Financing Community Business the Importance of Small

Financing Community Business

The Importance of Small Business in the Economy

Canadian Federal Support for SMEs

Tackling SME Tax and Fiscal Priorities

Rebalancing Canada's EI System

Assist Small Business Owners with Succession Plans

Growing Small Firms into Larger Firms

Federal Support for SMEs

Depleted Communities in Canada

Distressed Communities in United States

Community Economic Development Investment Funds

Community Economic Development Funds in U.S.

Non-Bank Financing

Community-based financial organizations have been developed in many countries to serve the critical needs of small to medium size enterprises (SME), especially in depleted or distressed areas. Most of these organizations exist to serve a public good and are quasi-governmental in form and behavior. Both Canada and the United States have supported these organizations at the Federal and Provincial/State levels. SMEs are highly visible political targets because they provide employment for over half of the population in North America. A variety of programs has been established to provide needed support including tax breaks, education, and access to capital. Community Economic Development Funds have been sponsored in both countries with special provisions established to make sure the funds are raised and invested locally.

Financing Community Business

Introduction

Leaders from around the world have long recognized the critical importance of small and medium size business enterprises (SME) in the economic development of nations. This consensus persists over time and in developing as well as developed countries. No politician need worry about the wisdom of including a small business plank in his/her platform for reform or change. Citizens of Canada and the United States have grown accustomed to a steady parade of Prime Ministers, Presidents, Governors and Mayors espousing the virtues of providing support for small businesses in their jurisdictions.

Entrepreneurs are everybody's darlings. Legislation to implement this grand love fest has tended to be hierarchical in nature. National support, by its very nature, skims the cream off the top of the list of entrepreneurial candidates, followed by the Provinces and States finding their more or less promising niches in the middle, leaving the unqualified, unprofitable and desperate applicants to the machinations of the local communities in which they reside. Societal support at the junior levels would be meaningless without the fiscal framework provided by national policy. This paper documents the observed critical nature of SME in modern economic society and explores various mechanisms that have been introduced to resolve the many practical barriers that exist to improving the success rate of these fragile enterprises in the North American context.

The Importance of Small Businesses in the Economy

The current state of the economy, above and below the long Canada-U.S. border, serves to remind citizens of both countries how fragile the comfortable North American way of life really is. Recent painful events have shown that long-lasting businesses or large corporations are not immune to the challenges of this kind of recession. Oh, how the mighty have fallen. It is perhaps not as surprising that individual families have had to deal with the financial meltdown in their own ways, and with widely varying outcomes. However, in the pursuit of economic recovery, many people may fail to realize the critical importance that small businesses play in keeping the economy's nose above the water line. From the many diverse job opportunities they offer, to an increase in the multitude of various goods and services they provide, small businesses play a vital role in the ongoing health of the economy. (Finance Exchange, 2011)

Unhappily, the first wave of casualties in a failing economy is the very small businesses that are so important to economic vitality. This is owed mainly to the fact that small businesses typically do not possess sufficient capital to keep the doors open over an extended period of time of slow activity. Therefore, when customers slow down on their purchasing, the SME begins to feel the ripple effect almost immediately, and must look for novel ways to relieve the pressure before the whole kettle blows its top. What generally follows is the vicious circle of laying off employees, businesses failing, and consumers not purchasing products and services after losing their jobs. This cycle results in the Dickensian nightmare of small business owners plunging into the abyss of bad credit, bankruptcy and unemployment during harsh economic times. (Finance Exchange, 2011)

Small Business Notes has compiled a report card for small firms in the United States. They:

Represent 99.7% of all employer firms.

Employ half of all private sector employees.

Pay 45% of total U.S. private payroll.

Have generated 60 to 80% of net new jobs annually over the last decade.

Create more than 50% of nonfarm private gross domestic product (GDP).

Produce 13 to 14 times more patents per employee than large patenting firms.

Are employers of 41% of all high tech workers

Are 53% home-based and three percent franchises.

