LOS ANGELES, Calif. — A large number of private business owners would take a business risk (91%) vs. maintaining the status quo (9%) and, at the same time, half (49%) said they rely on “gut feel” to make investment decisions according to a study from Pepperdine University’s Graziadio School of Business and Management. The study also shows that most private business owners expect at least a 20% return for investments within 1.5 to 3 years.
These findings were released as part of the Pepperdine Private Capital Markets Study, an investigation of the major private capital markets that examines the current state and outlook for the private capital industry.
Most private business owners also report they fundraise through traditional bank loans though nearly half expect more difficulty getting loans. Private business owners said if they were to invest in a company identical to their own, they expect a 20% return for a 10-year investment. However, a large number said they would pay a premium to escape a personal guarantee on their loan.
“Shrewdness, confidence and risk-taking are qualities that define a private business owner,” said the study’s author Dr. John Paglia, an associate professor of finance at Pepperdine University’s Graziadio School of Business and Management. “However, private business owners may be unrealistic in gauging investments and risks as well as sources of funding or return on investment. Generally, there may be an unhealthy expectation that the next big break is right around the corner and should take big risks to capitalize.”
Private Business Owners Say…
Many Reported Higher Probability of Failure in Last Six Months.
Despite being generally optimistic about prospects for growth, many businesses are struggling – 30% indicate the probability of failure increased over the past six months, 46% report decreased access to capital, 34% report declines in the number of employees, 38% report declines in the size of industry, 50% report increases in competitive pressures, 36% report a decline in confidence of economic growth, 33% report declines in revenues, 22% report declines in pricing.
They Use “Gut Feel.”
When evaluating investments, businesses report using payback analysis (54.0%), market analysis (51.5%), “gut feel” (48.5%), internal rate of return (41.3%), and discounted cash flow analysis (34.9%). Larger companies (>$1M in revenues) rely more on payback (62%) and internal rate of return (48%). Smaller companies rely more on market analysis (55%), and payback (47%).
Expect High Returns.
A general investment in the business yields a 20% return expectation. They expect a 10% return from purchasing a new phone system, 20% for a new computer system, 25% for expanding a current market niche or entering a new one, and 30% for hiring a salesperson and acquiring a competitor.
Expect Payback for Investments in 3 Years or Less.
Businesses report payback thresholds of approximately 1.5 years for hiring a sales person, 2 years for a new computer or phone system, 2.5 years for expanding a current market niche, 2.8 for entering a new niche, and 3.2 for acquiring a competitor.
Interest Rate Top Criteria for Loans.
Businesses report the most important factors when borrowing include interest rates, collateral requirements, loan size, and customer service. Companies are less concerned with location of lender, sophistication of bank, and length of loan term.
Want to Avoid Personal Guarantee.
Nearly 81% of respondents would be willing to pay a premium on their bank loan to escape a personal guarantee. The majority would pay between 1-3%, but the median response is 2%.
Expect ROI for Investment in Similar Business.
Businesses expect a 20% annual return for a passive, minority equity 10-year investment in an identical business. They place a premium on time as they’d expect 12% for a one-year investment and 15% for a five-year. Businesses prefer to use external equity to acquire a competitor while siding with personal equity for general expansion of business.
Take Risks for Financial Independence.
Most businesses would take a business risk to achieve financial independence as opposed to maintaining a current lifestyle. For increased expected returns, nearly 91% are willing to take a business risk vs. 9% who prefer the status quo.
Operate with a Lottery Ticket Mentality.
When faced with multiple investment opportunities, all with identical expected returns, nearly 75% of businesses are willing to take a significant business risk on a chance to earn greater returns despite lower odds.
Unrealistic About Raising Funds.
The majority of businesses are overly optimistic about their fundraising chances. Nearly 57% report an ability to obtain a bank loan, while 47% believe they can access private equity and 41% think VC is a source of funds for which they qualify. What makes this so startling is when 111 professionals in venture capital industry reported the number of investments in the last six months, most respondents ( 59.3%) indicate having made fewer than three investments, 27.5% reported making no investments, while 13.0% made one investment and another 18.8% made two. Looking ahead, nearly half (47.7%) of venture capital lenders believe venture capital investing over the next 12 months will be more restrictive.
Varying Expectations on Loan Qualifications.
Larger companies (>$1 million in revenues) claim the following qualification rates: 72% bank loan, 32% mezzanine financing, 60% private equity, and 44% venture capital. Smaller companies report the following qualification rates: 43% bank loan, 12% mezzanine capital, 35% private equity, and 38% venture capital.
The private business owner data is based on interviews with 304 business owners and is part of a larger study based on interviews with more than 700 professionals in the private capital industry. The Pepperdine Private Capital Markets Project is the first comprehensive and simultaneous investigation of the major private capital market segments. The 120-page study seeks to shed light on how private capital providers and others view their industry. The Pepperdine Private Capital Markets Study provides insights into four other private market segments in addition to venture capital: bank, asset-backed, mezzanine and private equity lenders.
With over 99% of companies having fewer than 500 employees, our economy is dependent upon the success of small businesses. The Pepperdine Private Capital Markets Project is critical step along the path of understanding and increasing the value of private companies and our economy. Professionals who work in the lending either for an institution or a specific fund are excellent bellwethers of what is ahead for other businesses and consumers. Through two survey cycles and published summary reports per year, lender, investors and the businesses that depend on them will be able to make optimal investment and financing decisions, and better determine where the opportunities to create lasting economic value may be realized.
The study is available at http://bschool.pepperdine.edu/research/pcmsurvey/