Forecast

What small companies can expect in the coming year, no matter which way the economy moves

Read enough periodicals at this time of the year, and eventually you'll run across these economic auguries (and similar variables) for 1997: the GDP will contract or expand; the G-7 will agree or disagree; no layperson will be able to define the difference between M-1 and M-2--or will care; the CPI will hold steady if the PPI doesn't overheat. The surest forecast of all: economic forecasts will tell you everything--and nothing.

Rather than joining the inexact multitude trying to make sweeping predictions about the whole economy, Inc. asked several practitioners to try to identify new trends and developments that small-company owners in particular should be alert to over the next 12 months. The responses focus on six areas that are bound to influence the conduct of emerging companies in 1997 for better or worse.

Credit When You Need It

On the favorable side of the '97 ledger is the availability of credit. Ever since the savings-and-loan scandal, banks have been stowing away so much in reserve that now, for a change, they'll lend to small-business owners when they actually need to borrow.

Most Fed watchers predict that, faced with the prospect of wage-triggered inflation (more on that later), the Federal Reserve Board will tighten credit in '97. And, as usual, not much good will come of it, holds Dennis Gartman, author of "The Gartman Letter," a daily advisory letter on practical economics. "No question the Fed will err in moving interest rates higher going into 1997," he predicts gloomily, "and then it will be slow to bring them back down again."

The board's more-often-than-not out-of-sync actions usually bode ill for small business. Not in '97, however. For once, small business will be the apple of lenders' eyes. For one thing, bank margins have been unusually generous in recent years, says Kathleen Camilli, director of economic research at Tucker Anthony Inc. At the end of 1996 the spread between the banks' cost of funds and their return in lending was about 300 basis points, an uncharacteristically wide gap, which gives banks plenty of room to maneuver if they're faced with Fed-mandated increases in costs. And banks aren't likely to run out of resources anytime soon. "The global flow of capital has been a beneficial force to economic expansion in the industrialized world," Camilli explains. "It helps lower the overall cost of credit for anyone who wishes to borrow." Might foreign banks close out U.S. investment in favor of some other country and cause interest rates to skyrocket? "Inconceivable!" insists Camilli. "We have the largest, most liquid debt market in the world."

For all their robust balance sheets, banks have increasingly fewer customers to lend to. As big corporations have been forging their own global financing channels, and downsizing companies have less need to borrow, says Wayne Ayers, chief economist at Bank of Boston, "the banking system is not that relevant anymore to middle-market and large corporations." Well, ain't that a shame! Like many large commercial lenders, Bank of Boston disdained small business until recently. Now the shoe is on the other foot. "Not only are we ready, willing, and able to lend to small business," Ayers says, "but we're anxious to." And if a downturn should hit in '97? "Small businesses with well-thought-out business plans in place and inventories under control," he says, "still could entice banks to extend them credit."

Labor, More or Less

Although the trained-labor force may continue to shrink, small businesses no longer have the disadvantages they suffered earlier. Indeed, thanks to downsizing among big corporations over the past several years, small business may gain the upper hand. "It used to be that a bright young man or woman starting on a first job tended to favor a large company, where there was job security, even though the odds of getting to the top were small," observes Dennis Gartman. "Now the choices have balanced out: big businesses aren't providing the security they did before; consequently, small businesses, which still offer a crack at the brass ring, can compete for talent on at least an even footing."

Making that footing all the more level, technology eases even the smallest business's need for workers. "Today a cabinetmaker who once drew his plans and cut his wood by hand weeks ahead can wait until the day before the customer needs those cabinets," Gartman says optimistically. "Then he puts them through a computer to design them, to analyze the best use of the wood, and to speed up production. And he can do the job with probably 20% less labor."

