Maybe David Stockman was right.

Back in 1985, President Reagan's controversial budget director sparked a firestorm on Capitol Hill when he called for the abolition of a Washington institution: the U.S. Small Business Administration. By guaranteeing loans to small businesses unable to get credit privately, Stockman told a Senate committee, the SBA does little more than shift capital from creditworthy companies to less creditworthy ones. The agency, he charged, "sprays a faint mist of subsidized credit into the weakest and most prosaic nooks and crannies of the nation's $4 trillion economy."

A five-month battle ensued, with the anti-big-government, pro-deregulation forces in the Reagan administration scuffling with a hastily convened coalition of SBA's backers from across the political spectrum -- including the leadership of the House and Senate small-business committees, small-business advocacy groups, banks that administered SBA-backed loans, and entrepreneurs themselves. It was a politically potent group, and in the end, the agency was deemed too sacred a cow to kill. The SBA, created by an act of Congress in 1953, survived.

Now, 18 years later, the SBA is preparing to mark its 50th anniversary. But doubts about the agency, and how its more than 3,300 employees spend a $797 million budget, never really went away. "Their history is that they lose lots of money and don't do all that much," says William Dunkelberg, chief economist of the 500,000-member National Federation of Independent Business, the powerful small-business lobbying group that fought for the agency's salvation in the mid-1980s. Adds Mark Zandi, chief economist at Economy. com in West Chester, Pa.: "I question whether there is a need for the SBA, and who really benefits." Such skepticism is easy to understand. After all, the U.S. economy has undergone considerable change. Most of its innovation and dynamism now come from high-growth, idea-centric companies led by sophisticated entrepreneurs. Yet the SBA seems mired in the past. Just look at who's getting loans. In 2002, small retailers and restaurateurs represented about 20% of participants in the agency's two largest loan programs. And information technology entrepreneurs? Less than 2%. Clearly, an entire class of companies is not being served. "The reality is that the SBA never even comes up," says Verne Harnish, who as founder of the Young Entrepreneurs' Organization and chairman of the Birthing of Giants program spends much of his time talking to the founders and executives of fast-growth companies. "It's a nontopic."

And that's cause for concern. Small companies contribute 75% of net new jobs; account for more than 50% of the gross domestic product; and receive as many as 14 times more patents per employee than large firms, according to government figures. Indeed, in years past it's been innovative, growing companies that have led the economy out of recession. But that's not happening this time. In fact, small businesses actually shed jobs in 27 of the past 29 months, according to the NFIB.

The SBA is empowered to guarantee some $21 billion a year in bank loans and venture capital investments to small businesses. That's a lot of stimulus -- if applied correctly. Unfortunately, the SBA as currently constituted behaves more as a lender of last resort, funneling the bulk of its resources to marginal companies that can't obtain funding anywhere else. That's not an entirely inappropriate role, especially considering the extent to which many entrepreneurs, especially women and minorities, are shut out of the credit market. But the SBA could have a lot more impact if it also began behaving like a seed investor in the kinds of companies that will drive the U.S. economy forward.

The picture is not entirely bleak. Apple Computer, Staples, Federal Express, and Intel all participated in SBA programs when they were young, which proves the agency can get things right on occasion. And Hector Barreto Jr., current SBA administrator, has taken some encouraging steps (see "Mr. Small Biz," page 81). But if the government is to remain committed to spending money to help small businesses, it ought to do it right. With that in mind, Inc. has drafted a 10-point blueprint for reform, a series of concrete steps designed to bring the SBA in line with the realities of today's economy.

Bring investment into the 21st century

Over the past five decades, the SBA has developed a variety of strategies to aid small businesses -- helping them write business plans, offering loan guaranties to banks, providing matching funds to venture capitalists, training small companies to compete for government contracts. (The agency also makes low-interest loans for victims of natural disasters.) But this portfolio of services reflects the way we did business when these programs were created -- in the 1950s and '60s. The SBA needs a more contemporary set of investment tools. A good start would be creating a kind of government-backed angel investment fund.

Angel investors are usually wealthy individuals, often successful entrepreneurs, who make small (generally less than $500,000) investments in start-ups. They play a key role in fostering entrepreneurship because few venture capitalists are interested in such small deals and most banks balk at lending money to early-stage companies -- even with a partial SBA guaranty. Amazon.com, the Body Shop, and Bell Telephone all got their start thanks to angels. But these days, such funding is among the hardest to come by.

