Forming A Small Business Investment Company: Threshold Considerations

This article originally appeared in Journal of Taxation and Regulation of Financial Institutions, Volume 26, No.4 (March/April 2013). Copyright © 2013 Civic Research Institute. All rights reserved. This article is reproduced here with permission. All other reproduction or distribution, in print or electronically, is prohibited. All rights reserved. For more information, write Civic Research Institute, 4478 U.S. Route 27, P.O. Box 585, Kingston, NJ 08528 or call 609.683.4450. (http://civicresearchinstitute.com/tfi.html)

When changes in the banking laws a decade ago permitted banks directly to own more than 5 percent of the voting securities of businesses that were not related to banking, many banks that had previously formed Small Business Investment Companies (SBICs) surrendered their licenses. A number of banks are now again considering the formation of SBICs, because the Dodd-Frank Act permits bank investment in SBICs. Although SBICs provide a number of advantages, threshold issues deserve careful consideration.

Established by the United States Congress in 1958 to stimulate long-term investment in American small businesses, the SBIC program has evolved into a significant factor in financing smaller American businesses. Over the years, SBICs have invested over $63 billion in more than 115,000 businesses, including well-known companies such as Apple, Federal Express, Cray Computers, Callaway Golf, and Quiznos. This critical investment capital has been provided to the full range of American small business including Silicon Valley start-ups, owners of New York taxi cabs and diners, generational buyouts, retail chains, distributors, waste haulers, technology and medical device companies, software developers and manufacturers.

SBICs are privately owned and managed lending and investment funds that are licensed by the U.S. Small Business Administration (SBA) generally in order to gain access to very inexpensive, long-term financing provided by the SBA. Investment decisions are made by the SBIC's principals, but must comply with the SBA's regulatory framework, which requires that portfolio companies be U.S. operating businesses that at the time of the SBIC's initial investment have net assets of less than $18 million and average after-tax earnings during the prior two years of less than $6 million (or meet an alternative test for the primary industry in which the company is engaged based on the number of employees or gross revenues) which are not organized to own real estate, are passive businesses, or are principally involved in reinvesting or relending activities.1

When licensed, an SBIC will be eligible to receive up $150 million of financing from SBA in the form of "Debentures" (commonly also referred to as "Leverage"). Debentures have 10-year maturities, are not amortized prior to maturity, and bear interest payable semi-annually at a fixed rate (which during recent years has been in a range of 80 to 135 basis points in excess of the interest swap rate on 10-year Treasury notes at the time of issuance). Debentures are unsecured and may be prepaid without penalty. An SBIC is eligible to draw down up to twice (and in certain circumstances, up to three times) the amount of its private capital, generally at the same time as the private capital is called. Use of such leverage can dramatically increase returns to investors. At the end of 2012, there were more than 161 licensed Debenture SBICs and 42 non-leveraged SBICs. The current stream of applicants seeking licensure is robust.

Prior to October 1, 2004, the SBA also licensed SBICs operating as venture capital and private equity funds using SBA funding called "Participating Securities" that were structured as preferred limited partnership interests and, while similar to Debentures in certain respects, were intended to enable an SBIC to make venture capital and other equity investments. That program has been discontinued and the last Participating Securities were issued in 2008. Approximately 300 Participating Securities SBICs were licensed between 1994 and 2004. Only 86 were operating at the end of 2012, although a number were being liquidated.

In addition to leveraged SBICs, banks and bank holding companies historically formed SBICs that did not use government funding, as the SBICs enabled them to indirectly own more than 5 percent of the voting securities of businesses that were not related to banking. Changes in the banking laws a decade ago permitted banks directly to make these investments, and as a consequence approximately 100 bank-owned SBICs that did not use Leverage surrendered their SBIC licenses. The recent Dodd-Frank Wall Street Reform and Consumer Protection Act generally prohibited a banking entity from engaging in proprietary trading and acquiring or retaining any equity, partnership or other ownership interest in or sponsor a hedge fund or a private equity fund.2 Notwithstanding this restriction, if permitted under other Federal and State laws, banking entities are permitted to invest in one or more SBICs.3 Because of this exception, banks are again considering forming SBICs. Banks investing in SBICs also are entitled to receive credit under the Community Reinvestment Act4 and receive more favorable capital treatment than investment in traditional private investment funds.

