United States: Forming A Small Business Investment Company: Threshold Considerations

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 to SBA as well as their ability to raise the required private capital. Fundamental issues include those discussed below.

Fund Size. SBICs typically have from $45 million to $225 million of capital to invest, including SBA Debentures. As the SBA will provide up twice the amount of a fund's privately raised capital, but not more than $150 million, the maximum size of an SBIC wishing to fully leverage the SBA's funding generally will not exceed $225 million ($75 million of private capital plus $150 million of Debentures). The SBA generally considers funds with less than $45 million to $60 million ($15 million to $20 million of private funds) too small for commercial viability. As a consequence, prospective managers need to consider whether they can raise at least $15 million to $20 million and whether the proposed amount of total capital is consistent with their investment objectives.

Alignment of Investment Objectives with SBA Regulations and Policies. When contemplating formation of an SBIC, it is critical to consider the following:

• Current pay investments: Because Debentures are 10-year loans requiring semi-annual interest payments, the SBA generally requires (except with respect to the limited policy initiatives described above) that an SBIC using Debentures structure at least two-thirds of the funds it invests in financial instruments (whether loans or preferred stock) requiring portfolio companies to pay a significant current coupon so as to enable the SBIC to operate with positive cash flow after an initial start-up period and pay interest on the Debentures from its operating income (not cash contributions from the SBIC's investors). This typically means that the SBIC's portfolio companies must have sufficient positive cash flow to service their obligations to make regular periodic payments to the SBIC. Accordingly, the traditional Debenture SBIC Program is not suitable for early stage equity investors or true venture capitalists. Today, successful SBIC applicants include buyout funds (frequently providing "one stop shopping"), mezzanine investors, stretch senior lenders, some providers of later stage growth financing, and venture lenders (where repayment is expected from subsequent rounds of financing provided by established venture capital firms constituting the equity investment syndicate).
• Number of investments: SBICs may not invest more than 10 percent of their total capital commitments (the sum of private capital commitments and the full amount of Debentures expected to be available from the SBA) in a single portfolio company, including its affiliates.¹¹ Thus, SBICs generally invest in a minimum of eight to a dozen companies. SBA policies do permit the reinvestment of investment proceeds, so a number of SBICs invest in a considerably larger number of companies than that.
• Size of portfolio companies: As more fully described below, each company in which an SBIC may invest must qualify as a "Small Business" and 25 percent of invested capital must be in "Smaller Enterprises" under SBA regulations.
• U.S. companies: Portfolio companies must be formed under the laws of the United States and its territories, and must generally have at least half of its employees and tangible assets located in the U.S.
• Permitted industries: Portfolio companies must be active, operating businesses and may not include banks, lenders, investment companies, real estate projects, or project finance.
• Direct investment in companies: Investments generally must be made directly in the small business and may not be used for secondary purchases of securities unless demonstrably beneficial to the small business or pursuant to the acquisition of a small business.
• Profit motivation: Portfolio companies must be "for profit" organizations. The SBIC Program was designed to stimulate the small business sector in the private economy and thereby create jobs and strengthen the economy. SBICs may not invest in economic development or other not-for-profit organizations.

Alignment of Investor Objectives. All investors in an SBIC should be "on the same page." Issues to consider include:

• Investor liability for commitments: Investors are liable for the full amount of their commitments which cannot be terminated (except for certain regulated investors such as ERISA plans and banks, if current regulations change precluding investment), and, as a consequence, investors may be required to make capital contributions solely to repay the loans from the SBA if the SBIC performs poorly.¹²
• Investor disclosures: Each entity that owns 10 percent or more of an SBIC must disclose the identity of each of its 10% owners. Each of these ten percent owners must in turn disclose each of its 10% owners. This disclosure continues until there are no 10% owners or an individual, a public company or a pension or benefit plan with no 10% beneficiaries is reached. There are certain finger printing and other requirements for investors owning over 33 percent and 50 percent of an SBIC.
• Bank investors: Banks and bank holding companies are permitted to invest in SBICs pursuant to the SBIC Act and under the recently adopted Dodd–Frank legislation.¹³
• Relief from UBTI: The loans from SBA do not cause unrelated business taxable income (UBTI) to tax-exempt investors so long as (1) no single tax-exempt investor (other than government plans) owns over 25 percent of the capital or profits interest of the SBIC and (2) all tax-exempt investors and government plans (such as public employee pension plans) do not own more than 50 percent in the aggregate of the capital or profits interest of the SBIC.¹⁴
• Foreign investors: Foreigners are permitted to invest in SBICs. However, as with all domestic investment funds that make loans to U.S. businesses, both the SBIC's management team and the foreign investors must determine that the SBIC is not engaged in a U.S. trade or business with the consequence that foreign investors have effectively connected U.S. income and are liable for U.S. taxes.¹⁵ The requirements of the SBIC Program preclude use of a blocker structuring mechanism between the SBIC and the portfolio company that is commonly employed to address this issue if the fund is primarily engaged in the business of lending.¹⁶

