Small Business Investment Companies (SBIC)

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The Small Business Investment Company (SBIC) program was created in 1958 with the passage of the Small Business Investment Act of 1958. Licensed by the Small Business Administration (SBA), SBICs are privately organized and privately managed investment firms that provide venture capital to small independent businesses. These loans, which are available both to new and established businesses, consist of funds borrowed (at favorable rates) from the U.S. government or from the lending institutions' own capital stock. In essence, an SBIC uses its own capital, combined with funds borrowed from investors and supported by an SBA guarantee, to make investments in qualifying small businesses. The SBIC program is designed to assure that there are institutions within the marketplace able and willing to facilitate the capital needs of a vibrant small business community.

Two different kinds of Small Business Investment Companies operate in the United States. In addition to regular SBICs, investment firms known as Specialized Small Business Investment Companies (SSBICs) also exist; this latter type of firm emphasizes service to entrepreneurs who "have been denied the opportunity to own and operate a business because of social or economic disadvantage," according to the SBA. Formerly known as Minority Enterprise Small Business Investment Companies (MESBICs), SSBICs are now officially called Section 301(d) SBICs. However, since the differences between SSBICs and regular SBICs are minor they are generally lumped together under the SBIC heading.

THE SBIC ORGANIZATION

Ownership of SBICs generally takes two different forms. The majority of SBICs are relatively small, privately owned and operated firms, but many others are firms owned by commercial banks or insurance companies. For banks, establishment of an SBIC subsidiary is often an attractive proposition, because it enables them to make small business investments that would otherwise be closed to them because of U.S. banking laws and requirements. United States law places few restrictions on SBIC ownership. As the SBA itself said, "almost any person or organization with a minimum initial private capitalization of $5 million and an SBA-approved full time manager who will be in charge of the licensee's operations and who is able to serve the licensee's small business concerns, may be approved for ownership." Indeed, the SBA's interest in encouraging SBICs is evident in the relatively hands-off regulatory environment that they have established for such enterprises. Those regulations that the SBA does enforce are concerned with ensuring the continued financial and ethical health of the SBIC program.

SBICs, then, range from limited partnerships to subsidiaries of multinational corporations. Whatever their ownership situation, however, their ultimate goal is to realize a profit from their various business transactions. Some SBICs make most of their revenue from straight debt financing, with their profit coming from the differential between the cost of borrowing from the SBA and the interest rate they charge the small business bar-rower. Other SBICs take a more aggressive tack in seeking profits by making equity-participation loans.

According to the SBA, prospective SBICs (and SSBICs) must have a minimum private capital investment of $5 million to form (the minimum requirement for those firms wishing to utilize participating securities is $10 million). The amount of private capital that an SBIC has at its disposal is important, for the SBA limits its loan guarantees to SBICs to 300 percent of its private capital. The SBA notes, however, that an SBIC "with at least 50 percent of its 'total funds available for investment' invested or committed in 'venture capital' may receive an additional tier of leverage per dollar of private capital for total leverage of 400 percent of private capital. However, in no event may any SBIC or SSBIC draw down leverage in excess of $90 million." An SBIC that engages in leveraging is in essence borrowing additional investment funds from the U.S. Treasury. Only those SBICs that have invested the bulk of its initial private capital and are in full compliance with state and federal regulations are eligible to do this.

Small Business Investment Companies have several different options to choose from in providing financing to small businesses. Most SBICs provide long-term loans to qualified small businesses that need funding for needs that range from expansion of existing facilities to modernization of operations. Sometimes this loan will take the form of equity or debt securities.

OPERATING RESTRICTIONS FOR SBICS

While the SBA provides SBICs with considerable freedom to operate, they do require that these organizations adhere to certain rules. For example, SBICs are not permitted to invest in the following entities: companies with less than one-half of their assets and operations in the United States; unimproved real estate; finance and investment companies; or companies seeking to purchase or improve farmland, cemeteries, or certain other stipulated types of real estate (exceptions are made for sub-dividers and developers, title abstract companies, and real estate agents and brokers. Small Business Investment Companies also are forbidden from investing in other SBICs, or in business enterprises that do not fit federal definitions of a "small business."