The SBA can help. It has the resources to create an angel fund, modeled on its Small Business Investment Company (SBIC) program, which is designed to encourage venture capital investment. Under that program, the SBA licenses private venture capital groups as SBICs, which then qualify for matching funds in the form of government loans at favorable rates. The problem is that the program requires SBICs to raise at least $10 million from outside investors before qualifying -- something that only about 20 funds have been able to do so far this year. As a result, the SBIC program has not taken full advantage of the $7 billion in guaranties Congress has authorized, awarding roughly $2.5 billion in each of the past two years.

Sometimes, SBA rules actually shut out companies that would make the most promising candidates for investment.

We suggest creating an angel investment program by shifting some of these unused SBIC guaranties. The government would require angels to raise much less private capital up front, say $100,000, and provide the same kinds of loans they do to VCs, albeit in smaller amounts. Of course, the angels would need a track record -- to qualify, the Feds could require investors to have made investments of, say, more than $100,000 in at least two companies a year for the last four years. Such a program would go a long way toward luring risk-averse angels to begin investing again, says Carol Sands, founder of the Angels' Forum, an early-stage investment organization in Silicon Valley. "It would have a huge impact on the economy," she says.

Make investment countercyclical

Congress has authorized the SBA to guarantee $21 billion in loans and venture capital for fiscal year 2003. You'd think that would provide a great boost to the small-business economy. But instead of acting counter to the markets -- picking up the slack when the private sector retreats -- SBA programs mirror the markets. Last year, for example, when commercial lenders and venture capitalists found it more prudent to sit on their cash, the SBA proved to be of little help. In fact, two of the agency's largest programs -- the 504 loan, designed to finance real estate and equipment purchases, and the SBICs -- both failed to come close to reaching their caps for administering government-backed funds.

Consider the SBICs. We like this program. It's a good example of how the government and the private sector can work together to stimulate investment. But here's the problem: In 2002, when the overall amount of VC dollars invested dropped 54% from the previous year, SBIC investment dropped right along with it, falling some 40%. The SBA needs to find ways to stimulate SBIC investment when the private market dries up. One idea is to open up the SBIC program to the big guns. Right now, SBICs are limited to borrowing $113 million from Uncle Sam at any given time. Why not double the cap and attract heavier hitters to the program? While 41 new SBICs were licensed in 2002, this year we'll be lucky to hit 25, according to Lee Mercer, president of the National Association of Small Business Investment Companies. The reason for the falloff: Most groups can't raise private funds to qualify for the SBIC matching dollars now. Raising the cap to allow bigger funds to participate would clearly have a countercyclical effect. In addition, the SBA should require SBICs to use it or lose it. Right now, the SBICs have four to five years to take out the loans for which they qualify. A shorter time frame would encourage investors to invest, rather than sit on, their money. Two years makes a lot more sense.

Cut the red tape

Wanna see something ugly? Take a gander at Standard Operating Procedures 5010. That's the SBA's 727-page rule book for its flagship loan program, the Basic 7(a) Loan Guaranty. Under that program, the government guarantees a percentage (generally 75% to 85%) of small-business loans made by commercial lenders, with the hope of reducing the lenders' risk. The rule book outlines all of the dos and don'ts that bankers must follow when making SBA-backed loans. Do ask customers if they've ever been convicted of a felony. Don't lend to a passive holder of real estate, except if it's a hotel, motel, trailer park, or residential care facility. No gambling establishments.

Patrick Lilly, vice president for commercial and SBA lending at Palm Desert National Bank in Palm Desert, Calif., calls the rule book his "biggest gripe" about working with the agency. "It's half a foot thick and has a lousy index," he grumbles. The unwieldy rule book is a serious disincentive for new, smaller banks to get into the SBA loan business, adds Steve Stultz, chairman of the National Association of Government Guaranteed Lenders. And if the bankers are deterred, imagine what it does to red-tape-loathing entrepreneurs, many of whom have been forced to hire consultants just to navigate the bureaucracy.

Fortunately, the SBA has taken some encouraging steps to cut through the morass of paperwork. In 1996, the agency launched something called SBAExpress, which guarantees just 50% of the loan but allows lenders to make loans of up to $250,000 by filing electronically. In spite of the lower guaranty, such loans are expected to account for nearly half of all SBA-backed loans in 2003, compared with 34% in 2002 -- strong evidence that the banks will step up and even assume more risk if the government gets out of their way. We just have one question: Why is it taking so long to streamline the SBA's other programs? Consider the 504 loan program. Borrowers are often required to submit 700 to 1,200 pages of paperwork to apply, says Barbara Vohryzek, executive director of California Statewide Certified Development Corp., a Davis, Calif., outfit that processes such loans. That's a disincentive, both to would-be borrowers and their bankers. Streamlining the process and allowing borrowers to file electronically would attract more banks to the program and enable the SBA to do more business, Vohryzek says.

