
Many entrepreneurs and SBE owners found themselves borrowing funds against their homes in the 2005-2008 period, where home prices (and interest rates) were higher, home equity was plentiful, and bankers were quite anxious to lend. Now these SBE owners, operationally challenged with the current economy, find themselves carrying high priced mortgages, unable to refinance as their home prices have fallen, cannot access any residual equity due to lender sentiment, and thus placing both their businesses and themselves at extreme financial risk. With equity sharing models, such as PRIMARQ (in ways, a crowdfunding platform itself), SBE owners could access the equity in their homes in a non-leveraged fashion, i.e., by selling a portion of the home analogous to their company selling its capital stock. Under such equity sharing arrangements, there would be no debt service (i.e., monthly payments), and more importantly, the risk of value changes in the asset which was used to generated needed funds (the home) for the SBE owner has been shifted, appropriately so, to the provider of such funds. If the property falls in value, the investor participates in the loss. Risk capital for risk capital.
It is critically important for capital, specifically equity, to flow into small business, the core engine of our economy. Existing market conditions and historic practices do not offer a compelling landscape to “prime the pump” for SBE expansion, job creation and investment. While there is capital available, it will need to come in different “flavors” and from different “directions” than in the past. Borrowing against a home alone is an anachronism. Capital will need to be defined not just by the return it seeks, but the risk it will bear. And given the limited size of SBE individual funding requirements, funds will need to be deployed cost-effectively, efficiently and fairly. Whether through the sale of capital stock of an SBE through a crowd funding platform or an equity share financing of an SBE owner’s home, the method of finance needs to share risk and return appropriately between user and provider of capital, and, done well, bring much needed funding into a space urgently needed, while protecting the interests and fortunes of the small business owner.
December 6, 2011