From the August 2009 issue of Entrepreneur
The Venture Capital Infusions

It's not often that America's small businesses get $2 billion in federal funds set aside just for them. But that's what happened when President Obama signed the American Recovery and Reinvestment Act this February.

Better known as the stimulus bill, the ARRA changed the rules for a little-known SBA program that loans money to qualified VC firms called Small Business Investment Corporations, or SBICs. SBICs, which are licensed by the SBA as federally funded VC firms, can tap SBA funds to supplement the venture capital they've raised privately, taking twice as much federal money as they've raised on their own, up to a limit.

The 50-year-old program pays for itself through fees and loan payments by the SBICs. The program has loaned more than $50 billion over the years to companies including Apple, FedEx and Outback Steakhouse.

All of the funds given to an SBIC must be used to fund small businesses, which the SBA defines as companies with no more than $18 million in net worth, or $6 million in after-tax income in the prior two years. Any business fitting this description can approach SBICs for funding. Within this pool, some of the funding each SBIC gets must go to "smaller" businesses, which the SBA defines as having no more than $6 million in net worth and an after-tax profit cap of $2 million.

Another plus to the program: the SBA makes sure a diverse group of venture firms are included in the SBIC pool, so there are VCs interested in funding small businesses in virtually every sector and funds focused on every investment stage--from startups needing seed capital to mature companies seeking money for growth initiatives.

$2 Billion Rule Changes
Restrictions on the SBIC program meant only $1 billion of the $3 billion available for loan to the SBICs was used last year. Few new SBICs have been approved in recent years due to a long and difficult qualifying process. Plus, funding limits stopped existing SBICs from borrowing more.

Among the rule changes intended to put more SBIC money into circulation:

  • Previously, an SBIC could get a maximum of $137 million in federal money for a single fund. It's now $150 million.
  • Large SBICs operating multiple venture funds can now borrow up to $225 million between all their funds.
  • Before, SBICs could invest only 20 percent of an SBA-backed fund in any one company. The ARRA upped that to 30 percent, giving SBICs more flexibility to back companies they think will succeed.
  • SBICs had to invest in smaller businesses to an extent determined by a complex formula that changed as their investment volume rose. The ARRA simplified this requirement to a flat 25 percent, streamlining the process for SBICs and likely directing more money to smaller businesses.

Established SBICs that were tapped out under the previous rules say they will move swiftly to leverage additional SBA capital for small business investment. John Harrison, senior managing director of Nashville, Tenn.-based Harbert Mezzanine Partners, which invests in a variety of business types, including software developers, service providers and manufacturers, says his firm has two qualified SBIC funds but had borrowed the old maximum of $137 million with its first fund.

With the raised limit, Harbert's second fund can immediately borrow nearly $60 million more from the SBA instead of waiting years for its initial fund to pay its SBA loan back. "That's money I can get today and have the ability to go ahead and invest today," he says. "That's a real change."

Patriot Capital managing partner Charles McCusker says his Maryland firm, which focuses on growth-stage service businesses in a variety of sectors, has three SBIC-approved funds. A $180 million fund the company raised in July 2008 included $120 million in SBA money and put Patriot at the limit at the time. With the rule changes, Patriot can access additional capital to invest without waiting for those funds to be paid off. "We think we can invest up to $225 million now," he says. "We couldn't have done that in the past."

McCusker is particularly pleased by the rule change expanding the amount he can invest in one business to 30 percent of a fund total. This change should be a plus for small-business owners, whom, he points out, will be able to spend less time pounding the pavement seeking new investors.

"It's been frustrating that you would get to know a company well, and then didn't have the ability to grow with them because of the SBA cap," he says.

The SBA's New Attitude
In addition to the increased funding available to existing SBICs, the SBA has indicated that it plans to streamline the process of qualifying as an SBIC. SBA officials have publicly stated the administration's goal of approving applicants in four to five months, a dramatic improvement for a process that was taking up to a year.

SBA deputy associate administrator for investment Harry Haskins says the agency is trying to cut the approval process down, particularly for SBICs that have already had previous venture funds approved. Haskins says the agency is well aware that there is more demand than ever for venture funding. "There has been significant interest in the program in two areas: the general economic trends where bank credit is limited, and from the stimulus package changes," Haskins says. "There's interest from new participants, and the expanded limits are an inducement for SBICs to stay with the program for their second and third funds instead of having to leave because of the cap."

Attorneys who assist venture firms with the SBIC application process say they're seeing lots of interest from firms that are hoping to qualify for the program. Former SBA general counsel Michael Wyatt, an attorney at Hogan & Hartson in Washington, D.C., says he's encouraged by the SBA's increased interest in approving new SBICs. "Many equity fund groups are approaching the SBA to discuss whether their experience would qualify," Wyatt says, "and some are going ahead and filing the paperwork."

Pitching the SBICs
Now that you know there's more venture money floating around, how can you tap in to it? Pitching SBICs is just like pitching any other VC firm; SBICs are simply venture firms that have qualified for the SBA program.

When it comes to pitching SBICs in today's tough economy, heed some advice from Joe Rubin, director of the online venture exchange FundingPost.com. "In this economy, you need to show that your product is a need-to-have, as opposed to a nice-to-have. Investors want to see that your customers will buy from you in a down market."

One key thing to know in approaching SBICs is that many of the SBIC investments are taking the form of venture debt rather than venture capital. That's the case with Harbert's investments, says Harrison. What's the difference? VC investments generally don't involve repayment, and they grant the investors a substantial stake in the company funded.

By contrast, venture debt deals don't involve giving the funder an ownership stake. The investment is a loan that doesn't require immediate installment payments; the loan comes due at an agreed-upon future point. Venture debt can be advantageous for owners who don't want to relinquish company control.

In May, Patriot's McCusker said his firm made several new investments due to the influx of additional SBA capital. "We are looking at a larger number of business plans," he says, "now that we know we can expand our capital base."

Business writer Carol Tice is a regular contributor to Entrepreneur, The Seattle Times and other major publications. Contact her at caroltice.com .