Make larger loans

Banks want to make larger loans because they tend to be easier to administer and more profitable. Entrepreneurs want to receive larger loans because it costs more to start or expand a business these days. The only factor messing up this equation? The SBA. The Bush administration has actually lowered the average SBA loan size from $225,000 to $165,000. "A loan of $50,000 is much more able to create jobs than necessarily a loan of a million or $2 million," Barreto told us in a recent interview. "In fact, when you're doing loans of $50,000, it takes $14,700 to create one new job. So there's a great opportunity." Now, what type of job is created by $14,700? A job that is neither as well-paying nor secure as one created as part of a $2 million investment, we're willing to bet.

But last year, the administration dropped the cap on the government guaranty of loans in the 7(a) loan program to $500,000 from $2 million. After an outcry from the banking community, the old levels were restored. But we think the cap should be even higher. "We found that the larger loans were more secure," said Fred P. Hochberg, deputy SBA administrator during the Clinton administration. "They helped pay for the program and keep the cost down." A higher cap would also lead more sophisticated businesses to seek SBA assistance, particularly at a time when banks have tightened their credit and venture capital firms are returning money to investors rather than investing it in start-ups. Banks, after all, are in business to make money. "It costs money to do a loan, do background checks, process the loan," says Paul Merski, chief economist of the 5,000-member Independent Community Bankers of America. "By increasing the cap, we might actually get more loans being made. It's not as attractive to make a large number of small, costly loans."

Work with, not against, the VCs

Sometimes, SBA rules actually shut out companies that would otherwise make promising candidates for investment. Case in point: A number of small biotech companies backed by VCs have been shunned recently by the SBA's grant program, Small Business Innovation Research, which is designed to funnel federal research projects to small businesses, and help those companies bring their technologies to market. The problem? The companies were not majority-owned by "individuals," as the program requires. In other words, because they were able to attract seed capital from private investors (in exchange for equity) as start-ups, they are deemed unqualified for SBA funds to help turn their research into commercial products. That rule seems to run counter to the whole point of the SBIR program, which in 2002 awarded $1.5 billion in grants to 5,000 companies through 10 federal agencies. One of those agencies, the National Institutes of Health, in May disqualified Cognetix, a Salt Lake City biopharmaceutical firm with 27 employees that is majority-owned by institutional investors, including VCs and pension plans. It's been a huge blow, says Vicki E. Farrar, Cognetix's vice president of intellectual property. "The loss of this grant, as well as our ability to draw on previously awarded grants, severely limits our ability to continue basic research and could lead to layoffs," Farrar says.

Unfortunately, Cognetix is not alone. According to the National Venture Capital Association, scores of biotech start-ups are having their SBIR grants yanked simply because they have turned over larger shares of their companies to venture investors -- something, incidentally, they are increasingly forced to do in the current, difficult marketplace. "This regulation is excluding a lot of companies," said Nancy Saucier, who manages the association's medical industry group. "If it continues, it will snowball."

Make the SBA administrator a permanent Cabinet position

This one is certainly more symbolic than the steps discussed above. But perceptions count. Former President Bill Clinton elevated the SBA administrator position to Cabinet-level rank during his administration. That meant Erskine Bowles or Aida Alvarez would meet regularly with the heads of Treasury, Defense, Agriculture, and the other departments in the President's inner circle. It also meant that small business was given the same clout as big business, which is represented in the Cabinet by the Secretary of Commerce. President Bush, by contrast, has chosen not to include SBA Administrator Barreto in his Cabinet.

Entrepreneurs need a cop on the beat to protect against policies and regulations that have a disproportionate impact on small companies.

Barreto, for his part, claims to have the President's ear, and the two men certainly seem to have a strong rapport. (Colleagues joke that Barreto has a reserved seat on Air Force One.) But formally adding the SBA administrator to the Cabinet sends an important message: a formal acknowledgement that entrepreneurs are a potent source of economic growth and new jobs. And it can yield real results, says Hochberg, who was Clinton's deputy SBA administrator. While SBA Administrator Alvarez was a member of the Cabinet, Hochberg sat on the President's Management Council, where the deputies of all of the Cabinet agencies met monthly. "It was not simply titular; it helped enormously," Hochberg says. The SBA is charged with helping small businesses get 23% of federal contracts, but agencies shirk those rules and have been bundling small contracts into large ones. In addition to advocating for entrepreneurs in the federal procurement process, Hochberg says, Cabinet-level negotiations led to the development of an initiative to bring venture capital and small-business assistance to rural and inner-city areas. "I had a relationship with every agency, including the Department of Defense, which has the largest budget," Hochberg says. "I could be more forceful and personal and argue and cajole."

