Solid Backing

It started out as a straightforward consulting project for Mahendra Vora and research partner Sundar Kadayam. They were analyzing software trends and perusing market research studies to assess the size of various software markets. But after spending 40 hours looking for information that should have taken 10 minutes to access, the pair concluded that more advanced tools were needed to search the Internet and databases of public information. Within months, they launched Intelliseek Inc., providing software to capture, track and analyze information for use in strategic planning, market research, product development and brand marketing.

Vora, 39, was no stranger to start-ups. By the time he co-founded Intelliseek in 1997, he already had three business launches under his belt. He sold all three to Fortune 500 firms, providing capital for Intelliseek. His initial investment of a few million dollars supported operations the first couple of years and through two major product launches.

By 1999, the Cincinnati company was laying the groundwork for its first round of venture capital. Vora had had two years to contemplate his dream investor. Foremost, size did matter: The venture capitalist should have the wherewithal for ongoing financing, but not be so large that it shunned all but elaborate business models.

Finding an investor with a broad network of investing partners also was important to the $10 million company. "If you become wildly successful and plan to raise $50 million someday, then [the investor] should have access to the big investors. The network is also important because it can [introduce] you to customers," says Vora, whose clients include CBS, Ford Motor Co. and Nokia.

Finally, Vora was looking for operational experience. "A lot of VCs are phenomenal in advising you about what to do, but they've never done it themselves," he observes.

Vora ultimately found his venture match in Cincinnati-based River Cities Capital Funds, a Small Business Investment Company. While River Cities was not large, it was well-connected and managed by industry veterans with extensive professional experience.

Starting Small
Licensed and regulated by the SBA, SBICs are generally organized and operated like any other venture capital fund. But unlike traditional funds, SBICs use their own capital, plus funds borrowed from the federal government, to provide equity capital and long-term loans to small companies. On the whole, SBICs tend to be more risk-tolerant than banks or traditional venture capitalists.

The program provides financing not typically offered by banks and equity financing in the $250,000 to $5 million range. While the average SBIC investment was $1.3 million in 2001, non-SBIC investments averaged $12 million, according to the National Association of Small Business Investment Companies (NASBIC). Another advantage is the SBIC's management team. Investors have extensive experience to supplement the skills of your own team.

Intelliseek's SBIC backer removed barriers to reaching larger, mainstream investors. Led by River Cities Capital Funds, the initial $6 million investment included capital from the venture arm of Nokia; later investors included Ford Motor Co. and General Atlantic Partners LLC. "Once you get a VC like River Cities, it is much easier to get access to bigger VCs," says Vora. "They can go to VCs and say 'One of our companies is doing so well, we're going to put in more money, and you guys should come in.'"

An SBIC's management and directors must have a broad range of experience. SBICs also are subject to annual financial reporting and compliance exams. Rigorous regulatory requirements provide a measure of security to VCs participating in joint transactions.

The SBIC program hasn't changed significantly since the introduction of the Participating Securities program in 1994, which aroused interest in early-stage equity investments by allowing SBICs to defer immediate principal and interest payments and give the SBA a share of eventual profits. Recent developments have made the program even more mainstream. For instance, SBICs can now own controlling shares in companies. And until recently, borrowers weren't allowed to repay the principal on an SBIC loan in fewer than five years. "It meant that for small businesses that needed shorter-term financing, the SBA wasn't a good fit," says NASBIC president Lee Mercer. Now companies can repay in 12 months.

Down but Not Out
SBICs invested roughly $2.8 billion in about 2,100 companies in the 12-month period ending September 30, 2002, down from $4.6 billion invested in 2,254 companies in the same period one year earlier. Like mainstream investors, they have had to adjust to deteriorating economic conditions. "Valuations have come down on deals, and due diligence periods have increased," says Patrick Hamner, vice president of Capital Southwest Corp., a Dallas-based SBIC. "People are being far more discriminating in how they invest their capital.

"The bar has been raised even more for small businesses trying to get capital," he continues. "As opposed to the overall venture industry, which has had a very marked decline in financing activity, SBICs are down but still active."

Nor has quality been an overriding concern, even as SBICs engage in riskier deals than their mainstream counterparts. "Part of what has happened with the bursting of the bubble is that the ideas being proposed are based on more substantive models," says Edwin Robinson, managing director of River Cities Capital Funds. "A lot of the excess is being wrung out of the system."

While the venture shakeup has impacted conventional investors more profoundly, it also has changed the way some SBICs operate. "During the bubble years, there was probably more of an inclination to overfund," says NASBIC's Mercer. "I don't mean in the sense that money might not be justified, but to make the unconditional investment. I suspect that what you're seeing now is a lot more investing on a milestone basis." For instance, a company that requires $3 million over three years is likely to receive $1 million upfront, getting the rest after meeting revenue and growth targets.

Fewer venture dollars, coupled with the banking industry's reticence to lend to small businesses, has contributed to an overall capital shortage, adds Mercer. "Banks that had been out doing subordinated debt financing had gotten out a little bit further on the risk curve than they probably normally do," he says. "The banks' own proclivity and the regulators kind of forced a pullback, so there has been a tremendous pullback in bank credit available even for small businesses that have had longtime banking relationships."

The SBIC program, meanwhile, is attracting mainstream investors having difficulty raising capital for venture-backed investments. The increased interest bodes well for the small firms that SBICs target: companies with a net worth of less than $18 million and average after-tax earnings of less than $6 million for the past two years.

Crystal Detamore-Rodman is a Charlottesville, Virginia, writer who covers the small-business financial market.