Bucking The System

Applied Knowledge

Whether it's an SBIC or SSBIC, there are some important things entrepreneurs should understand about these capital sources before applying.

First, many entrepreneurs labor under the mistaken impression that there is an arm of the government that gives money to businesses that can't secure financing from traditional sources. Are SBICs and SSBICs this elusive Holy Grail? No. In fact, the concept of entitlements, which carries significant weight within the federal government at large, is not prevalent in the SBA.

Second, many entrepreneurs believe the SBA, through a mechanism such as an SBIC or SSBIC, lends money to businesses even if there is no visible source of repayment. That's not true, either.

Briefly exploring the financial structure of these SBA-licensed investment companies shows what kinds of deals they will and will not do, and what sorts of companies should spend their time pursuing this option.

For example, Freshstart Venture Capital Corp., the New York City firm that loaned money to Coriolan, gets its money from two places. The first is from public and private investors, through whom Freshstart founder Zindel Zelmanovitch raises equity capital. But the second, far more substantial source of capital for Freshstart is loans from an SBA trust fund.

Like all SBICs and SSBICs, Freshstart pays interest on the funds it borrows, meaning it must get involved in deals where it receives interest as well. The difference between the interest it pays and the interest it receives is the source of its money.

Because the interest they pay for obtaining funds can be quite low, from 4 percent to 7 percent, and the price they charge to lend those funds can be quite high, from 9 percent to 17 percent, SBICs and SSBICs 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. The company also paid its shareholders a dividend of $0.44 per share--not bad for a $6.50 stock.

The only exception to the above scenario is a relatively new wrinkle in which SBICs and SSBICs issue so-called participating securities to the SBA, which in turn permits lenders to defer interest payments until the underlying investments start to generate cash or create a windfall in the form of a capital gain. When this happens, the SBA gets not only its interest and principal, but a hunk of the investment companies' profits as well.

What's the idea behind such a structure? According to Zelmanovitch, one effect is to encourage or enable investment companies to make investments in earlier-stage companies. A purist might say you can never get a lender to behave like an equity investor because at the end of the day, the participating securities are debt. But participating securities still seem like a good idea, even if they only serve to make lenders more adventurous than they might otherwise tend to be.

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This article was originally published in the June 1998 print edition of Entrepreneur with the headline: Bucking The System.

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