Provide hands-on guidance

When commercial banks make large loans, bankers usually help ensure the long-term success of the business by providing ongoing advice and counseling. It's simply good business. Indeed, the SBA's own research shows borrowers that receive some type of technical assistance are three times more likely to succeed than those that don't. The SBA needs to use its clout to make banks offer more help to loan recipients who would clearly benefit, such as start-ups or companies with inexperienced management. One way to do this would be for the SBA to give banks higher guaranties on their loans if they offered such assistance. They wouldn't even need to do it in-house. The SBA already has a variety of resources for providing technical and managerial assistance: the Service Corps of Retired Executives,or SCORE, a group of 11,500 volunteers who provide free advice; more than 1,000 Small Business Development Centers nationwide; as well as Business Information Centers and U.S. Export Assistance Centers. The infrastructure is in place. Now, the agency needs to ensure that it is being properly utilized.

Give the watchdog teeth

Small business needs a cop on the beat, inside the federal government, to protect against policies and regulations that have a disproportionate impact on small business and government agencies that bundle contracts and don't give small business a statutorily required piece of the pie. The watchdog already exists: The SBA's Office of Advocacy was created by Congress in 1976 in recognition of the fact that small businesses simply don't have the resources that big businesses do in Washington -- whether it's the 20,000 lobbyists, the corporate government affairs offices lining K Street, the Department of Commerce, the U.S. Trade Representative, the Export-Import Bank, etc.

There's just one problem: Congress never gave the Office of Advocacy a budget. Instead, the $10 million the office will spend in 2003 comes out of the SBA's budget. We think that the Office of Advocacy's work warrants a line-item budget. One reason: excessive regulation. The Office of Advocacy intervenes in about 100 different new rule-making procedures each year and has helped table onerous regulations and resolve some long-simmering problems. Last year, for example, the advocate's intervention led the Environmental Protection Agency to back off new rules governing storm-water runoff -- otherwise known as rain -- by pointing out that state, local, and regional authorities already had sufficient permitting requirements in place. The advocate has also fought to get muscle behind small-business protections. Earlier this year, at the suggestion of the Office of Advocacy and others, the White House ordered federal departments to report progress on meeting the statutory requirement that 23% of the more than $200 billion yearly in federal contracts be awarded to small businesses. The new steps are designed to prevent agencies from bundling smaller contracts together and awarding them as one large contract, thereby shutting out smaller contractors.

Do some data-mining

The SBA has a $797 million annual budget, and the authority to back $21 billion in financial assistance. What it doesn't have is a way to track whether any of its programs are actually working. The agency needs to find a way to demonstrate the efficacy of its loan guaranties, VC money, and assistance programs. Its managers have come under fire from Congress for failing to review the portfolios of its lenders. While it operates a program to help minority-owned businesses compete for government contracts, it doesn't keep stats on what becomes of the companies once they graduate and compete on the open market.

We need better documentation, and not just to justify the SBA's budget. Aggregated data on performance of SBA loans could be used to show private sector lenders that small-business loans, or loans to women and minority business owners, are not too risky. "If we had good data on small-business loans," says Betsy Zeidman, of the Milken Institute, a think tank based in Santa Monica, Calif., "there could be more private capital in the market, especially in tight financial times." Indeed, good data could send a ripple effect through the private sector -- particularly if the data showed that these SBA-backed companies went on to success. Instead, the failure of the SBA to provide clear and consistent measurements just serves to bolster critics of the agency.

Rename it the U.S. Department of Small Business

The SBA has baggage -- lots of it. The failed Whitewater land deal was financed by a $300,000 loan from an SBIC. The agency also has been accused of funding con artists and companies linked to the Mob. Its bureaucracy is legendary, with some loans still taking months and months to process. Is it any wonder that only 5% of NFIB members surveyed said they had received any assistance from the government in the past three years?

It doesn't take a marketing expert to see that the agency needs to make new efforts to get its message out and attract more entrepreneurs to the fold. Let's start with changing the name -- the U.S. Department of Small Business sounds good to us. Next, the SBA needs to begin reaching out to the very entrepreneurs who shun the agency, marketing itself as a resource for high-growth companies. We suggest a public-sector version of the highly effective "Intel Inside" campaign, one that associates the agency with such success stories as Nike, Ben & Jerry's, Federal Express, and, yes, Intel -- all of which got early help from SBA programs. Tom Stemberg, founder and chairman of the office superstore chain Staples, would be a good spokesman. In 1985, an SBIC coughed up $2.5 million to lead his second round of VC financing, helping the start-up compete against giants like Kmart and International Paper. Testimony from Stemberg and other heavy hitters would go a long way toward bolstering the SBA's credibility among entrepreneurs skeptical of the agency. "It was a race for real estate and money, and 20 horses were coming out of the paddock," Stemberg recalls. "Having U.S. government money invested in your business at a time when the market was becoming extremely competitive helped validate us."

