SBA will generally evaluate applicants for Early Stage SBIC licenses using the same factors used for other SBIC applicants, but with a particular emphasis on the managers’ skills and experience in investing in early stage companies.
Call Notice and Application Process
On February 2, the U.S. Small Business Administration (SBA) issued a 2016 Call for Early Stage Fund Managers. The call is for all experienced early stage fund managers to apply for SBA’s Early Stage Small Business Investment Company (SBIC) program. To be considered, all applicants must initially submit a management assessment questionnaire (MAQ).
The MAQ provides information about the management team, the proposed investment strategy, the principals’ track records and the proposed fund structure and economics. Based on an assessment of the MAQ, the managers may be invited for an interview at SBA. Fund managers who satisfy the criteria identified in the call, as determined by SBA’s Investment Committee, will be issued a “green-light letter.” The green-light letter permits the managers to submit a formal license application. Licensing requires approval by the SBA’s Divisional Committee and its Agency Committee.
SBA will accept MAQs for Early Stage SBIC applicants at the times and in the manner specified in the call. An applicant wishing to be considered must file the MAQ any time between April 1, 2016 and 5:00 p.m. ET on September 30, 2016. SBA will consider applications as they are received. However, SBA did not specify a time frame for how long it will take to review and process MAQs for the Early Stage SBIC program other than to state that SBA will send an applicant confirmation that it has received the MAQ within three business days of submission.
Based on current processing times for MAQs generally, an applicant can expect that it may take between 60 and 120 days for SBA to process the MAQ and decide whether or not to issue the applicant a green-light letter. An applicant who receives a green-light letter must file a formal license application no more than one year after the date of that letter. Although SBA does not charge applicants any fee for processing the MAQ, applicants must pay a nonrefundable license application fee of $25,000 at the time they submit their formal application for an Early Stage SBIC license.
Before filing a formal license application, the fund must have at least $20 million of “regulatory capital” (as described below). The fund’s capital commitments can only be conditioned upon receipt of an Early Stage SBIC license. The application includes the fund’s and the general partner’s organizational documents. Generally, the fund’s limited partnership agreement should adhere as closely as possible to the Early Stage SBA Model Limited Partnership Agreement (except that certain provisions of the Model Limited Partnership Agreement that appear in Bold Arial font must be included without modification).
In addition, the call sets forth a number of rules for certain types of provisions in the agreement. The Early Stage SBIC can be a wholly owned subsidiary of another fund (other than a business development company or other public entity), provided that the fund is organized in the United States. All principals must hold direct ownership interests in the general partner and receive carry directly from the general partner. Non-principals may not hold more than 25 percent of the carried interest. Any provision to remove or terminate a principal must be spelled out in the general partner’s organizational documents and cannot be tied to events occurring under other agreements. Although SBA recognizes that side letters may form the basis of the investment in an SBIC for certain investors, particularly those subject to regulatory oversight, SBA does not encourage the use of side letters. Any provision of a side letter that purports to control, alter or supplement a section of the SBIC’s limited partnership agreement must expressly identify each such section. If any side letter fails to do so, SBA states that it will consider the conflicting provision of the side letter to be without force or effect. SBA’s prior written approval is required for all side letters.
SBA will generally evaluate applicants for Early Stage SBIC licenses using the same factors used for other SBIC applicants, but with a particular emphasis on the managers’ skills and experience in investing in early stage companies. However, SBA reserves the right to maintain diversification among Early Stage SBICs with respect to (1) vintage year and (2) geographic location.
SBA’s Early Stage SBIC Program
In 2012, SBA established a new type of SBIC that is required to invest at least 50 percent of its invested capital in “early stage companies.” The Early Stage SBIC program implements the “Start Up America Initiative” announced by the White House in January 2011 to foster American innovation and job creation by promoting high-growth entrepreneurship. An “early stage company” is one that has never achieved positive cash flow from operations in any fiscal year prior to investment by the SBIC. An Early Stage SBIC must be a limited partnership and have a minimum of $20 million of regulatory capital to be licensed. Regulatory capital is the sum of paid-in capital from private investors plus unfunded commitments from private investors that qualify as “Institutional Investors” as defined in SBA regulations (both entities and individuals can qualify as Institutional Investors). After being licensed, the Early Stage SBIC will be able to draw leverage from SBA in the form of 10-year debentures, with no required amortization. The amount of leverage that can be reserved for draws by an Early Stage SBIC will be limited to the lesser of an amount equal to the SBIC’s regulatory capital or $50 million.
Interest on drawn debenture leverage is payable quarterly. An Early Stage SBIC must reserve the first five years of interest payments either by (1) having binding unfunded commitments in that amount from its Institutional Investors that can only be drawn to pay that interest or (2) maintaining that amount of cash in a separate bank or investment account. Alternatively, the Early Stage SBIC can draw discounted debentures from which the first five years of interest have been deducted from principal.
At the time SBA established the Early Stage SBIC program, it stated that the total amount of leverage commitments it would issue for the Early Stage SBIC program was $1 billion (i.e., $200 million on average per Federal Fiscal Year [October 1–September 30] from FY 2012 through FY 2016). On March 18, 2015, SBA published an “Advance Notice of Proposed Rulemaking” in the Federal Register seeking input from the public to determine whether existing market conditions merit continuation of the Early Stage SBIC program beyond FY 2016 and, if so, what changes should be made to attract qualified early stage managers. All comments were due by May 18, 2015. Although SBA has yet to publish any new rules or other guidance with respect to the Early Stage SBIC program, SBA states in the call that it intends during FY 2016 to make certain modifications to the Early Stage SBIC program regulations and make clear SBA’s intent to make the Early Stage SBIC program (including issuing new Early Stage SBIC licenses and leverage commitments) an ongoing part of the SBIC program.
A variety of regulations govern the investment and operations of SBICs. An SBIC can generally only invest in U.S. companies that are “small businesses.” A “small business” is one that has a tangible net worth not in excess of $19.5 million and average net income after federal income taxes for the preceding two completed fiscal years not exceeding $6.5 million or one that meets an alternative size test for its industry based on number of employees or annual receipts (the alternative test). An SBIC must also have 25 percent of its financings in “smaller enterprises,” which are companies with net worths of no more than $6 million and average net incomes after federal income taxes for the preceding two completed fiscal years of no more than $2 million or are companies that meet the alternative test. An Early Stage SBIC cannot reduce its regulatory capital without SBA’s consent and must obtain SBA approval to incur third-party debt (even if unsecured), other than accounts payable from routine business operations. Distributions by an Early Stage SBIC cannot be made to investors unless all payments on outstanding debenture leverage are current, and, depending on certain ratios, distributions may require a simultaneous repayment to SBA of outstanding leverage. SBA has a series of graduated remedies for failure to comply with its regulations.
A more detailed description of the Early Stage SBIC program is available from Pepper Hamilton LLP (see Description of the Small Business Investment Company Early Stage SBIC Program).