The SBA also has established regulations in the following areas:

  • Conflict of Interest—SBICs are not allowed to make business transactions with any of its associates, which are defined as officers, directors, employees, key "control persons," and certain shareholders.
  • Control—the SBA has stipulated that no SBIC may exercise either direct or indirect control over the operations of any small business on a permanent basis. The SBA has, under some circumstances, permitted SBICs to assume temporary control of a business enterprise in order to protect its investment. Before doing so, however, the SBIC and the small business must submit a plan of divestiture for SBA approval.
  • Overline Limitations—The SBA has established investment ceilings for both SBICs and SSBICs in their dealings with individual small businesses. SBICs are not allowed to invest more than 20 percent of its private capital with any one small business, while the limit for SSBICs is 30 percent. The SBA does, however, occasionally grant waivers to this rule.
  • Cost of Money—The SBA regulates the cost of money on SBIC loans and debt securities issued by SBIC clients.
  • Financing Proceeds—The SBA has established regulations designed to ensure that investment funds that are used to purchase securities go directly to the small business that has offered those securities.
  • Length of Financing Agreements—SBA rules stipulate (in most cases) that SBIC loan agreements with small business enterprises be made for at least five years, and that the small business taking the loan be given adequate opportunity to fulfill its obligations ahead of schedule if it is able to do so. According to the SBA, loan and debt securities of less than five years' duration are permissible only on those occasions when they are necessary to protect existing financing agreements, are made in contemplation of long-term financing, or are made to finance a change in ownership.

BORROWING FROM AN SBIC

"As is true with venture capitalists in general, SBICs have divergent philosophies and operating policies," wrote Art DeThomas in Financing Your Small Business. "Some specialize in equity financing while others provide debt financing in several different forms. This latter group of SBICs is the richest source of debt financing for small businesses outside commercial banks." Small business owners, however, need to weigh several factors before making a loan arrangement with an SBIC.

Entrepreneurs and small business owners seeking financing from SBICs first need to determine how many options they have. Regional SBA offices maintain information on SBICs that operate in their areas, and while they do not provide guidance in directing businesses to particular SBICs, they can give information on the industries and types of investments in which area SBICs have historically shown interest. In addition, a free directory of SBICs is available through the National Association of SBICs.

As many experts note, small businesses should narrow their search for a suitable SBIC by eliminating those that do not provide the business's desired financing route or display adequate management experience in the industry in which the business is involved. Analysts also caution small business owners not to rush through the decision making process. Given the latitude that SBICs have in shaping their loan policies, individual SBICs often maintain dramatically varied lending policies. Entrepreneurs and small business owners should take the time to find the program that best meets their needs.

Business consultants also encourage prospective borrowers to negotiate the best possible loan agreement for themselves when talking with SBICs. "Aside from the specifics of SBIC lending that are mandated by existing law or regulation," noted DeThomas, "particulars such as interest rate, maturity, equity participation, and collateral requirements can be negotiated. In general, the more attractive your firm as a financing opportunity—that is, the stronger the business plan—the more negotiating leverage you possess."

BIBLIOGRAPHY

DeThomas, Art. Financing Your Small Business: Techniques for Planning, Acquiring & Managing Debt. Oasis Press, 1992.

"Senators Propose New SBA Program: Under the bill, the SBA would get a bigger chunk of an SBIC's profits. Private Equity Week. 7 November 2005.

U.S. Small Business Administration. SBA Profile: Who We Are and What We Do. 1996.

U.S. Small Business Administration. Small Business Innovation Companies Program. Available from http://www.sba.gov/INV/forentre.html. Retrieved on 5 June 2006.





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