Sidebar: Mr. Small Biz

Former entrepreneur Hector Barreto has his own plans to transform the SBA.

With Inc. advocating an overhaul of the U.S. Small Business Administration, it seemed only fair to bounce some of our ideas off the agency's current leader, Hector Barreto Jr. Tapped by President Bush in 2001, Barreto is no stranger to entrepreneurship. Growing up in Kansas City, Mo., his family ran a restaurant, an import-export business, and a construction company. After graduating from college, Barreto moved to Los Angeles to strike out on his own, starting an employee benefits outfit and later, a securities brokerage specializing in retirement plans. He also served as vice chairman of the U.S. Hispanic Chamber of Commerce. Barreto recently discussed his plans for the SBA with Inc. executive editor Ed Sussman and contributor Elizabeth Wasserman.

This year, we'll do more small-business loans than we ever have in our history. We'll reach the fastest-growing segments of small business: women-owned businesses, African American businesses.

Question: You've been at the SBA two years now. What are you most proud of?

Answer: This year, because of changes we made in our SBAExpress program, we'll do more small-business loans than we ever have in our history. We'll reach the fastest-growing segments of small business -- women-owned businesses, African American businesses, Hispanic businesses, Asian businesses. When we first got here, the average-size loan was $225,000. Now, that has gone down to $165,000. Most small businesses are capitalized with a lot less than that, maybe $50,000.

Q: Why is that a good thing?

A: It has enabled us to touch more small businesses. We're up 45% on Hispanic loans, 75% on African American loans, 35% to women and veterans. One of the big pushes of our administration is jobs and growth. And we know who creates those jobs. It's the small businesses.

Q: There's a perception that the SBA mostly gives loans to mom-and-pop shops.

A: Thirteen percent of our borrowers last year got loans of $500,000 or more. That's not mom-and-pop stores. We put out $2.5 billion in venture capital last year. It wasn't going to mom-and-pop stores. What's so interesting about SBA is that its programs are evolutionary. Some people come to us for help putting together a business plan. Maybe their first loan is a micro-loan. But then it can go up to a working capital loan of as much as $2 million. Later on, if they're ready to go public or go national, they could get venture capital. All of those opportunities are available at SBA.

Q: Surveys show that very few small companies are hiring. How can the SBA act as a better stimulus in this economy?

A: I've been out seven times this year with the President, specifically to do small-business events all around the country. The President said, "I want to give you back more of your money because I know what you'll do with it. You'll put it back into your business." That's what the jobs and growth package did. It lowered that top marginal tax rate, put $2,209 in 23 million small-business owners' hands. It quadrupled the expense [deduction] from $25,000 to $100,000. And that is going to have a great impact.

Q: Are you concerned that SBA guaranties make banks lazy? That they just say, "Well, I've got the guaranty; I don't have to look as carefully at the business. I'm covered either way"?

A: I think the guaranty allows a lot of small businesses that wouldn't get the loan any other way to be able to get loans. Sometimes the banks want to do the loan, but because of their internal requirements they're not able to do it. But with the SBA guaranty, they are able to do it.

Q: But instead of being a lender of last resort, shouldn't the SBA serve as an engine of growth for small companies?

A: That "lender of last resort" is not the only thing that SBA does. There's no doubt that we need to change the way we operate. And that's what we're doing right now. We've got an incredible network. We have 70 major program offices throughout the United States. One of the things we need to do is make sure that our folks out in the field aren't burdened down with a lot of bureaucracy. So we're taking a lot of that away from them to free them up, and they're saying, "Hallelujah! Thank you."

Q: In the Clinton administration, the SBA administrator was a member of the Cabinet. That's not the case with you. What do you think of permanently elevating your job to a Cabinet-level position?

A: I feel that I've gotten tremendous access to this President. The SBA has never been one of the agencies that has been part of the Cabinet. Different administrators have attended Cabinet meetings, but that is at the discretion of each administration. This administration wanted to have a smaller, more effective Cabinet.

Elizabeth Wasserman is a freelance writer based in Washington, D.C.

Published on: Sep 1, 2003