SBA Suspends VC Program, Future in Doubt –

It appears that the Small Business Administration’s 48-year-old program to help small venture capital funds is dying a slow death, raising uncertainty about the future of about one-fifth of U.S. venture funds.

Faced with losses to the tune of almost $2 billion, the “participating security program” needs restructuring to survive. But a lack of an agreement between competing sides, coupled with a legislative agenda that was subject to the strains of an election year, produced no movement on the issue. The result is that the SBA has decided not to license any new Small Business Investment Companies (SBICs) until the next fiscal year, which begins Oct. 1, 2005.

The suspension of the program leaves a key source of funding out of the reach of many venture firms that rely on government funding to supplement their funds. Typically, they are firms with relatively small funds and they serve geographic regions that are not traditionally served by venture capital.

Industry observers say that the program may be finished for good, and that any temporary revival of it would amount to an empty gesture on the part of the government. “If it does come back, more likely than not it will be back in a limited form or it will be back but as window dressing, so it won’t be as effective as it was in its heyday,” says attorney Michael Littenberg, a partner with Schulte Rogh & Zabel.

Attorneys who work with firms that seek licensing saw first-hand a rush to get licensed for the participating security program before the end of the fiscal year. Attorney Mike Wyatt, a partner with the Washington-based firm of Hogan & Hartson, saw a handful of his clients not make the deadline. “[Firms] that want to do relatively early stage are just on hold,” he says. “A mix of applicants had already begun to skew away from early stage investing because it had already not been very profitable.”

Wyatt adds that the SBA is working with many of the companies that have been left in the lurch to see if they can participate in the SBA’s fully functioning and fully funded debentures program. “The immediate impact is not a significantly noticeable diminution flowing to small businesses in the short run,” he says. There hasn’t been a sudden dramatic drop in small businesses. If this goes on too much longer there will be. A number of the equity type funds either are or soon will be in liquidation.”

Littenberg adds that the White House has made it known that its support for such programs is low. “I personally don’t hold out high hopes for the participating securities program,” he says. “When I talk to people in the industry who are thinking about a fund-raising strategy for their new fund, they tend not to be putting out a lot of hope that this will be a viable option for them in the future.”

About one-fifth of the venture firms in the United States are backed by the SBIC, based on data gathered by Thomson Venture Economics (publisher of VCJ), the National Venture Capital Association and the National Association of Small Business Investment Companies. NASBIC reports that there are about 206 SBICs with about $15.4 billion under management. That means that 22% of the 919 U.S. VC firms (as tabulated by Thomson VE and the NVCA in 2003) are backed by the SBA.

“From a venture perspective, the amount of money that comes from the SBIC program is not a huge portion,” says Mark Heesen president of the National Venture Capital Association. Heesen stresses, however, that the economic impact on the country is larger than the number of dollars dropped into smaller venture firms, particularly the way the money goes to industries and regions underserved by private capital. “If you look at it as not just the dollars but what the impact is long-term in lots of different geographic regions, there’s a case to be made in keeping this program going.”

In a letter to President Bush earlier this fall, Heesen pointed out that between fiscal years 1994 and 2002, 71% of SBIC dollars went to companies outside of California and Massachusetts and that 50% of SBIC investments were in manufacturing- and consumer-related businesses that are also underserved by traditional VCs.

Under the current structure, the program invests double what a venture fund raises from private limited partners in exchange for it’s money back with a small amount of interest plus 10% of the fund’s returns. It begins collecting those returns after the private LPs have collected their returns.

Under changes proposed by the SBA, the program would increase its distribution share to 50% until its funds are returned and increase its profit share to 50% up from 10 percent. The SBIC program would also start taking profits when private LPs have been paid distributions equivalent to what they invested.

The SBA’s proposal was at odds with those within its industry. NASBIC proposed its own recommendations for salvaging the program. Under NASBIC’s plan, the program would act more like a private LP and take benefits on the same terms as a fund’s private LPs. The program would receive distributions equity to commitments plus a hurdle rate prior to the GPs taking carried interest.

The two sides failed to reach any compromise, and some industry insiders privately voiced their belief that the Bush administration intended to let the program die a quiet death.

Craig Orfield, a spokesperson for the U.S. Senate Committee on Small Business, says that negotiating a restructuring of the participating security program is in the top tier of priorities for the committee beginning next session. “There’s been an unusually high amount of back and forth on SBA reauthorization as a whole,” Orfield says. “Things simply did not go as planned at all. There was an enormous amount of back and forth between the House and Senate and the administration. To some degree the SBIC suffered along with the other programs in that process.”

Committee chairwoman Sen. Olympia Snowe (R-Maine), developed a compromise proposal, but it was never offered before the committee.

Founded in 1958 with the passage of the Small Business Investment Act, the SBA program provides funds borrowed at special rates to licensed SBIC firms. These firms invest capital in small, independent businesses.

The program underwent a restructuring in 1994 to better partner it with the venture capital industry and that structure stayed in place until this year