shuffling of scarce dollars from one sector of the economy to another, but rather an injection of vitality into an area which will earn, in the long-run, a fiscal dividend. This is possible since investment in small, fast-growing businesses generates, ultimately, a greater amount of economic activity which in turn provides greater aggregate wealth for the economy and additional tax dollars for the treasury. For example:

A recent study by Massachusetts Institute of Technology Development Foundation has arresting data on the importance of new companies and new technologies to property and jobs in America. It compares the performance of six mature companies, five innovative companies, and five young high-technology companies. From 1969 to 1974, the average annual contributions of these companies in jobs and revenues shaped up as follows:

2

2 U.S. Small Business Administration, "Report of the SBA Task Force on Venture and Equity Capital for Small Business," Washington, DC., p. 2.

Further, one Government study sampled SBIC-financed small businesses and found that those companies achieved annual growth rates of 25 percent for employment, 27 percent for revenues, 27 percent for profits and 35 percent for assets. It must be stressed that these companies are the innovative, high-growth type which have high potential for employment at a time when sustained, excessive unemployment remains one of our country's most severe economic problems. The availability of financing for small and independent businesses is and should be a high priority for a sound national economic policy. Because of high risk and reduced reward (the latter coming from strict government regulation and oppressive tax policies), however, traditional sources of venture capital financing are drying up. This phenomenon prompted the comment by Thomas Murphy writing in the April 15, 1977 issue of Forbes magazine that: "If Adam Smith could return, I think he'd be upset to learn that in a world's biggest capitalistic country the Government has become the biggest venture capitalist." He was referring to the fact that only the SBA loan guarantee program and the SBA-assisted SBIC program are making financing available to much-in-need small business. He goes on to further explain that:

"Roughly half the American economy is small business. It happens to be the half that furnishes most of the jobs everybody says we need: entry-level jobs for youngsters service jobs for women and something else that you cannot quantify— it finds places for the millions who don't fit the tidy mold at Xerox and the phone company."

To make matters worse, while venture funds are drying up small companies also cannot look to the public markets where they, once received a great percentage of their funds. The following is a chart showing the number of new issues sold for firms with net worth of less than $5 million for the period from 1969 to 1975:

In addition to small businessmen and venture capitalists, high level business and government leaders have addressed the problem of inadequate internal and external capital financing availability. In May of 1976, Treasury Secretary William Simon appointed the Treasury Small Business Advisory Committee on Economic Policy which recommended, among other things, the implementation of 10 specific tax proposals and further study and consideration in several other

areas:

"Recognizing that Federal taxation has the greatest adverse impact on capital formation for the bulk of all small independent business, the Committee ranked tax policy as its highest priority. In principle, we support H.R. 13687, the COSIBA small business tax bill, but we have focused on several items which we recommend for adoption or study. The first three items constitute the principal recommendations of the Small Business Administration Venture and Equity Capital Task Force chaired by William Casey."

Specific Treasury Advisory Committee proposals included :

(1) Adjustment of depreciation schedules so that a taxpayer would be permitted to write off any amount up to and including 100 percent of an asset value in the year of acquisition (up to $200,000).

(2) Revision of the corporate rates to graduate the tax at four levels with the maximum rate of 48 percent being reached at a taxable income of $200,000. (3) Deferral of capital gains tax if the proceeds from an investment in a qualified small business concern are reinvested in another small business

concern.

In January the Report of the SBA Task Force on Venture and Equity Capital for Small Business was released. That blue ribbon group, chaired by former SEC Chairman Bill Casey, recommended a number of changes which would significantly help the capital-short small business sector. Their tax recommendations included the following:

Tax laws and regulations

"Increase the corporate surtax exemption from the present level of $50,000 up to $100,000;

"Allow greater flexibility in depreciating the first $200,000 of assets; "Permit investors in qualified small businesses to defer the tax on capital gains if the proceeds of the sale of a profitable small business investment are reinvested within a specified time in other qualified small business investments; "Increase the deduction against ordinary income of capital losses in a small business investment made under Section 1244 of the Internal Revenue Code from $25,000 in annual deduction to $50,000, and increase the limit on an offering from $500,000 to $1 million and on issuer size from $1 million to $2 million in equity capital;

"Permit underwriters of the securities of smaller businesses to deduct a loss reserve against the risks inherent in the underwriting and carrying of such securities;

"Revise methods by which revenue impact of tax changes are estimated to reflect revenue gains from the business use of tax savings and the stimulus to capital formation that tax incentives provide."

Expounding upon the lack of external capital available for finance and expansion, the Casey Task Force reported:

"It is alarming that venture and expansion capital for new and growing small businesses has become almost invisible in America today. In 1972 there were 418 underwritings for companies with a net worth of less than $5,000,000. In 1975 there were four such underwritings. The 1972 offerings raised $918 million. The 1975 offerings brought in $16 million. Over that same period of time, smaller offerings under the Securities and Exchange Commission's (SEC's) Regulation A fell from $256 million to $49 million and many of them were unsuccessful. While this catastrophic decline was occurring, new money raised for all corporations in the public security markets increased almost 50 percent from $28 billion to over $41 billion."

