Since implementation in 1994 of a substantially improved small business investment company program, the number of privately-managed small business investment companies receiving reasonably-priced, government-backed financing has increased rapidly. In the federal fiscal year ended Sept. 30, 2000 alone, SBICs invested nearly $5.5 billion in over 3,000 small businesses. This represents an increase of 30% over the prior year, due primarily to the growing popularity of the Small Business Administration’s equity leverage program. Not only have the levels of government-backed funding for program participants increased dramatically, but at the same time those funding levels have become more reliable by becoming less dependent on Congressional budget appropriations.
As a result, more venture capital firms are participating in the SBIC program to leverage either the entire portfolio of a new fund or, by forming a “subsidiary” fund, a portion of the portfolio of a new or existing fund. With a cost of government-backed equity capital based on the yield on 10-year Treasury securities that provides private investors with a significant opportunity to leverage their investment returns, an ability for management to earn a management fee on the government-backed funding, a licensing process that may be commenced during private capital fundraising, a leverage process by which SBICs receive a funding commitment from the SBA which can be drawn down over time, and a requirement of only $10 million in private capital, it is easy to see why the program has become increasingly popular with venture fund managers.
The SBA provides capital to private VC funds licensed as SBICs, in the form of either equity under the participating security program or loans under the debenture program. In return, under the participating security program the SBA receives a preferred return on its capital, but only if, and when the fund realizes profits, certain fees and a percentage of the balance of the fund’s profits. Under the debenture program, the SBA receives periodic interest payments and a single payment of principal at maturity.
If management desires to leverage a fund’s entire portfolio, it may apply for an SBIC license for the entire fund. If management desires to leverage only a portion of the portfolio, it may form and license a subsidiary fund which represents only a portion of the private investors’ capital. As is the case with traditional VC funds, it is typical to form SBICs as limited partnerships with special purpose entities as their general partners.
The preferred return payable to the SBA under the participating security program is based on the yield for 10-year Treasury securities, plus a “spread” which recently has been slightly more than 1.5% per annum. In addition to the preferred return, an annual fee of 1% is payable on outstanding leverage. The preferred return and annual fee are payable only out of profits, which reduces the risks that are normally inherent in financial leverage. In other words, there is no mismatching between a fund’s cash flow and its payment obligations to the SBA, making the participating securities leverage an appropriate source of capital for equity investing in small businesses.
In addition to its preferred return, the SBA receives a share of the balance of the fund’s profits. This share is determined by a formula based on the 10-year Treasury yield and the ratio of SBA leverage to private investor capital (see chart). For example, at a 6% Treasury yield, an SBIC could obtain up to two-thirds of its capital from the SBA while giving up only 9% of its profits (in addition to the SBA’s preferred return).
Although the preferred return is payable only to the extent of profits, it is compounded annually and must be paid on a cumulative basis before any profits are distributed to private investors. After the preferred return is brought current, private investors are allowed to participate in distributions while the SBA’s profit share and capital are being paid out. This is done in a series of steps which allow for distributions to private investors and management to pay income tax obligations (SBA also participates in these tax distributions), followed by distributions to private investors and management concurrently with distributions to SBA. Although, after tax distributions, the program initially requires disproportionately large distributions to SBA if the leverage ratio exceeds one-to-one, distributions are made according to profit participation percentages after the leverage ratio is reduced to one-to-one.
Enhanced Return on Investments
To illustrate the favorable impact enjoyed by private investors and management through the participating security program, the authors developed a simplified economic model to compare the IRR for an unleveraged fund of $20 million with the IRR for a fund receiving leverage in the ratio of two-to-one. For this purpose, investments were assumed to be made ratably over a four-year investment period and liquidated after four years at various levels of portfolio return. A 10-year Treasury yield of 6% per annum was used, along with a combined federal and state tax rate of 45% for purposes of calculating tax distributions. Assumptions were also made as to levels of cash balances and start-up and operating costs, including a 2.5% management fee on all private and SBA capital, and as to the timing of receipts and expenditures during each year. The IRR took into account all fees, priority payments and profit participation paid to the SBA, and all management fees and other costs paid by the fund.
For example, take a moderately successful VC portfolio with a 25% average return on the portfolio’s investments. The combined IRR for private investors and management is approximately 19% for an unleveraged portfolio, after taking into account the assumed level of expenses and management fees. But under the same assumptions with the leveraged portfolio, the IRR jumps to 32%. Clearly, the SBIC program provides the significant benefits of financial leverage while at the same time providing a payment regime well-suited for equity investing.
