When the Small Business Administration (SBA) amended its regulations to expand the investment authority of Small Business Investment Companies (SBICs) in November 2002, it made participating in the government-sponsored program more attractive for investors. Now, an SBIC is permitted to assume control of a portfolio company for up to seven years. And the investor may extend its control for as long as is reasonably necessary to complete divestiture or to ensure the portfolio company’s financial stability.
An SBIC now also is permitted to sell its equity interests in a portfolio company to a competitor of the company.
As a result of these amendments, venture and private equity investors may want to consider organizing an SBIC as part of their investment strategy, whether on a stand-alone basis or “side-by-side” with, or “dropped-down” by, an existing investment fund.
What’s an SBIC?
An SBIC is a government licensed and regulated, privately owned and managed for-profit private equity fund that makes investments using (in part) financing from the SBA at below-market rates in American small businesses.
The small business has a net worth of up to $18 million and average net after-tax income for the two fiscal years preceding the investment of $6 million or less or a number of employees ranging from 100 to 1,500 and total annual revenue ranging from $750,000 to $28.5 million, depending on the industry.
About 20% of an SBIC’s investments must be made in so-called “smaller businesses,” which have a net worth of $6 million or less and average net after-tax income for the two fiscal years preceding the investment of $2 million or less.
An SBIC may use a portfolio company as a growth platform by making follow-on investments in a portfolio company generally without regard to whether the portfolio company remains a small business or a smaller business after the follow-on investment, but only until the first public offering of equity or debt securities by the company.
An investment fund that becomes licensed as an SBIC is eligible to obtain long-term, low-cost financing from the SBA in an amount of up to 200% of its private capital and up to a maximum of $113 million.
As a condition to receiving SBA financing, an SBIC must maintain a minimum amount of private capital – $10 million, comprised of cash contributions or binding capital commitments issued by investors with a minimum net worth of $1 million, of which $2.5 million must be drawn at the time an investment fund becomes licensed as an SBIC.
Thus, an investment fund licensed as an SBIC, which has aggregate capital commitments of $50 million, can with the assistance of SBA financing effectively operate as a fund with a total of $150 million in committed capital ($50 million plus $100 million of SBA financing).
To obtain SBA financing, an SBIC can apply to receive a five-year financing commitment of up to the maximum amount of SBA financing available to it based on its then outstanding capital commitments. The SBA charges a 1% commitment fee and a 1% annual fee on the unused portion of the commitment.
On each drawdown of the commitment (which can be made on 10 days notice), the SBA charges a 2.5% fee and is issued a participating security. This is similar to a preferred limited partnership interest, is generally redeemable 10 years after issuance and accrues a current return in the form of prioritized payments.
Prioritized payments are paid out of and to the extent of an SBIC’s realized earnings before distributions are made by the SBIC to its private investors. Under this formulation, the SBA would receive, at current rates, about 7% of an SBIC’s realized earnings – exclusive of fees – in exchange for providing two-thirds of the SBIC’s investment capital.
Participating securities also entitle the SBA to share in a percentage of the profits received by an SBIC from each portfolio company security held by the SBIC. These fees and prioritized payments can be partially offset by an SBIC’s ability to charge portfolio companies, within certain limitations, annual management fees, transaction fees, financing fees, and performance royalties.
In other words, SBA leverage can significantly enhance rates of return for an investment fund that is licensed as an SBIC.
A hallmark of venture capital and private equity investing is the value added by an investor in directing a portfolio company’s financial and strategic planning and overseeing the activities of a company’s management. The goal, of course, is that the investor would help structure an exit at a high internal rate of return within a relatively short time, usually five to seven years after the initial investment.
The ability to control a portfolio company is highly valued, as it is ultimately the only real way in which a venture capitalist can preserve an investment and encourage its growth. This explains why acquirers of businesses pay above-market prices for equity interests with majority voting power and the resulting ability to control an enterprise.
The pre-November 2002 SBA Regulations denied venture capitalists the ability to capitalize on this control premium. Prior to the enactment of the November 2002 amendments to the SBA regulations, an SBIC could principally control a portfolio company only if the SBIC was the major capital source for a startup or the SBIC was reasonably required to assume control in order to protect its investment. And then only if the SBIC certified to the SBA that it would relinquish control within five years thereafter.
Under this framework, an SBIC could only indirectly influence the activities of a portfolio company through a combination of various mechanisms. Such mechanisms include the complicated voting arrangements, minority representation on the board of directors, and affirmative and negative covenants contained in the investment documents regulating the scope of authority of the portfolio company’s management over day-to-day business operations, with financial penalties charged to the portfolio company for non-compliance.
From the perspective of a venture capitalist, each of these methods is ultimately inadequate. A venture capitalist can only react to actions already taken by a portfolio company’s board of directors or management, which weakens the venture capitalist’s ability to preserve or salvage the value of its investment.
But as a result of the November 2002 amendments to the SBA regulations, the framework of the SBIC program is more in line with the realities of private equity investing.
First, a venture capitalist can exercise real-time direct control over a portfolio company for a seven-year period. This fits the average exit horizon of most private equity investors.
Second, the scope of available exit opportunities has expanded since the SBA has recognized that likely exit opportunities for private equity investments are in the sale of such investments to competitors, making possible, for example, the sale of an SBIC-owned business to a portfolio company operating in the same industry and owned by another financial buyer.
Why Form an SBIC?
Both changes to the SBA regulations should make the SBIC program more attractive to private equity investors.
The SBIC program gives venture and private equity investors an opportunity to leverage their investment capital and increase possible rates of return by using long-term, low-cost financing provided by the government.
The amendments enacted in November 2002 to the SBA regulations more closely align the SBIC program with the expectation of a venture capitalist to control the destiny of its investment, from initial investment to exit.
SBICs remain subject to numerous other SBA regulations, including annual SBA audits, restrictions on dividend rates, and timing and pricing of redemption features and other investment terms. Although the SBA has proposed increasing the return earned from the capital it provides to SBICs, you may wish to explore setting up an SBIC to take advantage of capital available from the SBA.
Andrew Lindholm is a New York-based partner at Kirkland & Ellis LLP. His law practice focuses on venture capital and private equity transactions.