Prompted by the deteriorating small business climate and by the disconcerting lack of profitability in the SBIC industry NASBIC produced its 20-point Legislative/Regulatory Package for 1977. I would like to turn now to our industry and the specific tax changes we feel are necessary in order to improve the long-run health and viability of the SBIC industry-changes which, by strengthening SBICS, will ultimately benefit small businesses by strengthening one of their few remaining sources of long-term capital.

THE SBIC INDUSTRY

SBICS are the product of a joint venture between the private and public sectors initiated by the Small Business Investment Act of 1958. SBICs link the efficiency of private enterprise with the financial resources of the Federal Government to provide venture and equity capital financing exclusively for small businesses. Private funds put up by investors are leveraged up to 4-to-1 with long-term money borrowed from the Federal Government at a rate one-eighth of 1 percent above the cost of money to the government. In that manner, funds are made available to small business investors and the Federal government makes a profit in the deal to boot. I might add that all private funds are at risk before the government loses a nickel. This subordinization of private to government capital almost absolutely insures that the individual SBIC will pursue a prudent investment policy. Losses to the SBA have totaled only $29 million over the past 19 years. Over that time, almost $3 billion have been invested in approximately 40,000 small businesses in a total of 50,276 financings.

We are also glad to report that the owners of these companies were deeply grateful to the SBICs for financing their start-up or growth. An SBA survey revealed that more than 90 percent of all portfolio companies had benefitted from SBIC help, most of them to a major degree. Naturally, tensions sometimes arise between an entrepreneur wholly involved in the life of his business and the lender or investor advancing funds to that firm, but the true partnership nature of the relationship between the businessman and the SBIC is supported by SBA's findings that 87 percent of the owners were satisfied with their SBIC dealings and 87 percent said they "would use SBIC assistance again under similar circumstances."

In order to attract the capital needed in the SBIC industry, however, we must increase our profitability. Although the SBIC industry is an active one, with assets near the $1 billion mark, there is much demand for venture and equity capital going unmet. At the NASBIC Annual Meeting in November 1976, SBA Administrator Kobelinski said: "We estimate that small business faces a shortfall in venture and working capital that will average from $7 billion to $8 billion a year over the next decade."

As we all know, capital will tend to flow to where the risk-adjusted rate of return is greatest. Since the venture capital industry is an industry with a good degree of inherent risk, it stands to reason that its return on capital should be higher than in safer investments. That is not the case however, and our SBIC profitability rates have been very modest. Our highest rate of return on invested capital, for example, was 9.5 percent in the year ending March 31, 1969. The second highest return, however, was only 6.0 percent in the year ending March 31, 1968. In short, although the SBIC industry is an active and exciting one, its profitability is just not high enough to attract sufficient investment capital.

We at NASBIC feel that the SBIC program is a success. But to fill the needs for venture and equity capital in the upcoming decade, we must expand our activities by making the industry more profitable. The net return to the government from the SBIC industry via taxes paid by the SBICs themselves, portfolio companies made stronger and more profitable by SBIC financial and management assistance, and by the employees of those companies, is highly positive. But in order to expand the industry to help fill the small business "capital gap" we need to provide more incentives to attract additional private funds.

Mr. Chairman, in view of your Subcommittee's jurisdiction over Federal tax policy, I wish to place heavy emphasis on the following three recommendations contained in our Association package. The first would provide an incentive for all investors, individuals or institutions, to invest in the securities of smaller companies. The other two refer specifically to SBIC tax issues which will allow our industry to operate more profitably and to attract more private capital.

1. Defer capital gains taxes when proceeds of the sale of stock issued by a small business are reinvested in an eligible small business concern

The greatest moment in the life of a venture capitalist comes when he is able to generate hard dollars through the sale of his long-held stock (usually about 10 years) of a successful portfolio company. That's the culmination of a promising investment opportunity, proper structuring and pricing, continuous counseling, and an imaginative exit technique on the part of the SBIC manager or other investor. Less exciting, though, is the heavy burden of Federal and State taxation which will take away about 50 percent of the capital gain so generated. There's

a contradiction in this situation: the Federal Government has established and encouraged the SBIC program as a matter of public policy to provide capital to small business, but the same Government decimates the flow of such funds through the imposition of onerous taxation.

Undoubtedly, one of the worst threats to the continuation of the free enterprise system is contained in the Internal Revenue Code. Our tax law permits tax-free reorganizations which provide an irresistible incentive for the owners of a successful small business concern to sell out to a major corporation, since there is no immediate tax consequence of such a merger, so long as they take the stock of the big business in return. This provision of the Code lessens competition and compromises the free market system.

To offset this serious danger, NASBIC strongly urges that the tax law be made at least neutral. We propose an amendment to the Code which would encourage further investment in other small businesses. Taxation of capital gains arising from the sale of stock in a business firm which was small when the security was acquired, would be deferred when the proceeds of that sale were reinvested in a small business concern within a two-year period. There is a clear precedent for this amendment, both in the current corporate reorganization section and in the deferral of taxes on the sale of a residence.

