‘Tis the season for tax reform, and in tax reform season, politicians talk about how changing the tax code will help small businesses grow and create more jobs.
I thought long and hard about what would most help a Bootstrapped Service Business (“BSB”) like ours grow faster and create more jobs, and it all comes down to improving access to meaningful investment capital – not small changes to tax rates, increasing deductions, payroll tax holidays, or tweaking regulations (which doesn’t even help if you happen to be a vassal with a feudal lord like the state of CA or NY…side gripe for another time).
It is hard to find exact numbers, but it seems like a BSB is more rule than exception, and meaningful changes would have a real effect on the economy:
- 98% of small businesses do not raise venture funding
- 90% of businesses have fewer than 100 employees
- 80% of privately sector GDP comes from service businesses
- 60% of the Inc 500 were bootstrapped with $10,000 or less
Here is some basic background on our business – I get frustrated when someone gives an opinion but withholds real context on their experience, so I try to default to oversharing:
Our business, ArborBridge Group, has two parts:
- ArborBridge, a traditional service business where American tutors, based around the country, prepare high school students around the world for the SAT & ACT, one-on-one, live, in an online classroom
- CollegePlannerPro, a software-as-a-service business that provides practice management software for independent college consultants.
We started in 2007, bootstrapped, and in 2017 we will employ the equivalent of 75+ people, full-time, in the quality jobs that I assume politicians want people to have.
Like many BSBs, we are organized as an S-Corp and taxed as a partnership, which means that all profits and losses flow through to shareholders on their personal tax returns (same as most LLCs).
If the government wants to help BSBs create more good jobs for Americans, here is how it can help:
To grow, BSBs generally don’t buy new machines, they hire new employees who drive new sales or improve the quality of their services.
In a successful BSB, you will see a positive cycle where new hiring leads to new growth, which leads to more new hiring. The more investment capital a BSB has, the more they can accelerate this cycle.
A BSB gets investment capital in two ways:
- Retained, post-tax profits
The government could help expand both types of investment capital and accelerate new hiring with good policy.
Priority 1: Defer taxes on early retained profits to increase available investment capital
To reduce the risk of failure, a BSB hope to have roughly three months of payroll in the bank, and all of this cash needs to be built up through retained, post-tax profits. Once a basic margin for safety is established, a business can look to reinvest excess capital in new hiring and growth.
Since every dollar of profit from day one is taxed at personal tax rates of ~25%-45% (for S-Corp or LLC), it makes it much more difficult for a bootstrapped business to build up a cash base that can support growth. This in turn either makes it more difficult to hire new employees without overexposing the business to risk.
If a small business could delay paying taxes on the first $5,000,000 in retained profits (profits that go back into the business, not into the owner’s hands), it would be able to hire more employees and expand quicker in the early stages, resulting in larger, more stable businesses, with more employees.
The 25-45% in taxes that have to be paid every year have a negative compounding effect on available investment capital, and available investment capital is directly tied to increased hiring for a service business.
In turn, as the business gets larger, it gets more profitable, more access to bank lending and other sources of growth capital, and it should be able to pay back the deferred taxes. The government barely loses out in the short-term (because personal income tax collected from the owner is mostly traded for personal income tax from new employees), and we all benefit from more robust job creation.
Priority 2: Improve Bank Lending to Service Businesses
The traditional banking system is completely failing the service sector, and that slows job creation in BSBs.
Banks are set up to lend money against cash, receivables, or hard assets – growing BSBs will never have enough of any of these to borrow any meaningful amounts of money and cannot borrow money for the purposes of growth.
“Traditional” asset-heavy businesses can borrow money to buy hard-assets, in the hopes of generating growth, but modern service businesses cannot buy money to hire employees, which is how they generate growth. The irony is that asset-based lending is justified is because there is a hard-asset to repossess in the case of default, but is repossesing and reselling a used asset really easier than laying off employees if the business is failing to grow?
To broadly illustrate how ill-equipped banks are to lend to BSBs – banks use “10% of revenue” as a general rule of thumb for your maximum borrowing capacity.
This metric is asinine – a BSB’s capacity to pay has nothing to do with % of revenue (frankly I’m not sure this is good metric for any business whatsoever). How much debt a service business can handle depends on its gross margins, customer base, and how much of its expenses are tied to delivery of the core service versus trying to expand the business.
For instance, if a BSB sells repeatable annual services for $1,000,000 that costs them $500,000 to deliver. With $200,000 in overhead, they could have a profit of $300,000 if they chose not to grow.
However, say the business grew 50% from the previous year, and it would like to continue to grow rapidly. They decide to invest $250,000 in new sales people to acquire new business (that will come over the next 12-24 months), so their profit is only $50,000.
(It also makes sense to invest this $250,000 right away because you are using pre-tax dollars. This rational strategy unfortunately also increases your risk because you choose spending pre-tax dollars over saving post-tax dollars.)
The bank sees that business as a loser company and would maybe lend it $50,000, tops, which doesn’t really help the business grow in any meaningful way. But in reality, that company could safely handle probably $200,000 in debt.
The business has up to $500,000 of costs they could free up at any time (albeit with the pain of layoffs/reducing overhead) to pay back debt if the investment in new employees does not lead to growth. They don’t have a machine that they could sell, but they can easily free up cash if they need to.
Software-as-a-service businesses are even more misunderstood – they generally have much lower revenue, but much higher quality revenue (recurring, with 80%+ gross margins), and they still get lumped in with every other business if they are small. At least here, there has been a rise of SaaS specific lender-sharks that at least lend easier at high rates.
I am not sure what the policy solution is here, but if the government wants more job creation from the service sector, they need to find a way to encourage banks to reevaluate how they evaluate credit risk in asset-light service businesses.
My guess is that that banks have no incentive to do “growth” lending that is not tied to hard assets because a) they cannot get sufficient government loan guarantees, and/or b) these loans are regarded poorly by regulators and make banks more risky, which they don’t like. If anyone understands what is happening behind the scenes, please feel free to explain in the comments.
Also, someone please start an online bank that specializes in service business – huge opportunity.
Bootstrapped service businesses are small individually, but together they a meaningful part of the economy that can be an engine of quality job creation.
To maximize this segment of the economy, there needs to be increased access to investment capital – not from outside investors, but from traditional banks and by making it easier for firms to re-invest their own profits in the business.