SBA Early Stage SBIC Program
The U.S. Small Business Administration (SBA) is establishing a new type of Small Business Investment Company (SBIC) that will be required to invest at least 50 percent of its invested capital in “early stage companies.” The program, published in the Federal Register on April 27, 2012, 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). 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 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 (i) having binding unfunded commitments in that amount from its Institutional Investors that can only be drawn to pay that interest or (ii) maintain 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.
The amount of leverage commitments that SBA will issue for the Early Stage SBIC program will be limited to an aggregate of $1 billion. Not more than $150 million of leverage commitments can be reserved in 2012, not more than $200 million of leverage commitments can be reserved per year from 2013-2015, and not more than $250 million of leverage commitments can be reserved in 2016. If sufficient leverage commitments are not available in a particular year, the commitments will be apportioned by SBA “pro rata” among the licensed Early Stage SBICs.
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 $18 million and average net income after federal income taxes for the preceding two completed fiscal years not exceeding $6 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 not more than $6 million and average net incomes after federal income taxes for the preceding two completed fiscal years of not 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, 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.
SBA has issued a call, published in the Federal Register on May 1, 2012, to early stage fund managers to apply for the Early Stage SBIC program. There is a two-track process; Track 1 is for applicants with capital and Track 2 is for all others. 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 in for an interview at SBA. Funds that are deemed worthy will be issued a “green-light letter,” which permits the managers to submit a formal license application. Licensing requires approval by the SBA’s Divisional Committee and its Agency Committee.
For 2012, Track 1 applicants must submit their MAQs by May 25, 2012. At the time it submits its MAQ, a Track 1 applicant needs at least $15 million of Regulatory Capital and an additional $5 million of either Regulatory Capital or soft-circles from investors whose capital would so qualify. Green-light letter decisions for Track 1 are expected by June 29. Formal license applications for Track 1 applicants must be submitted by July 30, 2012, with anticipated licensing of qualified applicants by September 28, 2012.
For 2012, Track 2 applicants must submit their MAQs by June 19, 2012. Green-light letter decisions for Track 2 are expected by September 28, 2012. Formal license applications for Track 2 applicants must be submitted by May 15, 2013, with anticipated licensing of qualified applicants by September 30, 2013.
Calls for managers to apply in subsequent years will be made at later dates.
Before filing a formal license application, the fund must have at least $20 million of Regulatory Capital. The fund’s capital commitments can be conditioned upon receipt of an SBIC license and/or approval of the limited partnership agreement. The application includes the fund’s and the general partner’s organizational documents. Generally the fund’s limited partnership agreement will need to track the Early Stage SBA Model Limited Partnership Agreement, and the applicant must explain deviations from that model. 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), provided that 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. No side letters are permitted.
SBA will generally review 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.