Since the overhaul of the small business investment company (SBIC) program in the early 1990's, the program has grown rapidly to become a large source of equity and mezzanine capital for small and medium-sized businesses. This article provides an overview of the SBIC program, with particular emphasis on those features that benefit entrepreneurs.
Growth of the SBIC Program
SBICs are privately managed venture capital or other private equity funds that receive funding from the U.S. government in the form of debt (debentures) or equity (participating securities), which they combine with contributions from their private investors to create a large pool of capital to invest in eligible companies. For fiscal year 2003, government debenture leverage is available to SBICs in the amount of $3 billion, and equity leverage is available to SBICs in the amount of $4 billion. With so much low cost capital available, it is no surprise that investment management teams are lining up to apply for SBIC licenses.
Over the past decade, private and government-backed financing to SBICs has risen to unprecedented levels, resulting in a significantly increased flow of capital to eligible businesses. For example, the SBA has estimated that venture capital financings by SBICs (excluding pure debt financings) constituted 58% of the total number of venture capital financings to small businesses in calendar year 2002, and 11% of the dollar amount of such financings.
The SBIC program continues to have a strong impact despite recent economic conditions. In the fiscal year ended September 2002, over 340 SBICs reported more than 4,000 separate financings to a total of almost 2,000 businesses. The total financings reported by those SBICs exceeded $2.6 billion. The following two tables, based on statistics published by the SBA, illustrate the growth of the program over the past decade.
An SBIC is a professionally managed venture capital or other private equity fund that functions, in most respects, like other private equity funds. The difference is that an SBIC has access to long-term, low-cost, government-backed financing that enables it to supplement the capital it raises from private investors. The SBIC is thus able to "leverage" its private capital and (assuming the rate of return on its investments exceeds the cost of the leverage) significantly increase the return to its private investors.
The SBIC program is administered by the SBA, which licenses investment funds to participate in the program and issues regulations with which they are required to comply. Although the government is a major source of funding, it is not involved in the management of either the SBIC or its investment portfolio. All investment decisions are made by the SBIC's management team. They decide in which companies to invest and, with some exceptions described below, the terms of the investments; they monitor investments and work with company management; and they, together with company management, determine the timing and method of exiting from investments. The entrepreneur has access to government-backed financing through the SBIC, but deals only with investment professionals.
The SBA pools the debt and equity securities received from SBICs and sells interests in the pools in a secondary market. Access to capital in the secondary market enhances the amount of government-backed capital available to SBICs and, ultimately, to the entrepreneurs in whose companies SBICs invest. In addition, improved funding procedures now facilitate a smooth flow of leverage funds to SBICs to enable more timely investments in those companies. Those funding mechanisms, taken together, have enabled the SBIC program to grow rapidly without causing delay in the funding of investments.
Eligible Companies and Transactions
To be eligible for SBIC funding, companies must be located primarily in the United States and must satisfy certain size requirements. Investments in certain types of businesses, such as real estate, finance, and motion picture production companies, are restricted.
To satisfy the size requirements, a business must meet one of two alternative tests. A company complies with the first test if it has a net worth of not more than $18 million and average net after-tax income for the last two years of not more than $6 million. For companies unable to meet the net worth/net income test, there is a second test that is based on other factors, typically the number of employees or total revenues. Employee tests range from 100 to 1,500 employees and total revenue tests range from $750,000 to $27.5 million, depending on the industry.
Eligible companies may obtain financing at various stages of their development, from seed stage through later stage, and in forms ranging from pure equity to loans with or without equity features. Capital provided by an SBIC may be used for most any valid business purpose, such as working capital, capital expenditures, or research and development, as long as the capital is used in the United States. Companies with securities that are publicly traded, as well as those with securities that are closely held, are eligible for SBIC financing as long as they meet the size criteria.
SBICs may also serve as a readily available source of capital for managers who want to purchase an existing small business. SBICs are permitted to finance buy-outs and other ownership changes that promote the sound development or preserve the existence of a small business, that result in creation of a small business as the result of a divestiture, or that facilitate ownership in businesses controlled by certain socially or economically disadvantaged persons. Similarly, entrepreneurs who desire to sell an existing business may find SBICs that are willing to participate in the organization and financing of the buyer group.
There are relatively few restrictions on how an SBIC structures its investments in its portfolio companies.
In the case of loans and loans with equity features, the most significant restriction is the so-called "cost-of money" regulation, which limits the amount of interest, points, discounts, fees and the like that an SBIC can receive. Certain types of charges are excluded from the calculation, including application and closing fees up to specified amounts, certain expense reimbursements, reasonable prepayment penalties, standard director fees and royalties based on improved performance of the portfolio company. Generally speaking, the cost of money ceiling is 19% for loans and 14% for loans with equity features. These ceilings may be raised in certain circumstances based on the debenture leverage rate or the SBIC's cost of capital. Loans and loans with equity features generally must have a term of at least one year.
In the case of equity securities, the most significant restrictions are those relating to dividends and redemptions. An SBIC which obtains leverage in the form of equity issued to the SBA must invest an amount equal to its leverage in so-called "equity capital investments." For an investment in the equity securities of a portfolio company to qualify as an "equity capital investment," dividends on the equity security may be paid only out of retained earnings. If the redemption provisions of an equity security do not meet certain criteria, the equity security will be treated as a loan with an equity feature and thus will be subject to the cost-of-money regulation. Specifically, the redemption price must be either a fixed amount no greater than the price paid for the equity security or an amount that reflects the fair market value of the company based either on a reasonable formula or an appraisal. An SBIC generally may not require a portfolio company to redeem an equity security during the first year of investment.
The Outlook for Entrepreneurs
The SBIC program provides venture capital and other private equity fund managers with an attractive opportunity to multiply capital that is available for investment by using long-term, low-cost, government-backed financing.
Through this program the business community has access to a large and growing source of mezzanine and equity capital. Entrepreneurs, whether in need of seed capital to develop and commercialize their ideas or later-stage capital to expand or acquire businesses, should not overlook this important source of long-term financing.
¸ Bruce A. Kinn, David R. Pierson and Earl W. Mellott 2003. All rights reserved.