Qualifications of the Management Team. At least two of the key managers of the management team (who are members of the investment committee and are referred to by the SBA as "Principals") must have at least five years partner-level investment experience and an established, reportable track record during the last 10 years indicating a history of profitable investment experience which is consistent with the strategy proposed for the SBIC. Additionally, the key managers must have experience working together sufficient to indicate the team will operate cohesively.

Operating in a Regulatory Environment. The SBA operates pursuant to a detailed set of regulations and operating policies, both written, and sometimes, unwritten. The licensing process is arduous. Once licensed there are regular reporting requirements, which are important, although generally not considered onerous or unduly expensive. It will be important for management to invest the time necessary to become familiar and comply with these regulations and procedures.

Timeline. It takes most funds at least a year to go through the complete licensing process and obtain access to the SBA's financing.

FORMATION

Legal Structure. SBICs are structured in similar fashion to traditional U.S. private equity or venture capital funds. The fund itself typically is a limited partnership with a general partner that is a limited liability company. The general partner, however, is limited to having as its sole permissible function the service as general partner for one or more SBICs; and it may not manage other funds or conduct other business. It is customary that an SBIC will enter into a management services agreement with another entity (the legal form of which is not of concern to the SBA, and which usually is a limited liability company (LLC)) that employs the fund managers, pays the SBIC's day-to-day operating expenses (other than auditing and legal expenses and the costs of SBA leverage), and receives a typical management fee. A management company of this kind is not subject to restriction by SBA on its other activities or to SBA audit or inspection.

Fund Economics. A key step in the formation process is determining managers' compensation, which generally consists of:

• Carried interest: The general partner typically receives a 20 percent carried interest. The SBA is indifferent as to whether the investors receive the return of their capital prior to payment of the carried interest or the limited partners receive a preferred return. However, SBA policies restrict the portion of the carried interest that may be paid to lead investors to no more than 25 percent of the total carried interest, to ensure that the active managers have sufficient incentive to manage the fund during its term.
• Management fee: SBA sets a maximum management fee that an SBIC can pay. During the initial five years of its life, the SBIC may pay an annual management fee of between 2 percent and 2.5 percent (depending on fund size) on the total committed private capital and the amount of Debentures the SBIC intends to use as set forth in its business plan approved by SBA. If such total capital is $60 million or less, the permissible fee is 2.5 percent which declines to 2 percent as the total capital reaches $120 million. For example, if an SBIC has private capital of $30 million (and thus an assumed use of $60 million of Debentures), the permissible rate would be 2.25 percent. After the initial five years the fee is based on the cost basis of the SBIC's investments in active portfolio companies. Certain fees if not paid to the SBIC but paid to the general partner or its affiliates must be deducted from the management fee.¹⁷

Term. SBA regulations require that an SBIC have a term of at least 10 years. The SBIC may not, however, terminate its life prior to the repayment of in full of all outstanding Debentures.¹⁸

LICENSING

Team Qualification. The SBA primarily is concerned with the qualifications and cohesiveness of the individuals who make investment decisions for the SBIC. The SBA refers to anyone with formal investment approval (or veto) authority as a Principal, and the SBIC licensing process is centered on the qualifications, track record, commitment, and cohesiveness of the Principals.