Leverage under the equity program is available in an amount up to two times an SBIC’s private capital. The maximum leverage available to an SBIC, or to two or more SBICs under common control, is now $108.8 million. This maximum amount is indexed for inflation each year.
Previously under the program, leverage was available in four quarterly fundings each year. But the SBA has more recently adopted a “just in-time” approach that permits SBICs to match more closely their leverage take-downs to their investment transactions. Under this approach, an SBIC obtains a leverage commitment against which it may draw over a period of up to five years. As with funding commitments from private sources, the SBA charges an up-front commitment fee, pegged at 1% of the committed amount. An additional fee of 2% is paid on leverage when taken down. This process provides SBICs with considerable certainty as to the amounts they will have available to invest.
The SBA pools its rights to receive prioritized payments from SBICs and sells trust certificates in the pool to buyers in a secondary market. The SBA then guarantees payment of the trust certificates to enhance their marketability. The SBA charges a spread over the 10-year Treasury yield as part of its priority return to partially compensate it for its costs of administering the program.
The participating security program has recently become less reliant on annual Congressional budget authorization. For example, in the current fiscal year, available equity leverage of $2 billion is being squeezed from a budget appropriation of just $26.2 million. As an aside, the debenture leverage program has become entirely self-funding, and the current fiscal year availability of $1.5 billion required no budget appropriation.
Many of the provisions of the SBIC program relate to the investments an SBIC may make. An SBIC may invest only in small businesses and is required to invest at least 20% of its invested funds in smaller businesses. A small-business is one that either (a) has tangible net worth of not more than $18 million and average net after-tax income (exclusive of loss carry-forwards) for the two prior fiscal years of not more than $6 million, or (b) meets a standard for its industry based, depending on the industry, on number of employees or gross revenues. A smaller business is one with not more than a $6 million net worth and average net after-tax income (excluding loss carry-forwards) for the two preceding years of not more than $2 million, or one that meets the test in (b) above. These tests are applied looking at the company to be financed, together with its affiliates. An SBIC may continue to finance a company that is no longer small up to the time of an initial public offering, and thereafter may exercise options and warrants acquired prior to the IPO.
An SBIC may invest not more than 20% of its “Regulatory Capital” in a particular company and its affiliates. Regulatory Capital is the paid-in capital from private investors, together with the amount of unfunded commitments from those investors that the SBA defines as institutional investors. Any entity with a net worth (exclusive of unfunded commitments from its investors) of more than $10 million will qualify as an institutional investor. The definition also includes specified types of entities and individuals that meet specified net worth requirements.
SBICs that invest in a company, together with their associates (a definition that includes relationships beyond those of control), generally may not control that company. There are exceptions that permit an SBIC to take control for up to five years in the case of certain start-up companies and to enable an SBIC to protect an existing investment. Although a recent legislative change eliminates the prohibition on control of a portfolio company, SBA has announced that new regulations will be required to implement this change. Such regulations have not yet been proposed and, until the necessary regulations are adopted, SBICs remain subject to the existing control regulations.
An SBIC may not invest in companies whose principal business is lending or investing, most real estate businesses, passive businesses, project financings, foreign operations or, with certain exceptions, any business that acquires goods or services from a supplier who is an associate of the SBIC.
An SBIC is required to invest an amount equal to the amount of its participating securities leverage in “Equity Capital Investments.” These are investments in the form of common stock, preferred stock (provided that dividends are payable only to the extent of earnings) and unsecured debt with interest contingent on earnings and that is not amortized for five years.
An SBIC may not require a portfolio company to repurchase the SBIC’s investment sooner than one year from the date of the SBIC’s first investment in the company, although the company may do so voluntarily at any time. There are exceptions that permit earlier required repurchases in the event of a public offering, a change in management or control, or material breach of the financing agreements. The redemption price must be based on either (a) an earnings, book value, or other formula that reflects performance, or (b) appraised fair market value. Equity securities with redemption provisions that do not comply with these requirements will be subject to SBA Regulations regarding debt securities.
The SBIC program extends far beyond the few items described here. It includes requirements for diversity between management and ownership, provisions regarding borrowing other than from the SBA, restrictions on dealing with affiliates, tests and remedies for capital impairment and insufficient liquidity levels, reporting requirements, management fee provisions, and certain investment terms. In deciding whether to form an SBIC, a VC firm should weigh all factors in light of its overall investment and fund-raising plan. However, the compelling economic benefits merit a careful look at the participating security leverage program.
Bruce A. Kinn and Arnold M. Zaff are partners in the Boston law firm of Foley, Hoag & Eliot LLP and were actively involved in development and implementation of the SBIC equity leverage program.