A Boon to Small Firms and Their Backers

Tax advisers maintain that the current deficit-reduction package has something for everybody--most of it bad. The poor will be hard hit by higher taxes on cigarettes, alcohol and gasoline, while the rich will suffer the loss of many of their deductions.

But stockbrokers and small-business owners--and at least some rich investors--may come out ahead. Among the few revenue-losing provisions in this massive package are several that benefit small businesses and the people who invest in them.

If passed as proposed, the package is likely to ignite the moribund market for newly issued stocks and provide much-needed capital to small companies. Small-business advocates maintain that this tax break for public offerings will, in turn, prove beneficial to the economy as a whole.

“I’m sure that when this provision was announced, entrepreneurs from coast to coast shouted ‘Hallelujah!’ ” said Lloyd Greif, head of investment banking for Sutro & Co. in Los Angeles. “It is clearly an incentive for people who have shied away from the initial public offering market to invest.”

Although congressional leaders must draft and approve a final version of the budget compromise reached last Sunday, the plan would give investors in small companies up-front tax deductions for buying newly issued shares in a qualifying firm. They would also get a break when they sell the shares, provided they don’t sell for at least five years.

Moreover, small companies are promised a bigger research and development tax credit, as well as the extension of other credits. And small firms would gain accelerated writeoffs on the purchase of new equipment.

Small business was singled out for these benefits because President Bush wanted to create a proposal that would spur job growth and the economy. And historically small businesses have been the nation’s greatest source of new jobs.

Indeed, between 1980 and 1986, small businesses accounted for 63% of the job growth in the United States, said Marcia Bradford, spokeswoman for National Small Business United in Washington. Small firms also account for 39% of the nation’s gross national product, she said.

“We think (the budget plan) is a step in the right direction--something this country needs to remain competitive,” Bradford said.

Small-business owners say it couldn’t have come at a better time. Declining real estate values and a looming recession have caused many financial institutions to restrict their lending practices. Higher-risk small businesses are finding it virtually impossible to find new capital.

“The small-business community is really suffering,” said Maxine Weinman, owner of Maxine’s Seafood Cafe in Hollywood. “This recession is making people much more cautious about spending, and the banks don’t even want to talk to you. I would give my eye teeth for an investor.”

Stockbrokers have been equally frustrated.

Early this year, the initial public offering market was the one relative bright spot in an otherwise dismal investment banking landscape. Although mergers and acquisitions had nearly ground to a halt, many investment houses were still able to find small firms anxious to go public and investors willing to buy their stock.

But Saddam Hussein’s invasion of Kuwait brought an end to that, too. The stock market took a nose dive, and public stock offerings were shelved.

Virtually every brokerage on Wall Street has at least a few offerings “on the back burner” because they can’t find investors to risk their money on new issues, said John A. Kryzanowski, principal at Alex. Brown & Sons in Los Angeles. But the proposed budget plan--particularly provisions that give up-front deductions for investments in small company stock--could change that too.

“This really changes the game in the new-issues market,” said Hugh A. Johnson, chief investment officer for First Albany Corp. “I think this is more important than people will initially recognize. It will affect the private placement market and possibly stir interest in the new-issue business.”

Essentially, what the tax plan would do is boost the after-tax returns on investments in small company shares, said Richard Bernstein, manager of quantitative analysis at Merrill Lynch. Exactly how much better the return would be would depend on the investor’s tax bracket and how long he or she held the stock.

Investors in the 28% tax bracket would find returns at least 7% higher solely because of a one-time tax deduction worth 25% of the purchase price of a small firm’s shares, Greif said. (According to the proposal, a small firm is one that has less than $50 million in equity and has been in business for five years or more. Financial institutions are excluded.)

Those richer returns are likely to lure many wary investors back into the new and secondary offering market, industry experts predicted.

Several investment banking houses said they were already formulating ways to attract investors who want to capitalize on the small-business tax breaks. They’ll also court companies seeking to go public, Greif said.

“We’ve called a strategy meeting for tomorrow,” Grief said. “Clearly, the initial public offering market is at the top of the agenda.”

However, investors need to be cautious about buying these stocks, regardless of the tax benefits, industry experts said. Although investors sometimes win big on newly issued shares, they are much more likely to lose, noted Charles Allmon, editor of Growth Stock Outlook, a newsletter published in Chevy Chase, Md.

“I think you are going to see the biggest new-issue boom in history, and 96% of it is going to be absolute junk,” Allmon said. “If investors want to give their money away, why don’t they give it to charity?”

New issues only reward investors about 5% of the time, Allmon maintains. While others believe that the rewards are more frequent, even some of the biggest advocates of the initial public offering market acknowledge that high flyers are rare and failures are frequent.

Other industry experts caution that Congress has yet to clarify many details of the proposal, which could be crucial in determining whether investors will actually benefit from the plan.

“By the time Congress irons out the details, they could negate the benefits of the whole thing,” said Merrill Lynch’s Bernstein. “There’s really not much that you can say definitively yet.”