While everyone else is talking about this summer’s box office smash hits – Barbie, Oppenheimer, and The Sound of Freedom – here’s the story you haven’t been hearing about…
We are currently going through a historic modernization of how small business lending works in America.
Not only did the Senate Small Business and Entrepreneurship Committee recently vote to advance 11 bills that aim to bolster small-business lending, and modernize the Small Business Association (SBA)…
Isabella Casillas Guzman – the 27th Administrator of the SBA – recently finalized a rule to modernize the Small Business Investment Company (SBIC) Program as part of President Biden’s broader “Investing in America” agenda.
Here’s why this is something worth paying attention to…
From semiconductors to personal computers to electronic vehicles, public-private SBIC partnerships have advanced the growth of industries by financing start-ups and small businesses vital to their communities and our broader national supply chain.
With the modernization of SBIC regulations, SBA will play an enabling role in partnering with return-seeking private investors to fund businesses in corners of the economy critical to our national security and economic success.
What kinds of businesses, you ask?
Icons of American industry, including such household names as Federal Express, Apple, Intel, Costco, Tesla, Whole Foods, and Callaway Golf, all received SBIC funding in their early stages of growth.
Not only have SBICs delivered documented outperformance compared to similar private equity funds – Since 1998, SBICs that benchmark in the top half of private equity have delivered a five to 10 point boost in the IRR delivered to LPs as a result of SBA leverage…
It’s also one of the most efficient, job-creating programs within the government; A 2017 Library of Congress study found that SBIC-backed small businesses created almost three million new jobs, and supported an additional 6.5 million jobs over a 20-year period.
What does this mean for Private Capital Insiders seeking outsized returns in early stage opportunities?
That’s the topic in this issue of the Weekend Edition.
-Equifund Publishing
The Problem With Financing Early Stage Companies
Accessing financial capital is one of the biggest barriers entrepreneurs face in starting and expanding their businesses.
Raising capital has never been easy. But in today’s economy, it is even more difficult – especially for small businesses – to get funding.
- Access to capital was the number one barrier to company survival
- 75% of entrepreneurs have experienced challenges in obtaining capital
- 89% of entrepreneurs say access to capital is limiting their business growth potential
- 78% of entrepreneurs say access to capital is limiting their day-to-day operations
This situation has compelled an otherwise highly partisan Congress to get behind one of the few federal programs designed to alleviate these lack of access to capital problems.
Enter: The Small Business Administration and the Small Business Investment Company Program
On July 30th, 1953, President Dwight Eisenhower signed the Small Business Act of 1953 into law, creating a new agency, the U.S. Small Business Administration (SBA).
The SBA’s mission, often characterized by the three C’s – capital, contracting, and counseling – reflects its commitment to “aid, counsel, assist, and protect, insofar as is possible, the interests of small business concerns.”
- Capital: SBA provides funding opportunities and access to credit through programs like the 7(a) loan program, supporting small business growth and sustainability
- Contracting: SBA sets aside government contracts for small businesses, including disadvantaged ones, boosting diversity and competitiveness in the contracting arena
- Counseling: SBA offers counseling services through SBDCs, WBCs, SCORE, and VBOCs, equipping entrepreneurs with valuable guidance and skills for successful business management
By 1954, the SBA started providing loans and guarantees to small businesses, aiding them in securing the necessary funding for growth and expansion. Additionally, the agency extended its assistance to victims of natural disasters, offering financial support to rebuild and recover.
Recognizing that small businesses were struggling to access adequate credit, to keep up with technological advancements and remain competitive, a Federal Reserve study in 1957 highlighted the pressing need for further support.
As a response to this growing credit gap, President Eisenhower signed into law the Small Business Investment Act of 1958, which established the Small Business Investment Company (SBIC) program – designed to link public and private investment. Consequently, it fills an important role in the capital markets for businesses that have outgrown SBA’s flagship 7(a) loan program.
