No Hot Air

Nuts And Bolts

Here's how the program works, according to Klass: Licensed SBICs with at least $10 million of their own capital can borrow up to $20 million from a pool of money sponsored by the SBA. This pool of money has been raised by selling debentures (or bonds) to institutional investors through a Wall Street investment banking firm. During 1998, $280 million was raised and made available for participating securities.

Here's the wrinkle that makes the whole program work well for start-ups, says Klass: The SBICs defer making any interest or principal payments on the funds they borrow for a period of up to 10 years. Instead, interest payments are made by the SBA. And in their first step toward being true venture capitalists, the feds, in exchange for making interest payments on behalf of the SBIC, get to participate in the profits of investments that pan out. Klass says the government's level of participation depends on the prevailing interest rates and the amount of leverage (or borrowing) the SBIC has undertaken. "For instance," he says, "with Treasury bond rates at 6.5 percent and a two-to-one leverage, the government might enjoy about 10 percent of the profits on successful investments."

What does it all mean? Says Klass, "It means that SBA licensees freed from making immediate interest payments on their borrowings can now effectively and confidently make true equity investments in early-stage companies."

He also notes that it's not just entrepreneurs who should get excited about the program. Investors should, too. "With access to leverage," he says, "investors can increase their internal rate of return by as much as 25 percent. This premium, on top of what are hopefully rich venture capital returns to begin with, makes it easier for firms like ours to raise the funds required to participate in the program."

To appreciate the power of leverage in financial returns, consider an individual who puts up $10,000 and borrows $90,000 to buy a $100,000 house. If the price of the house rises to $150,000 and the homeowner sells, he or she makes $50,000 ($150,000 sales price minus $10,000 down payment minus $90,000 loan repayment) for a 500 percent return. If, on the other hand, the individual buys the home outright for $100,000 and sells it for $150,000, he or she makes $50,000, but the return is just 50 percent ($50,000 divided by $100,000). The presence of leverage in the first scenario increases the percentage return to the individual by a factor of 10.

Recognizing the power of this leverage, Klass has applied for an SBA license and is raising $25 million for an IT fund, a sum he hopes to complement with at least $50 million in leverage. "I'm confident the premium that investors can achieve with this leverage will be our strongest selling point in raising the $25 million," he says.

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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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