Ideally an SBIC will have three to five Principals (as few as two are permitted, but if there only are two, they must be "equals"). Larger teams of six or more Principals are not common, and are discouraged by the SBA. The SBA does not want an SBIC to be "a one man band," and looks at the division of the carried interest and other compensation as a way of determining the relationships between the Principals. Therefore, no Principal may have 50 percent or more of the carried interest (unless there are only two, in which case the carried interest must be evenly divided). It also needs to be clear that no single person has the ability to fire all of the others, and thereby, in reality, unilaterally control investment decisions. The SBA prefers horizontal, rather than vertical, management of its SBICs. However, investment decisions need not be unanimous, and one or more of the Principals may have the authority to veto investment decisions supported by a majority of the Principals.

SBA policies require that at least two of the Principals have experience that can be demonstrated by the presentation of a deal by deal track record showing successful investment experience at a "partner level" during the past 10 years in transactions similar to those planned to be undertaken by the SBIC. Usually, each Principal should have a minimum of eight to 12 investments including four to six exits, and preferably more. The portfolio companies should be similar to those in which the SBIC will invest, and the types of investments should demonstrate the Principal's successful execution of the SBIC's proposed strategy. Thus, successful venture capital equity investments will not serve as the basis for an acceptable track record for a proposed mezzanine fund.

Additionally, the track record must be for investing as a principal in a fund. Serial entrepreneurship (founding, managing and exiting a series of successful companies) does not count. Neither does advisory work, such as investment banking. Typically, commercial lenders operating in a bank or many other large commercial lending organizations do not have reportable track records on a deal-by-deal basis. So the track record hurdle can be very significant.

Not all of the Principals need to have the required track record, however. The SBA does recognize the contributions that can be made by experienced managers, entrepreneurs, investment bankers, and consultants. But even great success in these areas will not satisfy the SBA's requirement that at least two Principals have the requisite track record.

A second vital concern for SBA is the "cohesiveness" of the management team. While it is not necessary that the complete team has worked together in a prior fund, SBA will examine whether team members have done business together. Prior experience in the same firm is most helpful. Also helpful is prior co-investment experience or other work related experience. Social interaction (school, PTA, church, clubs, etc.) is not given serious weight.

Licensing Process. The SBA uses a formal two-part licensing process. Phase 1 consists of completion of a Management Assessment Questionnaire (MAQ) by the Principals, its review by the SBA (which includes telephone interviews of the Principals and reference checks) and an in person interview of the Principals by the SBA's Divisional Licensing Committee. Upon successful completion of the process, the SBA will issue a "Green Light Letter" to the applicant; this is not a guarantee of becoming licensed but, rather, authorizes the applicant to submit a formal license application when it has received commitments for sufficient capital to commence operations (typically, at least $15 million to $20 million, although in the past year SBA has requested certain applicants to raise larger amounts). During the formal licensing process a separate licensing group reviews the application, private placement memorandum, and legal documents (including review by the SBA's Office of General Counsel), calls references, and does a background check (including review of fingerprint cards by the FBI).

Review of the MAQ and issuance of a Green Light Letter currently is taking about three to four months, and normal License Applications are reviewed and approved in about six months. Investments made prior to submission of the formal License Application cannot be included in the SBIC's capital structure. However, many applicants hold a closing following filing of the formal license application and commence operations and make investments (which require SBA approval prior to license issuance; SBA checks for compliance with its investments regulations). Before the formal license is issued, all Principals are required to attend a one day regulations class conducted by SBA. It generally takes about two months following receipt of the License to actually obtain SBA funding. As a consequence, some applicants obtain a bank line of credit (typically secured only by the right to issue capital calls to investors) during the licensing process, which is repaid when the SBIC draws its first Debentures.

The MAQ consists of a two part questionnaire and typically takes at least one to two months for teams to complete. Prospective applicants are well advised to enlist the assistance of one of the handful of attorneys in the country with considerable SBIC experience prior to beginning work on the MAQ. The first part is a lengthy and quite complete plan of operations indicating the amount and sources of anticipated capital, the composition and compensation of the Principals and other management employees, the anticipated number and size of investments, the industry, stage of development, geographic location, and size of portfolio investments, typical deal structures, deal sourcing plans, the approach to due diligence, how the process is staffed and the decision making and monitoring process. The second part contains detailed resumes and track records of the Principals and a report on prior litigation in which they were involved and their other time commitments.