The mission of the SBIC program is to enhance small business access to capital by stimulating and supplementing “the flow of private equity capital and long-term loan funds which small-business concerns need for the sound financing of their business operations and for their growth, expansion, and modernization, and which are not available in adequate supply.”
The SBA carries out this mission by licensing and monitoring privately owned and managed investment funds.
Fund management teams that successfully complete the application process, may access this low-cost program, leveraging up to two times the private capital they raise.
- For every $1 the fund raises from private investors (“Private Capital”), SBA will commit up to $2 of SBA-guaranteed Debentures (“Debentures”), subject to a cap of $175 million.
- The maximum leverage for a group of commonly controlled SBICs is $350 million.
These funds then invest in a portfolio of U.S. small businesses seeking to create jobs, foster innovation, and fuel economic growth.
- Debt: A typical SBIC loan ranges from $250,000 to $10M, with an interest rate between 9% and 16%
- Equity: SBICs invest in a business in exchange for a share of ownership in the company. Typical investment amounts range from $100K to $5M
- Debt/Equity Hybrid: Financing includes a combination of loans and ownership shares. Loan interest rates are typically between 10% and 14%. Investments range from $250K to $10M
[Publisher’s Note: The SBA does not make direct investments in small businesses. It partners with privately owned and managed SBICs licensed by the SBA to provide financing to small businesses with private capital the SBIC has raised (called regulatory capital) and with funds (called leverage) the SBIC borrows at favorable rates because the SBA guarantees the debenture (loan obligation).
Essentially, the SBIC program is a “fund of funds” – meaning that portfolio management and investment decisions are left to qualified private fund managers. As a result, SBA has very minimal direct involvement in an SBIC’s portfolio management operations.]
Today, the SBIC program is comprised of more than 308 discrete private funds, across mezzanine, private credit, buyout, growth, venture, and multi-strategy, which collectively has more than $40 billion in public and private assets under management.
In 2022, SBICs invested $8 billion in more than 1,500 companies, which created and sustained over 103,000 U.S. jobs.
Also according to the SBA, Limited partners of SBIC-licensed funds benefit from several advantages that aren’t available to other types of investment funds.
- Regulatory benefits: Certain exemptions from registration requirements with the SEC are available to SBICs and their advisers
- Rapid deployment of funds: With a leverage commitment from the SBA equal to two times the private capital raised, fund managers are able to minimize the time spent on fundraising and focus on making investments
- Flexible fund structure: SBICs are allowed to organize themselves as stand-alone entities, drop-down vehicles, or side-car vehicles [publishers note: these are things that institutional investors care about, but are largely irrelevant to retail investors]
- Strong, stable returns: The low cost of SBA capital provides fund managers with pricing flexibility across cycles, while the 10-year term on SBA Debentures avoids the problems of duration mismatch
- Community Reinvestment Act credit: Investments in SBICs may be eligible for Community Reinvestment Act credit
The opportunity of investing in small businesses: Despite being the bedrock of the American economy, U.S. small businesses remain underserved and represent a value opportunity for investors
The SBIC Modernization: What it is (and why private capital insiders should care about the recent updates)
On October 19, 2022, the U.S. SBA published a notice of proposed rulemaking to revise the regulations for the SBIC program.
Why? To significantly reduce barriers for new SBIC fund managers and funds investing in underserved communities and geographies, capital intensive investments, and technologies critical to national security and economic development.
Up until recently, there was only one form of SBIC lender broadly called “Standard SBICs.”
SBICs borrow leverage by issuing debentures, which are unsecured 10-year loans issued by the SBIC, that have interest payable just semi-annually. Most debentures bear a temporary interest rate until they are pooled and sold to the public.
Because the traditional debenture structure requires the SBIC immediately to begin making loan repayments to SBA, much of the financing provided by SBICs has been to relatively later-stage businesses.