NEW SBA PROGRAM INITIATIVES

In recent years Congress and/or the Administration have announced three initiatives involving the SBIC Program: Energy Saving Qualified Investments, Early Stage Investing, and Impact Investing. Each of these initiatives is comparatively small and, as of the present time, not fully developed.

Energy Savings Qualified Investments. The Energy Independence and Security Act of 2007 authorized the creation of a program that would enable SBICs to make early stage equity investments in companies engaged in energy savings activities.5 The SBA issued final regulations in April 20126 that authorize the issuance of a very limited amount of Energy Savings Debentures each year to SBICs formed after 2008. To obtain these Debentures, the SBIC must use the funds to finance a Small Business that is primarily engaged in "energy savings activities."7 The first five years of interest will be deducted from the Debenture when it is issued, with interest for the remainder of the ten year term payable semi-annually. The total amount of such Debentures in any year may not exceed five percent of all of the Debentures issued during the year; as a consequence, it is likely that the total amount of annual funding will be limited to about $70-$100 million, based on usage of traditional Debentures during the past two years.

Start-Up America Initiative. On January 31, 2011, the Obama Administration announced the "Start-Up America Initiative" to encourage American innovation and job creation by promoting high-growth entrepreneurship with new initiatives to help encourage private sector investment in job-creating start-ups and small firms and address barriers to success for entrepreneurs and small businesses.8 This led to two SBIC Program initiatives—an Early Stage Investment Program and an Impact Investment Program. A portion of authorized traditional Debentures are being set aside for each of these programs during each of the next five years.

Early Stage Investment SBICs. Final regulations for the Early Stage Investment Program were issued on April 27, 2012.9 Early Stage SBICs will be entitled to use between $20 million and $50 million of Debentures (on a ratio of Debentures to paid-in investor capital that does not exceed 1:1). Early Stage SBICs may use either conventional Debentures (subject to providing a 21-quarter interest reserve of cash or un-called capital) or so-called discounted "Early Stage Debentures," which, similar to Energy Savings Debentures, accrue interest for five years and then require monthly interest only payments for the remainder of their ten year term. Early Stage SBICs must invest at least half their invested capital in companies which have not had positive cash flow at the time of initial investments. Additionally, prior to repayment of the Debentures, distributions of profits are required to be shared with Debenture prepayments and SBA's consent is required for all distributions which would reduce the SBIC's Regulatory Capital.10 SBA has announced that $1 billion of Debenture commitments will be available for use of Early Stage SBICS between 2012 and 2016.

Management teams applying to form Early Stage SBICs must have a successful venture capital track record, and will be subject to the same rigorous licensing requirements as are users of Debentures. However, licensing is not done on a first-come first-served basis. Rather, the SBA makes annual calls, specifying windows of time when applications may be filed. As of the end of March 2013 only two Early Stage SBIC licenses have been issued.

Impact Investment SBICs. The Impact Investment initiative provides for a modestly streamlined licensing process for SBICs that will provide growth capital to companies located in underserved communities (including investing in economically distressed areas), as well as investing in companies in emerging sectors such as clean energy and education. Impact Investment SBICs use traditional Debentures. The SBA has set aside $200 million of Debentures for Impact Investment Funds beginning with Fiscal Year 2012, but to date only two Impact Investment SBICs have been licensed. Applicants are subject to the same licensing standards as other funds, but licenses are processed on a somewhat expedited basis.

THE STRATEGIC DECISION TO BECOME AN SBIC

The decision of whether to form an SBIC is complex. It depends upon the alignment o of SBA policies and regulations with the investment objectives of the sponsors, the qualifications of the persons making investment decisions for the planned fund and, equally important, their ability to properly display those qualifications...