The formal License Application contains all the contents of the MAQ, plus legal documentation, fingerprint cards and additional questions about prior arrests or criminal charges or government investigations, a Capital Certificate setting forth information about each investor and the amount of the investor's capital commitments, and a variety of other informational forms about the management team and planned operations. It also contains the opinions of legal counsel as to the formation of the SBIC and its compliance with securities laws and the tax status of the SBIC.

While it is not required to form the legal entities prior to filing either the MAQ or the formal License Application, it is necessary to have a formal closing and call at least $2.5 million of capital (which must be contributed, pro rata, by all investors) prior to receipt of final licensing approval.

LEVERAGE

Amount and Timing. An SBIC is entitled to use twice the amount of its "Regulatory Capital" (see definition in footnote 10) of SBA Debentures, up to $150 million for a single SBIC and up to a total of $225 million for two or more commonly managed SBICs. The SBA and the SBIC trade association¹⁹ are hopeful that the amount available for commonly managed SBICs will be increased by congressional legislation within the next year to $350 million. After two to three years of successful operation an SBIC may request SBA approval to use Debentures in an amount up to three times its Regulatory Capital (subject to the $150 million and $225 million limitations), and SBA has approved several of such requests. SBA has adopted a policy precluding application for a second SBIC license within two years of the receipt of an earlier license.

SBICs may draw Debenture funding only after they have secured a Commitment from SBA to issue Leverage. An SBIC may obtain a Commitment for an amount equal to its Regulatory Capital at the time it is licensed, and thereafter apply for additional commitments up to two times per government fiscal year (October 1 to September 30). Commitments expire on the last day of the fourth full fiscal year following the fiscal year in which the Commitment is obtained. The SBIC must pay a commitment fee when it receives the commitment equal to 1 percent of the commitment.

After receipt of a Commitment an SBIC (in good regulatory standing) can draw down Debentures on comparatively short notice that usually is coordinated with capital calls from investors. A Commitment is not a revolving line of credit. Once Debentures are drawn the outstanding availability on the Commitment declines and is not increased by the amount of Debenture repayment. On the other hand, SBICs are permitted, and frequently do use the proceeds from realized investments for reinvestment in portfolio companies or to pay fund expenses.

Characteristics. Debentures are unsecured 10-year loans to the SBIC. The General Partner does not have liability for repayment (in the absence of breach of its fiduciary duties or other significant regulatory violations). Debentures may be prepaid in full (but not in part) on any interest payment date (the oldest Debenture first) without premium or penalty. The principal balance does not amortize during the term of Debentures but is payable in full at maturity (subject to acceleration for significant regulatory violations). Interest is payable semi-annually on March 1 and September 1.

Interest Rates and Fees. When an SBIC draws down standard Debentures it must pay the SBA and the underwriters 2.425 percent of the amount drawn in fees (deducted from the loan proceeds). The money is advanced to the SBIC pursuant to line of credit from the Federal Home Loan Bank of Chicago and the interest rate is set at LIBOR plus 30 basis points based on the remaining number of days prior to the projected pooling date of the public sale. Every six months, the SBA pools the outstanding Debentures funded from the line of credit and publicly sells trust certificates (typically to insurance companies). At that time the permanent interest rate is established and remains fixed for the term of the Debentures and the ten year term for the Debentures begins. The rate charged to the SBIC is a combination of three factors: the rate on Treasury Notes with 10-year maturities, the amount of premium above the Treasury swap rate required by the purchasers, and a "Charge" established by SBA at the time the Commitment was issued. The Charge is determined every fiscal year (by the joint effort of Congress and the Office of Management and Budget) in order that the SBIC Program operates on a breakeven basis, but applies (without adjustment) to all Debentures issued pursuant to the Commitment. Over the past two years, typical premiums required by purchasers of Trust Certificates have ranged from 47 to 78 basis points (having exceeded 220 basis points in March of 2009), and the SBA Charge has varied from a low of 28.5 basis points to 81 basis points (the increase coming from implementation of the New Initiatives).

Example: The interest rate for Debentures issued in the September 2012 pooling pursuant to a Debenture Commitment issued during FY 2012 was:

General Availability. For each of the last 10 years Congress has authorized the issuance of $3 billion of Debentures. The highest demand for Debentures occurred in Fiscal Year 2012, when about $1.4 billion were drawn. Demand is expected to increase, based on the 30 new licenses issued during Fiscal Year 2012. While interest in the SBIC Program continues to be strong, there appears to be an ample supply of available Leverage for the foreseeable future.

