No Hot Air
"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.
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.
At the most basic level, this means there's more money out there and more places for entrepreneurs to turn to when they're looking for true equity capital. To date, more than $500 million has been pumped into companies by SBICs using participating securities. And the $284 million of participating securities leverage provided to SBICs in 1998 meant that the SBICs themselves had to come to the table with a minimum of $140 million of their own capital. All told, an estimated $440 million was added to the national pot for start-up and early-stage companies.
Another benefit, notes Klass, is that SBICs aren't supposed to control com-panies. "It's not uncommon that an entrepreneur starts a company," he says, "and the investors take it over, leaving him or her little more than a grub-stake. Or worse, the founder is ousted altogether." While SBIC investors can have board seats, they can't have a majority. In addition, they are generally prohibited from owning more than 50 percent of the company. As a result, there's less risk of losing control of the company.
Third, and most important, says Klass, is that SBICs are supposed to invest in small companies, which are defined as companies with assets of less than $18 million and after-tax income of less than $6 million. This adds a welcome replacement to traditional institutional venture funds, which have in many instances shifted their focus toward larger enterprises. "Overall," notes Klass, "the trend in venture investing has been toward bigger investments in larger companies."
The downside, however, continues Klass, is that if an SBIC makes several investments that turn out badly, the SBA could step in and force liquidation to recover the borrowed funds. "This could cause some discomfort for companies that the SBIC had invested in and were doing well," Klass says. "All of the sudden, they might find themselves scrambling to buy out the government."
Calling All Participants
Finding the SBICs that utilize participating securities is both easy and challenging. Here's the easy part: Go to the SBA Web site (www.sba.gov). Navigate your way through the "Financing" button to the "Invest-SBIC" section of the site, where you can find a directory of operating SBICs. They're conveniently listed by state and in one catch-all listing.
Now comes the tricky part: how to identify the SBIC firms which traffic in participating securities. The best first step is to focus on firms whose stated investment policies are listed as equity. It's a challenge, because many investment firms view a long-term loan subordinate to, say, other loans (i.e., the other loans get paid out first in a liquidation) as a form of equity. And still other investment firms view mak-ing a loan with so-called equity kickers, where the lender also gets options to purchase stock, as a form of equity investing.
What does it all mean? Well, the landscape is certainly muddled-and entrepreneurs who aren't careful can end up wasting time on lenders when what they really need is an equity investor, who can be more patient and who doesn't have to rely on immediate cash flow. Once you've isolated candidates, narrowing them down is the easy part. Simply ask the firm if it utilizes participating securities and if it can make straight equity investments.
David R. Evanson's newest book about raising capital is called Where to Go When the Bank Says No: Alternatives for Financing Your Business (Bloomberg Press). Call (800) 233-4830 for ordering information. Art Beroff, a principal of Beroff Associates in Howard Beach, New York, helps companies raise capital and go public and is a member of the National Advisory Committee for the SBA.