But that kind of labor reduction may not be enough. Late last year help-wanted signs were hanging in shop windows throughout New England, where five of the six states boasted unemployment rates of less than 5%. The last time there was a labor crunch in that area, hamburger flippers were offered twice the minimum wage by desperate business owners--and they snubbed the jobs. Without clerks, cleaners, orderlies, and assemblers, many small operations are literally helpless. Even skilled temporary workers who had been casualties of downsizing that were forced into job-placement agencies are now moving back into full-time situations, causing a shortage of part-time accountants, telemarketers, and other small-business white-collar staffers.

And labor shortages are spreading to the unlikeliest of regions. Both small and big businesses seeking the open-space lifestyle have been moving to the Dakotas, for example, only to find themselves vying for workers.

The overall lack of workers threatens to drive up wages. But unlike in the old days, when entire industries raised prices en masse, most businesses won't be able to pass on increased labor costs through price hikes, because of stiff global competition. The conclusion: higher wages won't drive prices up, but they will drive profit margins down.

To complicate matters further, companies that employ skilled labor will increasingly feel the "Silicon Valley Effect." If employers skimp on incentives in terms of income and work environment, good employees will leave for greener places. To keep valued workers, be prepared to reverse the trend, seen over the past six years, of shrinking benefits in the areas of bonuses, profit sharing, and employee stock ownership plans. Some businesses are already doing so, according to a survey by Arthur Andersen's Enterprise Group and National Small Business United, which found that fast-growing businesses were offering more such benefits, compared with the average company, which continued to trim them in an effort to reduce costs.

Reform Opens Money Tap

Contributing to '97's fiscal betterment is, of all things, tax reform. No, Congress didn't eliminate taxes, but our enlightened solons did reformulate Subchapter S rules in ways that, as appraised by Arthur Andersen Enterprise Group deputy director John Evans, "dramatically" enhance the payoffs of electing Subchapter S status.

Among other provisions, the Small Business Job Protection Act of 1996 encourages outside investment in small private businesses by pension plans, trusts, and other tax-exempt entities. Those capital pools were previously ineligible investors. Now such an entity may constitute a single stockholder among an S corporation's new limit of 75 stockholders. (Before the act, the limit was 35.) For fiscal years beginning after December 31, 1997, the act also provides for employee participation in an S corporation through an ESOP, a strategy also previously forbidden to S corporations. (Concomitantly, C corporations with ESOPs and pension plans already extant will then be able to elect S corporation status.)

As a consequence of those new sources of equity financing, S corporations can seek a capital stream that's never before been available. Whether that stream proves to be a trickle or a torrent for the growth of closely held businesses, time will soon tell, says Evans. "After January 1, we'll see if there's a shift in fund interest. Until now fund investment managers focused on the public stock market. But if the market turns and everyone gets frightened, where else is all that money going to go?"

VCs Seek Less Venture

Even at this late point in the current economic expansion, more venture capital is available than ever. Unfortunately for small-business aspirants, more is less. The nature of venture capital is changing rapidly, notes venture capitalist William Elmore, a general partner of Foundation Capital, a Silicon Valley venture firm. One dynamic emerging from more than six straight years of plenty is the compounding effect of nouveau riche entrepreneurs streaming from prosperous companies and eager to start others. So many millionaires have been created among the employees of start-ups in the past few years (in going public in 1995, Netscape Communications created scores of paper millionaires, down to founder James Clark's own office staff), that there are fewer I-can-do-it-too hopefuls looking for seed capital. They've already got their own.

Not long ago, venture-capital firms called the shots and grabbed huge chunks of every deal. Today, awash in capital, the venture-capital industry rushes to accept a smaller share for a larger contribution with less risk. That's OK by Elmore, who has no problem letting rich, smart second-time-around entrepreneurs do their own early financing. More and more often his firm steps in only after customers are buying the company's product. Even in the later stages of a company's development, he says, "a small business coming to a venture firm saying, 'I'd like a half million dollars' is likely to hear, 'I'm sorry, our minimum investment is $3 million."