DISTRIBUTIONS BY DEBENTURE SBICs

SBICs using Debentures may distribute their undistributed net realized, cumulative earnings less unrealized depreciation to investors. However, without prior SBA consent (which is unlikely to be given), they may not make distributions which would reduce their Regulatory Capital by more than 2 percent in any fiscal year.²⁰ Note that this restriction may cause "phantom income" in the early years of an SBIC's life. After completion of its investment period, an SBIC is required to submit a "Wind-Up" plan to SBA indicating when and how it intends to liquidate its assets and repay the Debentures. Several SBICs that have previously repaid some of their Debentures have been successful in negotiating wind-up plans that enable them to return some of their private capital to investors prior to the repayment in full of outstanding Debentures.

Fortunately, SBA regulations permit the "recycling" of investment proceeds which enables their use for making investments or paying fund expenses (including management fees). When the regulatory restrictions on distributions have been explained to investors, they typically have not objected to provisions in an SBIC's limited partnership agreement permitting recycling.

ELIGIBLE INVESTMENTS

Small Businesses and Smaller Enterprises. SBICs may invest only in companies which, together with their "affiliates,"²¹ meet SBA's definition of a "Small Business."²² If a business satisfies either of the following tests, it qualifies as a Small Business:

• Primary test: It has a tangible net worth (book value minus goodwill) of less than $18 million and also had average annual after-tax profits (excluding loss carry-forwards) during the prior two years of less than $6 million,²³ or
• Alternative test: It satisfies the requirements of the North American Industrial Classification System (NAICS) which is based on either the number of employees (generally 500 to 1,000 for manufacturers) or revenues for companies operating in specific industries.²⁴

Additionally, at least 25 percent of the SBIC's invested capital must be in companies classified as Smaller Enterprises – defined as either (1) having a tangible net worth of less than $6 million and average annual after-tax profits during the prior two years of less than $2 million, or (2) satisfying the alternative test described above. SBICs have rarely found it difficult to satisfy the requirement to invest in Smaller Enterprises.²⁵

Once having invested in a Small Business the SBIC may continue to make follow-on investments in a company even if the company no longer satisfies the definition, up until the company has a public offering. If during a one year period following an SBIC's investment the company's primary business is not an impermissible investment for an SBIC, the SBIC must divest the investment, absent SBA approval.²⁶ The SBIC may exercise pre-existing investment rights following a public offering. An SBIC may invest directly in a public company that meets the required size definitions for being a Small Business.

U.S. Businesses. Portfolio companies must be formed under the laws of the United States or its territories. At least 50 percent of the employees and tangible assets of the portfolio company must be located within the United States or its territories at the time of investment and for the following 12 months, unless it can be shown to the SBA's satisfaction that the SBIC's funds were used for a specific domestic purpose (such as payroll, travel, facilities, and the purchase of assets other than from foreign affiliates) for use or sale domestically. SBICs may only invest in a company if it primarily uses the funding for domestic purposes, and therefore are not permitted to provide financing to acquire a foreign business. ²⁷

Prohibited Industries. SBICs may not invest in companies whose principal business is re-lending or re-investing (venture capital firms, leasing companies, factors, banks, life insurance companies); most real estate projects; single-purpose projects that are not continuing businesses (a movie or an oil well); businesses that are passive; not for profit businesses; or businesses that use 50 percent or more of the funds to buy goods or services from associated suppliers.²⁸

If, during a one year period following an SBIC's investment, a portfolio company's primary business changes to an impermissible business or if a majority of its assets or employees become foreign, the SBIC will be required to divest itself of its interest in the business.

STRUCTURING INVESTMENTS

Need for Current Income. The SBA administratively has determined that SBICs licensed to use Debentures generally must structure at least two-thirds (this assumes that the business plan of the SBIC that was approved by SBA anticipates using Debenture Leverage equal to twice the SBIC's private capital) of the amount they invest in portfolio companies with a current pay return (interest, current pay dividends or royalties) that is enough to assure sufficient cash flow from operations to pay Debenture interest and, after an initial start-up period of two to three years, provide for positive operating income. Compliance will be judged on an aggregate portfolio basis, so there is flexibility in structuring individual investments.

