December 20, 2011
The U.S. Small Business Administration (SBA) recently published proposed rules to govern the licensing of Early Stage SBIC funds and the issuance and
repayment of the debentures issued to Early Stage SBIC funds.
During the past seven years, SBA has not granted Small Business Investment Company licenses to venture capital and private equity funds that solely
finance early stage companies due to the inherent risk posed by investments in portfolio companies with no earnings track record. However, beginning in
2012, SBA will commit up to $200 million per year for five years (up to $1 billion total) to Early Stage SBIC funds, a new category of Small Business
Investment Companies (SBIC funds) that will be required to provide start-up financing to small businesses in the early stages of operations.
Currently, SBA debentures have a coupon rate of 2.877%, which is fixed for a ten year period with no prepayment penalties. The historical interest
rate pooling information is reflected in our chart (click to view).
SBA funding for the Early Stage SBIC funds will be in two forms of 10-year maturity debentures: Standard Debentures, which require quarterly interest
payments throughout their terms, and Discounted Debentures, which are issued at a discount and do not require interest payments during the first five
years of their terms. An Early Stage SBIC fund that receives Standard Debentures will be required to maintain funds in reserve to cover interest and
charges on outstanding debentures. There is no such requirement for Early Stage SBIC funds using Discounted Debentures.
To qualify for licensing as an Early Stage SBIC fund, the applicant must be organized as a limited partnership and be licensed pursuant to the new
“early stage SBIC” regulations; current licensed SBIC funds will not qualify under the new early stage rules. The applicant must have at least $20
million in Regulatory Capital at the time of licensing (although the applicant may have less at the time of initial application), and SBA may require
applicants to show progress in fundraising between the first phase and the final phase of the licensing application
process. The applicant will not be licensed
if under common control with any other Early Stage SBIC fund that has already been licensed, unless the first Early Stage SBIC fund has repaid all its
leverage and does not intend to seek any more leverage. An Early Stage SBIC fund must seek SBA approval for any third-party debt, whether secured or
An applicant for an Early Stage SBIC fund license must undertake a process similar to that by which traditional SBIC license applicants apply for
leverage — a first-stage management assessment questionnaire that, if successful, is followed by a “green light letter” and the completion of an
application for a license. However, SBA has stated that Early Stage SBIC fund applicants may apply only during certain windows of time that will be
announced in the Federal Register. Further, applicants for an Early Stage SBIC fund license must pay a $25,000 license application fee. In evaluating
applicants, SBA will look at four broad categories: (1) management’s qualifications and investment track record; (2) proposed investment strategy; (3)
organizational structure; and (4) economics of the fund, similar to the criteria evaluated for all SBIC license applicants. The proposal makes clear
that the “qualified management team” approved for an original license must remain a “qualified management team” for the entire period the Early Stage
SBIC fund is licensed by the SBA. SBA also reserved the right to seek vintage year diversification and geographic diversification in evaluating
applicants. In the proposed regulations, SBA stated a preference for Early Stage SBIC funds to be located in regions outside traditional hubs for
venture capital investment.
Post-licensing, an Early Stage SBIC fund must commit 50 percent of its capital to “early stage” companies, defined as companies that have not yet
achieved positive cash flow from operations in any full fiscal year, regardless of the number of years the company has been in business. SBA
examination fees will be 10 percent higher for Early Stage SBIC funds than the fees paid by other SBIC funds.
Early Stage SBIC funds must make prepayments of outstanding debentures at the same time they make distributions to their private limited partners. The
allocation of the distributions will depend on (1) the Capital Impairment Percentage (CIP) of the Early Stage SBIC fund and (2) the ratio of
contributed capital from the Early Stage SBIC fund’s investors to the amount of leverage drawn from SBA. If the Early Stage SBIC fund’s CIP reaches 50
percent or more, the SBA receives 100 percent of all distributions until all outstanding debentures are repaid. If CIP falls below 50 percent, the
Early Stage SBIC fund could resume payment of distributions on a pro rata basis as described above. SBA expects that the maximum allowable CIP for
Early Stage SBIC funds will be 70 percent.
Events of default for Early Stage SBIC funds would include the failure to invest 50 percent of funds in early stage businesses and failure to maintain
the interest reserve for the repayment of Standard Debentures. SBA would have additional remedies for recovering capital from Early Stage SBIC funds
that have gone into liquidation, including limiting investments to those that have been approved by SBA and requiring limited partner commitments to be
funded at the earliest time permitted under such fund’s organizational documents.
The Private Equity practice group at McGuireWoods LLP is dedicated to keeping
clients advised of new legislative and business developments as they occur. If you have any questions regarding these issues, please feel free to
contact the authors.