Make up 97% of all exporters and produce 26% of export value. (Small Business Notes, 2011)

Canadian Federal Support for SMEs

Small and medium-sized enterprises are the backbone of the Canadian

economy and their impact on Canada's job creation over the last 25 years has been significant. There is ample evidence that the tremendous expansion of Canada's economy in recent years has been driven by SMEs and they continue to be the major source of wealth and economic growth underlying Canada's current economic success. It only makes sense that any plans to enhance Canada's competitiveness and productivity have a major focus on encouraging the birth and growth of Canada's SMEs. (CFIB, 2006)

In 2006, the Canadian Federation of Independent Business made numerous recommendations to support its assertion that, "growing small firms into larger firms, and improving productivity, are essential to building a more competitive Canada & #8230;ultimately positioning Canada as a highly desirable place to live, work and do business in an increasingly competitive world." (CFIB, 2006)

In summary, CFIB recommended:

Tackling SMEs Taxation and Fiscal Priorities

• Reduce personal income taxes

• Reduce fuel taxes

• Speed up the implementation of promised corporate tax

• Increase the $500,000 Lifetime Capital Gains Exemption

• Allow businesses to expense the first $75,000 in annual business capital costs

• Allow businesses to expense up to $100,000 in technology costs in year of purchase

• Reduce the General Sales Tax and simplify compliance process

• Curb federal payroll taxes (CFIB, 2006)

Rebalance Canada's EI System

(Employment Insurance (EI) provides temporary financial assistance for unemployed Canadians while they look for work or upgrade their skills.)

• Lower EI premiums

• Freeze expansion of non-regular benefits

• Review cost-effectiveness of existing EI programs

• Make EI fairer for employers

• Reimburse employers for EI over-contributions (CFIB, 2006)

It should be noted that during a campaign stop in Regina on Tuesday March 29, 2011, Prime Minister Stephen Harper announced a plan to establish a one-year EI tax break for small businesses to hire new employees. Harper said that the plan would spur job growth and finalize Canada's economic recovery. The Hiring Credit for Small Business would deliver a one-time credit of up to $1,000 against the resulting increase in a small employer's EI premiums in 2011. The hiring incentive credit would reach approximately 525,000 employers, reducing their 2011 payroll costs by about $165 million. (Harper, 2011)

Assist Small Business Owners with Succession Plans

• Defer taxes on capital gains from the transfer of the business to the owner's children

• Defer tax on capital gains when proceeds reinvested within six months

• Allow business owners to borrow from RRSPs for use as business equity (CFIB, 2006)

Growing Small Firms into Larger Firms

CFIB believes that in today's increasingly competitive global environment, Canadian firms have a more difficult time growing from small to medium-sized firms. When comparing the proportion of medium size firms in Canada to the United States, CFIB found that U.S. firms are more successful at growing and expanding their establishments. In the U.S., medium size firms represent five percent of total establishments in the economy, which is more than double the percentage of firms in Canada, where only two percent of total establishments are medium size. CFIB also found that U.S. firms strike a healthier balance between the number of micro size establishments (1-4 employees) and small establishments (5-99 employees). Micro size firms in the U.S. represent 42% of total establishments, while small firms represent 37% of U.S. establishments. Canada has a much higher concentration of micro size firms, which represent 58% of total establishments, as well as small firms, which are 40% of total establishments. (CFIB, 2006)

Another challenge facing Canadian firms (according to CFIB) is lower levels of productivity compared to their U.S. counterparts. CFIB opines that this is linked to levels of investment in research and development and/or machinery and equipment. Economists blame Canada's productivity lag on the dominance of SMEs in its economy, suggesting that SMEs do not invest enough. However, CFIB research has found evidence to the contrary with many SMEs willing and eager to grow and invest in human and productive capital. In fact, survey results reveal that almost half want to expand their business and more than one quarter want to diversify their businesses. Only one third wants to maintain their current status with just one tenth hoping to close/sell their business or downsize. (CFIB, 2006)

Previous CFIB research at the provincial and local level has consistently found that when SMEs were asked about how they would use savings from tax reductions, the top answers were to invest in new capital, raise employees' wages and/or expand their business. CFIB emphasizes the importance of keeping taxes competitive, as the majority of firms will use those savings to invest back into their business and their employees. (CFIB, 2006)

CFIB has found evidence that Canadian SMEs are already supplying a healthy share of investment into the Canadian economy; however, CFIB believes that in order for the economy to continue to grow, more must be done. When asked about what keeps SMEs from investing even more in technology, more than half said that purchasing and training is too costly, far ahead of the next highest issue, and is therefore the most significant barrier to SME investment in technology. (CFIB, 2006)

When asked about how government could positively impact the level of investment by small business over the next three years, lowering the tax burden and specifically payroll taxes were viewed as the most helpful measures to encourage more investment. Also important to almost half of SMEs was reducing the burden of regulations, an important element of enhancing productivity in Canada. (CFIB, 2006)

