Five years ago, small business owners from around the nation, elected by their peers, assembled in Washington, D.C., to hammer out an agenda for the 1980s. Their biggest single concern, as it turned out, was the availability of capital. Six months ago, small business representatives met again to review the issues. As before, the area of greatest concern proved to be capital availability.

It isn't that national policymakers weren't thinking about capital formation during the intervening four and a half years. Indeed, key figures from big business and big labor -- Irving Shapiro of Du Pont, Felix Rohatyn of Lazard Freres, and Lane Kirkland of the AFL-CIO, among others -- were busy in Washington pushing for multi-billion-dollar industrial development banks. But not much is heard about small business in these "industrial policy" plans.

The irony is that America's big companies, even those in declining industries, already have plenty of options for obtaining capital. They can sell long-term bonds that carry lower interest rates than most small businesses ever see. They have access to huge pools of capital controlled by such institutional investors as pension funds and insurance companies. They can issue new stock or negotiate new credit lines with big financial institutions, and they can take advantage of tax breaks written by Congress to their specifications. Given these choices, one could conclude that a big, established company that can't raise capital in the existing market probably isn't such a hot investment.

At the other end of the spectrum lie small start-up companies. These generally risky ventures tend to get their capital today from the same places they got it 30 years ago: from the families, friends, and personal savings of the entrepreneurs, and from bank loans, including those guaranteed by the Small Business Administration. Although recent federal policy has done little to improve these companies' access to capital, changes in the tax laws have at least improved their cash flow. They can reduce their taxes with extended loss-carry-forward rules; they can now expense the first $5,000 in annual capital investment; and they can take advantage of liberalized tax credits for the purchase of used equipment.

These tax changes, along with the continuing availability of traditional lending sources for small start-ups, may account for a surprising finding in a survey conducted by the National Federation of Independent Business. The companies surveyed, mostly mom and pop-size, ranked availability of capital as only a middle-level problem for them.

If large businesses have plenty of capital-raising options, and if very small companies don't view capital access as a major problem, then why all the fuss?

The fuss is because between these two extremes there is a huge hole -- the Grand Canyon of capital formation -- where thriving small- and medium-size businesses that want to expand can't raise capital without losing their independence. No access to the bond market for them; no long-term loans; little interest on the part of institutional inventors; limited access to the stock market; no generous bank credit lines.

This huge market imperfection, which shrinks the potential growth of expanding companies, is not just bad capitalism, it is bad public policy. A high percentage of new jobs now come from businesses that are small and expanding; more than half of all industrial innovations come from smaller enterprises. The ability to respond rapidly to changing market dynamics and to target small, unmet demands -- characteristics of successful small businesses -- will gain increasing importance as the United States becomes more deeply involved in international trade. A sensible economic policy would assure that growing businesses are free to pursue what they do best without losing the independence that is the source of their strength.

The reduction of capital gains tax rates in 1981 helped some, and in this rare instance supply-side economics made some sense. Tax revenues after the rates were lowered exceeded tax revenues before the reduction, even in the depths of the deepest recession since the 1930s. Lowering the rates still further would make good sense. Even so, most of the capital for business expansion is not going to come from the individual investors for whom the capital gains tax rate is a paramount consideration. Instead, it must come from society's largest capital pools -- banks and institutional investors.

For capital to flow from these pools to growing businesses, we must create channels that don't exist today. It is important to keep in mind that expanding businesses are fundamentally good investments; in a more nearly perfect marketplace, debt and equity capital would flow freely toward them. But without some changes in the current legal structure, that capital can't cross the Grand Canyon. The trick is to get the government to correct one market imperfection without creating a worse one somewhere else.

A promising approach to the problem is to improve the secondary market for small business paper, or bank debt, using the government as a broker. Recently, President Reagan signed legislation permitting the SBA to "bundle" individual guaranteed loans into larger blocks that would appeal to institutional investors. And work is underway at the federal and state levels to facilitate pension fund investments in sound, expanding businesses.

The most important change needed, however, is in the basic orientation of bankers toward small businesses lending. Since the 1930s, bankers have been trained to think that their job is to provide small, short-term loans to expanding businesses; large blocks of more patient money would come from equity investors. We need to change the bankers' thinking, and one way to do that would be to create a secondary market for long-term loans so that banks could resell them easily. The SBA, or some other government entity, could seek authority to purchase from banks, at the agency's discretion, any loans made to small businesses, with or without an SBA guarantee. Such loans could be bundled and resold to large institutional investors just as SBA-guaranteed loans are now.

Also, a loan reinsurance provision, similar to one recently created by the state of California, would increase the incentives for larger-scale bank lending to expanding businesses by reducing the risk. Under the California formula, each time a qualifying loan is made, the borrower, the bank, and the state contribute equal small amounts to a loan-loss reserve fund, which, in turn, can be used only to back loans to small companies. Thus, as the reserve pool grows, so does the banks' incentive to make more small business loans.

Finally, we ought to develop a method to include federally insured or guaranteed loan funds in financing packages with private-sector equity capital. While it may still be unwise to have banks invest directly in expanding businesses, we should at least permit overall business finance packages to include loans and equity investments, even when some of these loans are federally insured.

These initiatives would help capital cross that Grand Canyon, but as with any other federal intervention in the market, we should encourage only as much as is required to fix a problem that the private sector cannot fix on its own. Fortunately, the private sector is already making some progress:

* A Wisconsin bank has formed a holding company to buy small business loans from the bank, bundle them, and resell them as commercial paper (see INC., February, page 90). This procedure enlarges the capital available to expanding enterprises without involving federal funds or guarantees.

* A San Francisco commercial credit firm is lending to medium-size businesses, bundling the oans, insuring them with a private insurer, and reselling the bundles on the commercial paper market. Again, more credit is provided for expanding enterprises without federal intervention.

But a couple of examples do not constitute a trend, and the county needs to move faster to bridge the giant capital gap facing the companies upon which our future economic well-being rests.

Published on: Dec 1, 1984