Equity Investments, Dividends, Liquidation Preferences, and Puts. Equity investments consist of common or preferred stock. Dividends (payable from the income of a portfolio company) may be at any rate, and may be required to be paid on a current or deferred (PIK – pay-in-kind) basis. The stock may have a liquidation preference of any size, since the SBA regards a liquidation preference as fundamentally an arrangement between the owners of the company (as opposed to being an obligation of the business). However, it must be a true liquidation where the company either transfers its assets or a majority of its stock is sold or is merged in a transaction with a true change of ownership control.

SBA regulations require that the compensation that an SBIC may receive for a forced redemption ("put") of its equity be limited to one of the following:

• its cost (not including accrued, but unpaid dividends)
• a formula agreed upon at the time of investment that is based on a reasonable calculation such as a multiple of EBITDA or revenues, or
• an appraisal by a qualified, independent third party.²⁹

Mandatory redemptions that do not adhere to the regulations are treated as if they were a Debt Security and will be subject to a 14 percent interest ceiling (subject to adjustment as described below).³⁰

"Cost of Money" Rules. The SBA regulates the amount of interest that a portfolio company can be required to pay. The ceiling adjusts upward if the SBIC's own cost of securing Debentures exceeds 8 percent. Interest is based on the total costs imposed on the portfolio company (regardless of what they are called), not including the following items: the original issue discount on associated warrants or options, permissible application and closing fees (described below), and reasonable closing costs and expenses.³¹ The interest rate ceiling depends on whether a loan is made in conjunction with obtaining equity rights (such as warrants or conversion rights).

Loans. Loans that do not have any equity features may bear interest at an annual rate of up to 19 percent. If the SBIC's cost of Debentures rise above 8 percent, the ceiling will increase so that it is 11 percent above the SBIC's cost.

Debt Securities. Loans that have associated equity features are called "Debt Securities" and have an interest rate ceiling of 14 percent. The ceiling will increase if the SBIC's cost of Debentures exceeds 8 percent so that it is 8 percent above the SBIC's cost.

Default Rates. If a loan is in default an SBIC may charge an interest rate that is up to 7 percent higher than the contractual rate.

Permissible Fees. SBICs are limited in the fees they may charge, as discussed below.

Application and Closing Fees. An SBIC may charge a portfolio company an application fee of 1 percent of the amount of financing it provides. It also may charge a closing fee of 2 percent with respect to a Loan (no equity features) and 4 percent with respect to the amount of funds it provides that is structured as Equity or as a Debt Security. Note that the fees must be paid to the SBIC and not to the management company or the general partner.³²

Consulting, Investment Banking, Management, Directors and Monitoring Fees. An SBIC is only permitted to charge fees for providing services to a portfolio company if they are for services actually rendered for the benefit of the portfolio company (which does not include "monitoring fees"), if the fees are charged pursuant to a written agreement and are reasonable in comparison to fees charged by other service providers in the area where the portfolio company is located. While the fees need not necessarily be charged on an hourly basis, the person providing the services must keep written time records showing the hours spent and the services provided.³³

With the sole exception of investment banking fees charged by a licensed broker dealer that is an affiliate of an SBIC, all board of directors fees, consulting fees, management fees, advisory fees, transaction fees, and the like, either must be paid directly to the SBIC or, if paid to an affiliate of the SBIC, must be credited against the management fees otherwise payable by the SBIC to its management company.³⁴ While this SBA policy (which applies to SBICs filling applications after April 1, 2004) is a departure from common practice in the private equity world, SBA believes that the ability of the SBIC managers to charge a management fee on the assumed use of SBA Debentures provides adequate compensation.

Expense Reimbursement. An SBIC may be reimbursed by a portfolio company for reasonable closing costs and reasonable expenses of attending board meetings. An SBIC's management company is expected to pay the costs of sourcing deals, including travel. SBIC managers often begin the computation of "closing costs" after execution of a term sheet or letter of intent.