For this reason, the SBA believes that the Standard Debenture does not align with the cash flows needed for what’s often referred to as “patient capital” – strategies that primarily invest in the equity of, or provide revenue-based financing to, Small Businesses.
And for this reason, the SBA finalized wide-ranging revisions to the regulations governing the SBIC program, on Thursday, July 13, 2023.
The regulations make nearly three dozen revisions to 13 CFR §107 and §121, and taken together, represent the most significant regulatory changes to the SBIC program in a quarter of a century.
Among other things, the new ruling will now create an additional type of SBICs (“Accrual SBICs”) – along with the new Accrual Debenture – designed to be more useful for early stage companies.
The SBA’s proposed accrual debenture could make the SBIC program more relevant to early stage business investments.
This debenture would not require payment until the end of a 10-year term, with the possibility of a five-year, “roll-over” extension.
This proposed rule change may remove the pressure for SBICs to produce immediate returns, thereby helping the participation of new types of investment strategies in the program.
Under an accrual debenture, SBICs could make investments in earlier-stage companies that produce returns over the 10-year period, instead of right away.
The final rule also limits Accrual SBICs to a maximum of 1.25 tiers of leverage – significantly less than the two tiers for which most Standard Debenture SBICs are eligible.
The regulations will be effective August 17, 2023.
And this leads us to perhaps the bigger story…
A Renewed Call for SBA Reauthorization
On December 8th, 2022, the U.S. Senate Committee on Small Business & Entrepreneurship Chair, Ben Cardin (D-Md.), introduced the Small Business Administration Reauthorization and Modernization Act of 2022 — legislation to reauthorize and modernize key SBA programs, including the agency’s entrepreneurial development, capital access, and contracting programs.
According to Chair Cardin,
The SBA is long due for reauthorization, and I am proud to introduce this package that will reauthorize and improve numerous programs to better serve and expand access to our entrepreneurs and small business owners.
I look forward to engaging with my Republican colleagues on the Committee, and my colleagues in Congress to move this package forward and reauthorize the SBA in the upcoming 118th Congress.
Reauthorization of SBA used to be a regular occurrence in Washington. Between 1980 and 2000, Congress reauthorized SBA seven times, with reauthorization periods ranging from every two to five years.
As the SBA celebrates 70 years since its founding on July 30, 1953, small business owners from Goldman Sachs’ 10,000 Small Businesses Voices are marking the occasion by calling on Congress to reauthorize and modernize the agency for the first time in 23 years.
Although SBA has not been reauthorized as a whole in over two decades, programs overseen by individual SBA offices have been independently reauthorized, leading to gaps in coordination within the agency.
Often, one office does not know what the other is doing, as is clear from the experiences of small business owners. This lack of agency coordination generates confusion and communication issues for small businesses trying to navigate the federal government.
Many small businesses do not even know what SBA does or offers. Poor messaging has led to the creation of organizations that aim to fill the gaps and guide business owners to SBA resources. Streamlining this path would enable SBA to provide thorough support.
For those who have been following the ongoing JOBS Act 4.0 updates, these coinciding updates to capital formation in America appear to be getting ready to hit the Senate floor, just in time for the upcoming elections.
Final Thoughts
While we here at Equifund aren’t an SBIC lender (and don’t have plans to become one)…
We like to view ourselves as a “Capital Stack Solution” for the issuers we partner with.
Inevitably, this means having an understanding of what types of financing options are available for the types of Issuers we support.
Why? As we’ve said many times already, “as early stage investors who own common stock, our biggest risk is being subordinated by another round of financing.”
With what appears to be more – and more affordable – capital sources for early stage companies, we could be seeing more of our issuers combine these types of financing options in addition to equity crowdfunding.
As these stories develop, we’ll continue to explore these other government sources of funding – especially non-dilutive grant funding – that may provide early stage companies with a competitive advantage…
And potentially provide investors with better, risk-adjusted returns by lowering the “fee drag” associated with the cost of capital.