United States Federal Support for SMEs

"I'm thrilled to be here on what is an exciting day," President Obama said as he prepared to sign the Small Business Jobs Act on September 27, 2010. He went on to state:

Now this is important because small businesses produce most of the new jobs in this country. They are the anchors of our Main Streets. They are part of the promise of America -- the idea that if you've got a dream and you're willing to work hard, you can succeed. That's what leads a worker to leave a job to become her own boss. That's what propels a basement inventor to sell a new product -- or an amateur chef to open a restaurant. It's this promise that has drawn millions to our shores and made our economy the envy of the world. (Obama, 2010)

The bill included a series of small business proposals that the President had sent to Congress earlier in 2010. Among the many important provisions in the bill, twelve of the top benefits to small businesses were:

Extension of Successful Small Business Administration (SBA) Recovery Loan Provisions -- Loans to Over 1,400 Small Businesses: The SBA Recovery loan provisions have already supported $30 billion in lending to over 70,000 small business across the nation.

A More Than Doubling of the Maximum Loan Size for The Largest SBA Programs: The bill permanently raised the maximum size for SBA's two largest loan programs, from $2 million to $5 million.

An Initiative to Strengthen Innovative State Small Business Programs -- Supporting Over $15 Billion in Lending: The bill supported at least $15 billion in small business lending through a new State Small Business Credit Initiative,

Zero Taxes on Capital Gains from Key Small Business Investments: Over one million small businesses are eligible to receive investments that, if held for five years or longer, could be completely excluded from any capital gains taxation.

Extension and Expansion of Small Businesses' Ability to Immediately Expense Capital Investments: This provision means that 4.5 million small businesses and individuals will be able to make new business investments and be eligible to immediately write off up to $500,000 as a current expense.

Extension of 50% Bonus Depreciation: The bill extended a Recovery Act provision for 50% "bonus depreciation" through 2010 for two million businesses, large and small.

A New Deduction of Health Insurance Costs for Self-Employed: For two million self-employed people and their families.

Tax Relief and Simplification for Cell Phone Deductions: The bill changed rules so that the use of cell phones can be deducted without burdensome extra documentation.

An Increase in the Deduction for Entrepreneurs' Start-Up Expenses: The bill temporarily increased the amount of start-up expenditures entrepreneurs can deduct from their taxes from $5,000 to $10,000.

A Five-Year Carryback of General Business Credits: The bill allowed certain small businesses to "carry back" their general business credits to offset five years of taxes.

Limitations on Penalties for Errors in Tax Reporting That Disproportionately Affect Small Business: The bill changed the penalty for failing to report certain tax transactions from a fixed dollar amount to a percentage of the tax benefits from the transaction.

Depleted Communities in Canada

The Canadian maritime provinces of Newfoundland, New Brunswick, Nova Scotia, and Prince Edward Island have lagged the rest of the country in economic development for decades. Their industries of agriculture, logging, and fishing are at best stagnant and at worst dying. Regional economic development policy in Canada generally has its origins in the attempt to improve the standard of living in the Maritime Provinces. (Watkins, 2011)

Harvey Johnstone (Johnstone, 2004) asserts that "depleted communities are a persistent feature of late capitalism." He sees them as areas that no longer have economic rationale as space, but they still offer high attachments and social relations of place. (Detroit may not be an attractive place anymore, but it still evokes a lingering history of the glory days of the automobile.) Johnstone sees opportunities in depleted communities for far-seeing entrepreneurs. He argues that depleted communities can spawn a unique form of enterprise that "combines good business practices with community goals." He refers to this as "community business entrepreneurship" and argues that it is similar to, but distinct from, the traditional entrepreneurial process. Johnstone envisions modifying the entrepreneurial process to include the pursuit of community goals, and in the process "creating new opportunities and making new forms of development possible." (Johnstone, 2004)

Harvey Johnstone observed in his seminal article, "Financing Ventures in a Depleted Community" in 1998 that "traditional sources of finance may not be adequate in meeting the full spectrum of small-firm needs." The Canadian Federal Minister of Small Business had modified the Small Business Loan Act in 1992, to allow banks to make government guaranteed loans to small businesses carrying higher interest rates. The banks did not respond to this incentive, leaving intact the barriers to financing for startup companies and to growth capital for existing firms. Further deficits in financing small businesses are found in the area of long-term equity. Banks are not only unwilling, but are unsuited to provide permanent capital, particularly for start-up companies. (Johnstone, 1998)