While statistics indicate that start-ups can still find venture cash (see " Are Big VC Deals Bad for Start-ups?"), the newly conservative venture-capital firms are achieving dramatically higher success rates in their investments. For instance, in Foundation Capital's last eight deals, six companies already had revenues when the first venture commitment was made. The typical cash-out interval has shrunk from about seven years to fewer than four. "We're building management teams that can execute rapidly and cleanly and reduce risk," Elmore says. "I'd rather have a smaller ownership position in a company that's likely to succeed." Even longtime speculators like Boston's TA Associates have turned ultraconservative; TA now admittedly seeks only situations involving companies that have $25 million in annual revenues.

But how long can new business be capitalized with billions of "dollars" minted out of thin air via hot IPOs, and aftermarkets that value new companies at 1,000 times earnings? "We're not even close to the limit," asserts Elmore.

IPO Threat Lingers

Only a few Wall Streeters assume that the stock market, and by extension IPOs, will continue to be hot in '97. One is Alfred R. Berkeley III. "I'm not in the game of predicting where stocks will go in '97," he ventures, "but there's every reason to think that unless something derails it, we'll continue to have a good market." To be sure, there's self-interest involved: Berkeley is president of the NASDAQ exchange. A novel underpinning of stocks today, he theorizes, is that the country's 50-somethings need 20%-somewheres to park their money in. For the first time in history, individual households have more money in the market than they have in banks. And that's not likely to change anytime soon. "You've got all these baby boomers starting to get serious about saving for their retirement," Berkeley points out. "They need a higher return than they can get from a bank in order to make their retirement work."

If stocks do cycle into a downturn, the plenitude of aftermarket investment capital nonetheless suggests that the window for IPOs, agape in '96, won't shut completely. But what might narrow the window are initiatives like the Retirement Savings and Consumer Protection Act. A binding proposition on California's November '96 ballot, the act would have removed the personal-liability buffer that a public company legally provides its officers and directors. Instead, it would have held them, as well as their accountants, investment advisers, and other corporate intimates, subject to punitive damages for issuing statements regarding the company's performance that later proved inaccurate. Sponsored by a lawyer (of course) specializing in securities-fraud suits, the initiative failed, thanks to the fact that nervous Wall Streeters poured some $40 million into defeating it. But a proposition like it may pop up again, with national implications: a shareholder in the state that passes such legislation could initiate a suit against a company incorporated in any state.

"This is the most negative piece of legislation I've ever seen," frets William Elmore of Foundation Capital. "It will dampen capital formation. Anyone standing to create wealth by building a growth company would face putting personal assets at risk." There will be fewer future IPOs if some founders choose not to go public as a result of lingering concern.

Consumers: 'Rainy Day?'

We hesitate to throw a wet blanket over what will soon become--barring two successive down quarters in the gross domestic product--the country's longest postwar economic expansion. But no one who's concerned with the health of the economy can ignore consumer spending. Consumers account for a whopping two-thirds of the GDP. Credit cards have been so abundant that to many businesses they represent a more enlightened mode of borrowing than approaching a bank and defending an analysis of their financial statements. Last year the piper got paid: consumers set records in both personal-bankruptcy filings and credit-card defaults. Is consumer debt a threat for '97? Could be, Tucker Anthony's Kathleen Camilli warns. "The ratio of debt service to disposable income is at the highest level since 1989--just before the last recession."

On the other hand, consumer nonspending would be an unwelcome business trend. But the economy can't have it both ways. "People today feel they deserve the good life, and if someone's dumb enough to send them a credit card, they're going to use it to pay for a style they can't afford," notes A. Gary Shilling, a former Merrill Lynch economist who currently heads his own advisory service. Nineteen ninety-seven's spenders have singular reasons to pull in their horns. "Given widespread job insecurity," Shilling cautions, "people ought to be putting something aside for a rainy day. Furthermore, nobody expects to get a dime out of Social Security when they retire, so you'd think they'd be saving like there's no tomorrow."

Which, if they keep spending as if there's no tomorrow, there may not be.

Robert A. Mamis is a senior writer at Inc.