Venture Capital, Federal Government Style

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David R. Evanson

Entrepreneur Magazine, Fall, 1999

RESUME: SMALL BUSINESS INVESTMENT COMPANIES & SPECIALIZED SMALL BUSINESS INVESTMENT COMPANIES
Definition or Explanation: Small Business Investment Companies (SBICs) and Specialized Small Business Investment Companies are primarily lenders that are licensed by the Small Business Administration (SBA). These investment companies have their own private capital of several million dollars, and may borrow additional funds from an SBA-sponsored trust at favorable rates. SBICs tend to specialize in an industry, making them more risk tolerant than traditional bank lenders.

Appropriate For: Companies that are capable of repaying a loan. This typically means established to early stage companies with sales and earnings, or perhaps about to turn the corner toward profitability.

Supply: SBIC financing is abundant. According to the National Association of Small Business Investment Companies, Washington, DC, there are 300 SBICs and SSBICs with more than $6 billion under management

Best Use: For activities which generate cash flow in a relatively short period of time, such as product roll-out, or additional manufacturing or service capacity for which there is a demand.

Cost: Expensive. SBICs and SSBICs charge interest, but in addition, many look for some kind of equity compensation in the companies they finance. This equity compensation is usually in the form of stock as well as options or warrants which are instruments which allow the holder to buy stock a pre determined prices for a pre determined period of time.

Ease of Acquisition: Challenging but attainable. The challenging aspect is that a company must submit itself to traditional credit analysis to prove it can repay a loan. This is countered by the fact that these investment companies are hungry for new business and can be helpful in shepherding companies through the application and due diligence process. In addition, an SSBIC or SBIC generally represents a one-stop shop, and companies need only satisfy the requirements of this single investor to obtain funding

Range of Funds Typically Available: $150,000 to $5 million.

IS THIS OPTION RIGHT FOR ME?
The affiliation which SBICs and SSBICs have with the federal government through their SBA license, tends to inadvertently mislead many entrepreneurs. This is because many labor under the mistaken idea that there is an arm of the government that gives money to business that cannot secure financing from traditional sources of capital. Unfortunately, SBICs and SSBICs are not this elusive holy grail. Second, many entrepreneurs believe that the SBA, through a mechanism such as an SSBIC or SBIC, lends money to businesses where there is no visible source of repayment.

Unfortunately, this is not the case; SBA licensed investment companies tend not [italicize not] to finance companies that do not exhibit an obvious source of repayment and where there is a high degree of risk.

In fact, briefly exploring the financial structure of these SBA-licensed investment companies is helpful, because it shows not only they kinds of deals they wonzzt do, but the kinds they will, and what kinds of companies should spend their time pursuing this option.

For example, Freshstart Venture Capital Corp., an SSBIC in New York City gets its money from two places. The first is equity capital, which Freshstart founder Zindel Zelmanovitch is able to raise from public and private investors. But the second, and far more substantial source of capital for Freshstart, are loans from an SBA trust fund.

The interest which Freshstart must pay on the funds it borrows, like all SSBICs and SBICs, means the investment company must get involved in deals where they receive interest as well. Otherwise, there is a massive mismatch between the investment companyzzs sources and uses of funds. After all, how can an SBA-licensed investment company make investments where they receive no interest, but still pay interest on their own borrowings? The answer is investment companies canzzt because the difference between the interest they pay, and interest they receive, is precisely how it makes money.

And because their cost for funds can be quite low — from 4% to 7% — and the price SBICs and SSBICs charge on loans can be quite high — from 9% to 17% — these lenders can be quite profitable. Freshstart for instance earned approximately $781,000 on about $1.8 million in interest income for the 12 months ending November 30, 1997.

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Donzzt Forget: Remember, SBICs and SSBICs are primarily lenders. If your business can support a loan, then an SBIC or SSBIC may be right for you.

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MORE VERVE THAN A LENDER
If SBA-licensed investment companies are primarily lenders, what makes them any different than a bank? There are two differences, really.

First, SBICs and SSBICs tend to take slightly more risk than a banker in terms of collateral. That is where a banker needs a loan to be fully collateralized, and or guaranteed, at an amount which is equal to or greater than the loan value, an SSBIC or SBIC may not. The reason is the most investment companies specialize in a particular industry. As a result of their specialized focus, they tend to assign higher values to collateral than a general commercial lender.

