- November 30, 2018
- Posted by: Jeff Hudson
- Category: Capital Markets, Opportunity Fund, Opportunity Zone, Private Equity
How to fund SMBs in Opportunity Zones
We previously discussed if Opportunity Zones (O-Zones) are to succeed, that capital needs to flow into SMBs within the O-Zones. For the last 100 years, the method to inject capital into SMBs is a loan. The IRS rules for O-Zones appear to exclude loans as an option for SMBs. Therefore, flowing capital to O-Zone SMBs requires a new solution.
Halagard has developed the solution
We are creating a capital market that is focused on SMBs. SMB owners will use equity in their business to raise capital. Equity is very different from a Loan. We will provide a full stack solution, which includes underwriting, analytics, offer creation, digital IPO, a marketplace to trade shares and reporting. In public markets, the activities above are performed by multiple companies. We are performing all of these activities inside Halagard; significantly lowering costs and increasing efficiency.
What does equity usage compare for SMBs and Large companies?
- Less than 1% of SMBs are currently using equity for capital in one-off private deals.
- If you are a large corporation, 60% of the capital comes from equity.
Applying the Halagard solution to Opportunity Zones
First, we will work with local Economic Development offices to identify prospective companies within an O-Zone. Second, we will meet with the companies to educate them on our process. Third we will explain the use of equity for capital. Fourth, interested companies will gather information and financials required for our underwriting process.
Most of the companies in the O-Zones are not big enough to do a stand-alone digital IPO. Therefore, we will be “bundling” the equity of multiple companies into more manageable tranches. For example, we will create a bundle called O-Zone 531 that contains the equity for 12 different SMBs within an O-Zone. We will provide information about each company such as their financials, business information, etc. We will run all of this information through our underwriting process and create a rating. Qualified Opportunity Funds (QOFs) will review the O-Zone 531 offering documents and determine if this bundle meets their investment criteria.
Halagard will hold a digital IPO for O-Zone 531, and investors will be able to buy shares. The investor capital is distributed to the SMBs in O-Zone 531. Annually the SMBs will provide an annual report on their business that is shared with all investors. One year after the digital IPO, the O-Zone 531 shares trade on the Halagard Marketplace.
The QOFs will be able to take advantage of building diverse, uncorrelated portfolios of one of the best performing assets classes available. Traditionally small cap stock outperforms other equities over time. We believe that these bundles will be attractive to the QOFs as a way to balance their investments in O-Zones.
Real Estate investors should also invest in O-Zone SMBs
During prior economic redevelopment efforts, the majority of investments went into real estate. These investments included upgrading commercial buildings and rebuilding homes. Generally the efforts are not considered successful. The impact was not broad and self-sustaining. Why? Jobs were not created in the redeveloped area. In the average selected O-Zone, 38 percent of the prime age population is not working – nearly 10 points higher than the U.S. as a whole.
Questions to consider:
- Once the revitalized buildings are complete, how do you fill the space?
- Is it easier to convince people to move into the area or get someone to stay in an area?
We believe it is easier to get someone to stay, but they need to have a job. This is where investments in SMBs comes into the formula.
- Inject Capital into SMBs = Growth.
- Growth = New Jobs.
- New Jobs = ability to buy/rent revitalized space.
The formula is simple. Invest in both real estate and SMBs and watch the principles of economics at work.
Why are Qualified Opportunity Funds (QOF) great for investors?
The best way to understand the value of a QOF is an example.
You have a capital gain of $1M in 2018 from a long-term investment. There are 2 basic options. You could pay the government 20% tax and move on or you could invest the $1M in a Qualified Opportunity Fund. Below we use a best case example of 10 years.
- Your $200K tax bill is reduced to $170K and not due until 12/31/2026
- You use the $170K for free for 8 years / house money
- Any capital gains generated by the investment are not taxable.
The macro rules for QOF investments and capital gain reductions are as follows:
- 5 years Investment – 10% reduction capital gains tax
- 7 years Investment – 15% reduction capital gains tax
- 10 years Investment – 15% reduction capital gains tax + no capital gains tax QOF investment
O-Zone investing is not a fix and flip process. An investment must meet the IRS substantial improvement test. To pass this test a QOF must double the adjusted basis in their investment after the initial purchase (excludes land value).
Does investing in a Qualified Opportunity Fund mean I’m stuck with x investment for x years?
- If your QOF mainly invests in real estate, then exiting project A to invest in project B may be difficult. This is due to the IRS substantial improvement test.
- If your QOF is invested in SMBs via Halagard, we will offer a secondary market. Your shares can be traded allowing liquidity and freedom to adjust investments. How does the IRS test for substantial improvement with equity investments in SMBs. It is too early to know the answer.
We are asking the IRS for clarity on the rules. We are submitting the below questions.
- The majority of the information available on Opportunity Zones relates to investing in Real Estate.
- Can the IRS provide more guidance for investors related to investing in businesses within Opportunity Zones?
- How does the substantial improvement test apply to investments in a business?
- How does the 30-month rule apply to investment in a business?
- Can a Qualified Opportunity Fund
- buy shares in a business (say in 2018),
- sell the shares (say in 2020),
- reinvest the proceeds (still in 2020) in shares of another O-Zone businesses; and
- still be operating within the rules set up for Opportunity Zones?
A few resources we have found helpful
- IRS FAQ on Opportunity Zones
- Audio overview of O-Zone value
- Detailed compare of O-Zone investment returns
- Good Overview of Opportunity Zone investing
- Online calculator comparing O-Zone investor to public stock portfolio
- Compare Opportunity Fund to a 1031 Exchange
Please share your thoughts on Opportunity Zones