REGULATORY COMPLIANCE

Training, Personnel and Consultants. As noted earlier, in order to equip the management team with sufficient knowledge of SBA regulations and policies, the SBA requires each "Principal" (member of the investment committee) and the SBIC's chief financial officer to attend a day long regulations class. In addition, the SBA provides a variety of check-lists and software to enable compliance. Also, SBIA sponsors an annual meeting and several regional meetings each year at which substantive issues are discussed. Legal and accounting firms with active SBIC practices also regularly hold seminars and conferences with significant substantive regulatory content, often with participation by SBA personnel.

SBICs typically designate at least one of the Principals to serve as a compliance officer to review term sheets and legal documents, work with legal counsel, oversee preparation of required filings by the chief financial officer or third-party service provider, and be the person primarily responsible for communications with the SBA.

A significant number of SBICs outsource compliance to one of the several firms that provide specialized SBIC back office services. It also is customary that SBICs use the services of the specialized law firms that assisted them in the licensing process to advise on structuring investments, distribution strategy and other compliance matters.

Investment Related Forms. During the period between filing its formal License Application and becoming licensed an SBIC needs to seek prior SBA approval of investments. The SBA's Consent Request Form is designed to demonstrate that the proposed investment is both consistent with the applicant's business plan and complies with SBA regulations. After licensing such consents are not required except when the SBIC is seeking approval of a transaction involving a conflict of interest.

When making investments, an SBIC is required to have the portfolio company complete short forms indicating it is an eligible small business and that it will not improperly discriminate in its employment practices. The SBIC simply retains these forms in its files. Additionally, the SBIC is required to notify SBA of the investment, within 30 days after closing, on a short form briefly describing the company and the investment terms.³⁵

Financial Reports to SBA and Audits. SBICs are required to provide SBA with unaudited quarterly financial statements and annual audits by independent certified public accountants.

Valuations. SBICs using Debentures must value their portfolio companies semi-annually using SBA's approved Valuation Guidelines.³⁶ Pursuant to the Valuation Guidelines, the value of an investment in a portfolio company is largely dependent on the cost basis of the SBIC's investment and changes only if there are significant events concerning the financial viability of the portfolio company (which may cause a write down of a loan or equity investment) or a new financing or two years of positive cash flow (which might cause an equity investment to be written up). The Valuation Guidelines do not conform with generally accepted accounting principles; they do not require mark to market valuations and are not based on the fair value of the investment.³⁷

SBA Examinations. The SBA will annually examine the SBIC and its General Partner for regulatory compliance. The examiner will request information in advance and then spend two or three days in the offices of the SBIC reviewing deal documents, board resolutions authorizing investments, bank records, ledgers, and the like. On conclusion, the examiner will write a report and indicate whether there are any findings of regulatory violations. If so, the SBIC works with its assigned analyst at SBA to resolve them.

Regulatory Violations and SBA Remedies. If an SBIC violates significant regulations (conflicts of interest, improper distributions, investments in ineligible businesses, investment of more than 10 percent of total capital in a company, or "capital impairment") there are a number of remedies. For minor violations, particularly those that are inadvertent, warnings are given. For significant violations that are not cured, the SBA may accelerate the outstanding Debentures, and in severe cases, replace the general partner with a receiver. The most common significant regulatory violation is capital impairment, which arises when an SBIC has net realized losses and unrealized depreciation in the value of its portfolio companies. The percentage of permissible capital impairment varies depending on the percentage of investments structured as equities versus debt instruments. ³⁸

SUCCESSFUL OPERATIONS

The key to a good and successful relationship with the SBA, in addition to successfully investing, is high quality work and transparent communications. Successful SBIC managers treat the SBA as their largest, and most valuable investment partner, and strive to make their communications with the SBA both high-quality and timely. They participate in trade association activities where SBA personnel are present and get to know their analysts as well as more senior SBA personnel. The other key to a successful relationship is having investment objectives that fit squarely within the SBA's policy objectives and regulatory structure.

The SBIC Program works very well for management teams who are good investors as well as good communicators, as evidenced by the large number of firms that have formed multiple SBICs. The managers of these SBICs have found that the substantially higher financial returns they and their investors have realized by using Leverage far outweigh the cost of the administrative requirements of participating in the SBIC Program.