Second, SBICs and SSBICs take a larger interest in smaller loans which range in size from $150,000 to $1 million. Large commercial banks like to make large loans. Itzzs that simple. The reason is that the systems which these banks have installed to analyze, disburse and monitor loans are so expensive that for many, a large loan is the only way they can hope to make any money.

By contrast, many SBICs and SSBICs are smaller partnerships. They have limited capital, and are careful not to make investments which will outstrip the financial resources which they have to offer. Some SBICs however, are affiliated with large commercial banks. These SBICs are capable of making substantial-sized loans and many have investment minimums of $1 million.

SIDEBAR: DAVIDS WHO BECAME GOLIATHS

The following companies were, at some point in their development, nurtured by SBIC funding.

Year SBIC # of Employees
Company Invested Today
Intel Corp. 1969 41,600
Federal Express 1973 110,000
Apple Computer 1977 13,191
Staples, Inc. 1986 22,714
Source: National Association of Small Business Investment Companies.

MAKING DEBT BEHAVE LIKE EQUITY
Recognizing the inherent mismatch between emerging growth companies and loan financing, the SBA has taken steps to make financing from its investment companies more appropriate for younger companies.

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Shop Talk: Some SBICs and SSBICs invest in earlier stage companies that canzzt yet support a loan through a new source of SBA financing known as zzparticipating debentures.zz The word “participate” comes from the fact that by deferring interest on its loans to SSBICs or SBICs, the SBA participates in the profits made on the investment.

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Specifically the agency has created what are known as participating securities or debentures. These participating securities allow SBICs and SSBICs to borrow capital from the SBA trust fund and defer interest until their investments start to generate cash. The bottom line of this arrangement is that it allows investment companies to finance businesses that are not yet capable of paying interest, which presumably means earlier stage companies.

Participating securities are creative, and once again demonstrates the fiscal prudence within the SBA. For instance, while interest payments to the SBA trust fund are deferred, the agency actually makes the payments on behalf of the investment company. But if the deal works out, the SBA takes 10% of the profits earned by the SBIC or SSBIC on its investment. Of the 300 SBICs and SSBICs which are currently in operation, approximately 60 are licensed to issue participating securities and have approximately $1 billion in capital.

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Taking Action: You can find SSBICs and SBICs fairly easily. The National Association of Investment Companies (NAIC) represents SSBICs as well as other investment companies focusing on minority investments. The NAIC does not have a referral service, but will sell its membership directory for $30. Write or call The National Association of Investment Companies, 1111 14th Street NW, Washington DC, Suite 700, 20005. 202-289-4336.

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Taking Action II: The National Association of Small Business Investment Companies is a trade group which consists of SBIC and SSBICs exclusively. The NASBIC will also sell its membership directory, which costs $25. Write or call The National Association of Small Business Investment Companies 666 11th Street NW, Suite 750, Washington, DC 20001. 202-628-5055.

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SIDEBAR: A CASE IN POINT
When Henrick Coriolan immigrated from Haiti in the late 70s, he had nothing but entrepreneurial verve, and a vision for making himself into a successful businessman. “I came to learn and to be a professional” he says.

Today, with a small taxicab fleet, and an auto service center in Brooklyn, New York, Mr. Coriolan has achieved success. It took not only hard work but capital too. Coriolan got his thanks to a Specialized Small Business Investment Company.

After establishing his taxicab fleet, Corilan decided to get into the auto service business as well, and in 1989 opened his doors for business. Five years later he needed $350,000 to buy the building and some equipment.

Coriolan was summarily rejected for loans at banks for want of collateral. He had collateral, his taxi medallions, but banks didnzzt recognize it. Thatzzs why an SSBIC which specialized in taxicab lending easily saw a way to finance Coriolanzzs deal when the large commercial banks could not.

“The bank generally would not consider them as collateral,” “We specialize in financing taxicabs, I understand their value, and can back a loan with them,” said Freshstartzzs Zelmanovitch the SSBIC which did the deal. Even if the loan went permanently south, Zelmanovitch said could take possession of the medallions, and because of his focus on this area, easily get it resold at market prices, to pay off the loan.

Not that lenders like to liquidate assets, per se. They just like knowing that if they have to, there will be enough left over to pay off the loan. “We look at every deal on a case by case basis,” says Zelmanovitch. “Sure, we look for stability, but we also look the person in they eyes to see if we will get repaid.”

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A Good Deal: SSBICs and SBICs typically specialize in an industry, and as a result, assigned more value to any specialized collateral you might have.

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