Johnstone found much to admire in a new form of finance company called a "community venture-finance company" formed under the auspices of the Companies Act of Nova Scotia. At the time, BCA Holdings Limited was in an experimental phase and was struggling to raise funds and to establish standards for loan candidates in the struggling Cape Breton community. Being "limited by guarantee," the company was a not-for-profit company established for a public purpose rather than as a regular share-capital company with private purposes. BCA Holdings was set up as an umbrella company for a group of related firms, the most important of which was BCA Venture Capital which can lend to and purchase shares in other companies. (Johnstone, 1998)

In 1990, Enterprise Cape Breton offered the BCA Group an interest-free loan of $500,000 if they could match the amount in the market. BCA hit the street with an offering memo talking to the Kiwanis Club and other organizations as well as pedestrians on the sidewalk. The Group received support from an unexpected source in the form of the local clergy who understood the values in ethical community principles. BCA raised more than the required amount in six months time and set about creating a new kind of financial company. (Johnstone, 1998)

Whether buying shares or making a loan, BCA adheres to three main criteria:

The company must be viable commercially

The company must serve the local community good in some way

The company must be locally owned and controlled and must have more than one owner

BCA has adopted a conservative investment posture and most of the investments are secured by real estate. Most investments are for $75,000 or more and must be approved by the BCA Board of Directors, which is populated with local community leaders and business experts. While BCA has many of the characteristics of a regular business, it differs in four important aspects. (Johnstone, 1998)

BCA is motivated toward community improvement; profit is a means to achieve the company's primary goal

BCA is not owned by shareholders; it is a trust with local community interests

BCA is localized and cannot be "bought out"

BCA depends on a large input of volunteer expertise

BCA has served as a pioneer in its campaign to bridge the gap that existed in small company financing. It has continued to serve the Cape Breton community and has raised new funds nearly every year since its inception.

BCA Funds:

Year Amount

1999-2000 $713,000

2000-2001 $564,000

2002-2003 $378,000

2003-2004 $269,000

2004-2005 $129,000

2009-2010 $600,000

Distressed Communities in the United States

The U.S. Economic Development Administration (EDA) was formed in 1965 with a charter to lead the U.S. economic development agenda by promoting competitiveness and preparing American regions for growth and success in the worldwide economy. EDA is an agency within the U.S. Department of Commerce that partners with distressed communities throughout the United States to foster job creation, collaboration and innovation.

EDA Investment Priorities: within the parameters of a competitive grant process, all projects are evaluated to determine if they advance global competitiveness, create jobs, leverage public and private resources, can demonstrate readiness and ability to use funds quickly and effectively and link to specific and measureable outcomes. The EDA has established the following investment priorities:

1. Collaborative Regional Innovation: Initiatives that support the development and growth of innovation clusters based on existing regional competitive strengths. Initiatives must engage stakeholders; facilitate collaboration among urban, suburban and rural (including Tribal) areas; provide stability for economic development through long-term intergovernmental and public/private collaboration; and, support the growth of existing and emerging industries.

2. Public/Private Partnerships: Investments that use both public and private sector resources and leverage complementary investments by other government/public entities and/or non-profits.

3. National Strategic Priorities: Initiatives that encourage job growth and business expansion in clean energy; green technologies; sustainable manufacturing; information technology (e.g., broadband, smart grid) infrastructure; communities severely impacted by automotive industry restructuring; natural disaster mitigation and resiliency; access to capital for small and medium sized and ethnically diverse enterprises (EDA,2011)

Community Economic Development Investment Funds

In 1993, the Provincial Government developed the Nova Scotia Equity Tax Credit in an effort to encourage local residents to invest in small local businesses. (Nova Scotia, 2011) As an incentive, the Province offered a personal tax credit of 30% (deduct 30% of the value of the initial investment from taxes due that year) to encourage investors to participate. The Equity Tax Credit allowed equity investment in corporations, co-operatives and (notably) community economic development initiatives. The Equity Tax Credit program was successful and encouraged the Province to enhance the program in the form of Community Economic Development Investment Fund's (CEDIF's). A CEDIF is a pool of capital, formed through the sale of units to persons within a local community, meant to be invested in local businesses in that community. It must have at least six directors elected from residents of the local community. In addition to the 30% tax credit available under the Equity Tax Credit, investments in CEDIFs are:

pre-approved holdings for a self-directed Registered Retirement Savings Plans