Endnotes

1 See the discussion under "Eligible Investments" below.

2 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, title VI, § 619, 12 U.S.C.A. 1851 (West Supp. 2012) (amending the Bank Holding Company Act of 1956, 12 USC §1851 (West Supp. 2012), adding §13. The prohibition is contained in paragraph (a) of the Bank Holding Company Act of 1956, 12 USC 1851 (a)).

3 Bank Holding Company Act of 1956, 12 USC §1851(e) (West Supp. 2012).

4 Housing and Community Development Act of 1977, Pub. L. No. 95-128, title VIII, 12 U.S.C. § 2901 et seq. (2010).

5 Energy Independence and Security Act of 2007, Pub. L. No. 110-140, title XII, §1205(a), 15 USC 683 (amending §303 of the Small Business Investment Act of 1958 to authorize the issuance of energy saving debentures, 15 U.S.C. 683 (2010)).

6 See Small Business Investment Companies – Energy Saving Qualified Investments, 77 Fed. Reg. 23,373 (Apr. 19, 2012) (codified at 13 C.F.R. pt. 107).

7 Defined in 13 C.F.R. §107.50 (2013).

8 Startup America, http://www.whitehouse.gov/economy/business/startup-america (last visited Mar. 1, 2013).

9 See Small Business Investment Companies – Early Stage SBICs, .7774908, Dec. 18, 2012.

10 "Regulatory Capital" is the sum of an SBIC's paid in capital from investors and binding commitments from "Institutional Investors." Institutional Investors are entities or individuals that have sufficient net worth as determined by SBA that their unfunded commitments appear collectable. See definitions in 13 C.F.R. §107.50 (2013).

11 See definition of "affiliates" in 13 C.F.R. §121.103 (2013).

12 See Model Debenture SBIC, L.P. Version 2.0 , §§5.05-5.10 and 8.05-8.12, http://www.sba.gov/category/type-form/resource-partner-forms/sbic-forms (last visited Mar. 1, 2013).

13 See 15 U.S.C.§682(b); Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, title VI, §619, 12 U.S.C.A. §1851(h) (West Supp. 2012).

14 26 U.S.C.§514(c)(5)(A) (2010).

15 26 U.S.C. §872(a) (2010); 26 U.S.C. §882(a) (2010).

16 13 C.F.R. §107.720(b) (2013).

17 See SBIC TechNote 7A, http://www.sba.gov/category/type-form/resource-partner-forms/sbic-forms, (last visited Mar. 1, 2013).

18 13 C.F. R. §107.150(c)(1) (2013).

19 Small Business Investor Alliance (SBIA), formerly known as National Association of Small Business Investment Companies (NASBIC), http://www.sbia.org/ (last visited Mar. 1, 2013).

20 13 C.F.R. §107.585 (2013); 13 C.F.R. §107.1810(f)(2) (2013).

21 Defined in 13 C.F.R. §107.50 (2013).

22 13 C.F.R. §121.103 (2013).

23 13 C.F.R. §121.301(c)(2) (2013).

24 13 C.F.R. §121.301(c)(1) (2013); 13 C.F.R. §121.301(a); 13 C.F.R. §121.201 (2013).

25 13 C.F.R. §107.710 (2013).

26 13 C.F.R. §107.760 (2013).

27 13 C.F.R. §107.720(g) (2013).

28 13 C.F.R. §107.720 (2013).

29 13 C.F.R. §107.850 (2013).

30 13 C.F.R. §107.800(b) (2013).

31 The cost of money rules are set forth in 13 C.F.R. §107.855 (2013).

32 13 C.F.R. §107.860 (2013).

33 13 C.F.R. §107.900 (2013).

34 SBIC TechNote 7A, supra note 17.

35 13 C.F.R. §107.610 (2013). These forms are SBA Form 480 (Size Status Declaration), SBA Form 652 (Assurance of Compliance) and SBA Form 1031 (Portfolio Financing Report).

36 13 C.F.R. §107.650 (2013).

37 The Valuation Guidelines are Exhibit I to the Model Debenture SBIC, L.P., Version 2.0, http://www.sba.gov/sites/default/files/files/inv_valuation.pdf (last visited Mar. 1, 2013).

38 13 C.F.R. §107.1810 (2013). For the Capital Impairment rules see 13 C.F.R. §107.1830 (2013); 13 C.F.R. §107.1840 (2013).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.