2. Allow all SBIC's to pass through their earnings to their shareholders without the imposition of corporate tax

It is our goal to attract different types of investors to the SBIC program. To those who are particularly interested in capital appreciation through the growth of the SBIC, the capital gains provision outlined above is especially attractive. Other investors, though, have the need or desire for current income, so they would be more likely to invest in SBICs which pay regular dividends. At the present time, publicly owned SBIC's which are registered under the Investment Company Act of 1940 may avoid corporate taxes on their earnings so long as they pass through at least 90 percent of their profits to their shareholders. This authority has proven to be most valuable to several of the public SBICs which have increased their private capitalizations regularly over the life of the program.

We believe that all SBIC's should be given this authority whether or not they are publicly owned. Although this position may appear at first blush to contradict our goal of bringing more capital to the program (since earnings will be distributed, not retained), we are certain that the payment of regular dividends will indede attract many millions of dollars of new capital to those SBIC's which are primarily income-oriented and, thus, able to pay such dividends to their shareholders. Present SBIC's will get the new capital they need to grow and new SBIC's will be formed, we are sure, if the passthrough provision is approved. 3. Provide a statutory loss reserve of 10 percent for SBIC's based upon equities, as well as debt securities

No matter how we redesign the SBIC program, one constant will remain: the high level of risk involved in providing financial assistance to new and small businesses. Over the past 18 years SBIC's have grown more skillful in screening out the doomed investments and in protecting themselves against losses, but every SBIC will inevitably have to swallow its share of complete or partial losses. At present, the Internal Revenue Code permits an SBIC to set up a reserve for bad debts based upon its experience, but this authorization is seriously deficient in two respects: first, for an SBIC, the past is no certain guide to the future. An SBIC may be fortunate enough to have minimal losses for 10 or 12 years and then it may have two or three deals go sour in a very short period. We believe it would make good business sense for the SBIC to set aside a reserve to take care of such unexpected losses. The second problem with the current law is that it allows for losses only on loans and not on investments, even though the latter are ordinarily far more risky. The NASBIC proposal then, would have the law permit any SBIC to establish a reserve against losses in an amount up to 10 percent of its total portfolio, both loans and investments. Here again, the change would encourage further equity investments.

These three specific recommendations would make a significant contribution to the profitability of SBIC's and we are certain they would encourage millions of additional dollars to come into the SBIC program, both into existing licensees and into new ones. The major beneficiaries of these changes, however, would be: (1) new and growing small businesses; (2) the Federal Government which would reap greatly expanded taxes from the small businesses assisted by SBIC's and from the new workers employed by those growing firms; and, (3) the economy

which would receive new products and services at lower prices through increased competition.

In summation, NASBIC genuinely believes that there is a significant investment capital shortage for small and independent enterprises in the United States today. We are proud of the role SBIC's have played in the financing of small businesses for the past 18 years but feel that there is much more investment of that sort needed. Since purely private sources of venture capital have dried up significantly in recent years, government-assisted stimulation is necessary. We firmly believe that adoption of the NASBIC Legislative/Regulatory package will be a significant step in the right direction toward closing the equity and venture capital gap, and would encourage the Subcommittee's support in the specific tax areas we have focused upon.

Thank you.

Senator BYRD. The next witness is Mr. E. F. Heizer, National Venture Capital Association.

STATEMENT OF E. F. HEIZER, JR., NATIONAL VENTURE CAPITAL ASSOCIATION

Mr. HEIZER. Good morning, Mr. Chairman. I want to apologize for not having supplied a written statement in advance but we will supply one. I would like to start off by emphasizing several background points and then make three specific tax recommendations.

First of all, so you understand the vantage point from which I speak, I have been a venture capitalist like Herb Krasnow for many years and our firm, the Heizer Corp., is one of the largest firms specializing in financing what we call early stage growth companies. These companies are very small when they start, but they become very large and very important contributors in terms of net new employment and in terms of taxes to the Federal Government.

I might add that I think the Senate and the House, when considering legislation, should keep in mind that the Federal Government owns, in effect, 50 percent of every successful small business.

Senator BYRD. The Federal Government has a bonanza. It has 50 percent of all the profits and does not share in the losses.

Mr. HEIZER. That is right.

Senator BYRD. I think that is an ideal situation.

Mr. HEIZER. We feel that the Federal Government, having that in mind, should be more supportive of the various programs which we would like to see you support.

In that light, we are very pleased, of course, that you are holding these hearings and that a number of us are having an opportunity to express our views to you. I think that a major point that is sometimes missed in this picture is that, over a period of years, our country has gone from where our inoney and our capital was in the hands of people who built this country and built these businesses and understood what it takes to build businesses and who have the spirit of wanting to help their fellow man and woman get going in business, into the hands of institutions.

The institutionalization of our money, just in my short lifetime, has gone from where the major movement of funds to small businesses came mostly from individuals to where this source of funds is essentially shut off for all practical purposes, or down to a dribble, and where we must look to the institutions for most of our financing.