No Hot Air

The SBA's participating securities program proves SBICs can help companies get off the ground.

"Historically, one of the big challenges associated with SBA financing," says Ric Klass, financier, founder and chairman of Connecticut Capital Markets LLC in Greenwich, Connecticut, "is that it has been driven by debt."

Klass, 48, whose firm raises private capital for emerging high-tech firms, makes a good point. Though two of the SBA's cornerstone financing efforts-the loan guarantee program and the Small Business Investment Company (SBIC) program-have unlocked billions of dollars of growth capital for small businesses, there are caveats and significant limitations to this funding. Specifically, Klass says, SBA programs make capital available mostly to companies that are capable of repaying a loan.

For instance, the loan guarantee program, also known as the 7(a) program, is all based on the SBA standing behind the loans taken out by companies. The reasoning goes that by seeing the full faith and credit of the U.S. government behind a majority of the loan, banking institutions lend in situations where they otherwise would not. This reasoning has merit: In fiscal year 1999, some $12 billion of SBA-guaranteed loans were approved, resulting in loans to companies that otherwise might not have had a chance.

SBICs, which are also SBA licensees, can leverage their own capital by borrowing from pools of SBA-guaranteed debt capital. However, the presence of debt in the structure of SBICs means that SBICs have to make debt-oriented investments as well. Specifically, SBICs need cash flow from their investments to make interest payments on their leverage.

In certain respects, this has led many entrepreneurs down the wrong path in the past. Many came to view SBICs as venture capital outfits, when in fact they were making loans that were riskier than anything a bank would touch. All this was fine, notes Klass, except that such financing precluded an entire strata of firms that needed capital: start-up and early-stage companies without a predictable source of cash flow. Says Klass, "This is a problem in a knowledge-based economy, where companies must fund development and marketing for new information services before revenue--to say nothing of profits--materializes."

To sum it all up, says Klass, "For start-up and development-stage companies, SBA financing was not in the cards." Until now, that is.

Klass is referring to the SBA's so-called participating securities program. Though six years old, participating securities have only come into their own in the last few years. The total dollars invested under the program grew from a mere $29 million in the inaugural year to more than half a billion dollars in 1998 (the most recent year for which statistics are available). And the number of SBICs participating in the program had grown from a handful to nearly 70 in 1998, which offers the semblance of a national footprint.

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This article was originally published in the May 2000 print edition of Entrepreneur with the headline: No Hot Air.

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