Small business investment companies (SBICs) are an important source of capital for middle-market transactions, but many traditional lenders and private equity sponsors are hesitant to involve SBIC capital in their transactions because they are not familiar with the SBIC program. Winston & Strawn now boasts one of the nation’s most active SBIC practices, representing SBICs in fund formation, obtaining licensure and leverage from the U.S. Small Business Administration (the SBA), debt and equity transactions, regulatory compliance, and liquidation. Here are some things you should know about SBICs when considering SBIC financing for your transactions:
1. What are SBICs? The SBIC program was started in 1958 to stimulate long-term investment in American small businesses. SBICs are private funds licensed by the SBA. One of the main advantages of SBICs is their ability to access low-cost leverage provided by the SBA—often up to $2 of SBA leverage for every $1 of private capital. As of October 2018, there were 305 SBICs in existence, including 252 SBICs with leverage from the SBA and 47 bank-owned or non-leveraged SBICs. On an aggregate basis, SBICs represent more than $30 billion of capital at risk.
2. What types of deals do SBICs do? SBICs provide debt and equity capital through a variety of structures and across many industries. Most SBIC dollars are invested in debt, with or without warrants, conversion features, or other attached equity. SBICs generally invest $1 million to $10 million in a single portfolio company. Some SBICs invest larger amounts, either on their own or through parallel funds. SBICs also frequently co-invest together in deals that qualify for SBIC investment.
3. What types of business qualify for SBIC investment? SBICs may only invest in businesses that qualify as “small businesses” under SBA regulations. Businesses with tangible net worth (in this case, total net worth minus goodwill only) of $19.5 million or less and average annual after-tax net income (excluding carry-over losses) of $6.5 million or less for the preceding two completed fiscal years are deemed “small businesses.” Businesses that do not meet these tests may also qualify under an industry-specific test based on employee count or gross revenue.
SBICs may not invest in certain businesses, regardless of size. SBICs may not invest in businesses that are relenders or reinvestors, such as banks, other funds, factors and leasing companies; many real estate businesses; single-purpose project financing, such as oil and gas wells and motion pictures; farm land purchases; and businesses that use the proceeds for a purpose that is illegal or contrary to public interest. SBICs may not invest in businesses that use the proceeds for a foreign operation or have (or will have within one year after financing) more than 49% of their tangible assets or employees outside the United States. SBICs may only invest in active entities, subject to limited exceptions for holding companies and other passive entities that directly or indirectly own a majority of an active entity.
4. Do SBIC transactions require special documentation? SBICs typically use the same documentation as other investors, subject to limited exceptions and terms to deal with specific SBA regulations. Many SBICs include any SBIC-specific provisions in a side letter to avoid affecting other investors. SBICs typically require portfolio companies to provide three short SBA forms at closing.
5. Are there limitations on SBIC deal terms? SBIC deal terms are subject to a few limitations intended to protect small businesses, and these limitations do not apply to independent co-investors. The most prominent limitation for SBIC lenders is a cap on fees and interest equal to 19% per annum for loans with no attached equity or conversion features and 14% for loans with attached equity or conversion features. Excluded from the cap are application fees of up to 1%, closing fees of up to 2% for loans with no equity or conversion features and 4% for convertible loans and loans with attached equity, default interest of up to 7% per annum for payment defaults and failure to provide required information, and royalties based on post-funding improvement in the borrower’s performance. Reasonable prepayment fees are also outside the cap, and SBA has deemed 5% in year one, decreasing by 1% per year through year five, to be reasonable. SBIC returns on equity investments are not capped, but mandatory redemptions of equity held by SBICs are subject to price limitations in certain circumstances.
6. Is the government involved in SBIC transactions? Generally, no. The SBA reviews fund managers and their track records before granting a license to operate an SBIC. Once an SBIC receives its license, the SBA does not review individual transactions in advance. Instead, the SBA periodically audits SBICs to review closed transactions for regulatory compliance. When an SBIC invests in a company, the company must certify financial and demographic information on SBA forms to document its qualification for SBIC funding. The company must also agree to provide summary financial data to enable the SBIC to file quarterly and annual reports with the SBA and must provide the SBA access to books and records if so requested to verify the information certified by the company. In our experience, most portfolio companies find the SBIC reporting burden to be quite manageable, and SBA access rights are rarely used.