Structural advantages

Early stage investors choosing to restructure as SBICs would avoid pending US regulation and gain the government as an LP, but should prepare for a rigorous registration process, writes Kevin Ley.

Early stage investors should give more thought to registering as a small business investment companies (SBIC) following recent changes to US Private Fund Investment Advisers Registration Act.

While the bill, which would require fund advisors to register with Securities and Exchange Commission if they manage more than $150 million in assets, still awaits a full vote in the House of Representatives, and would then need approval by the Senate, it was recently amended to include an exemption for venture capital funds and small business investment companies (SBICs).

While the venture capital carve-out is only partial, as venture capital funds will still be required to provide some information to the SEC, SBICs on the other hand are exempted wholesale from the registration process and the additional reporting requirements that the bill will stipulate.

The SBIC programme was created in 1958 to fill a gap in financing for entrepreneurs and early stage companies; currently SBICs make over 65 percent of all venture financings. For every $10 million in private equity raised, managers can receive $20 million in leverage from the government, typically at a very low cost of capital. The government acts as the preferred limited partner in the fund, and is first in line to receive distributions. There is a leverage limit of $150 million per fund, and a leverage limit of $350 million for a “family of funds”.

Kevin Ley

If a guaranteed pool of low-cost capital isn’t incentive enough, the Small Business Early Stage Investment Act of 2009 should make venture capitalists sit up and take notice. It would create a new programme in which the government matches funds raised for early stage investments in targeted industries. A fund need not be registered as an SBIC to participate, but being an SBIC allows candidates to jump to the head of the approval list, because many of the criteria for participation are already met in the process of obtaining an SBIC license.

Such incentives may be behind a reported increase in applications for SBIC status since the financial crisis. In order to obtain a license, applicants must complete training classes held by the National Association of Small Business Investment Companies, and such classes have been sold out throughout the year. This surge in interest has caused the House to include language in the new legislation that would speed up the licensing process, bringing wait times down from six months to 60 days.

In order to qualify for the programme, a management team must submit to a government background check, and must have a proven track record of success in their investment sector. An SBIC may only invest in “small businesses”, defined as having a net worth less than $18 million and after-tax income less than $6 million for the prior two years. The team must present proof that they can raise a minimum private capital commitment of either $5 million for a debenture fund, or $10 million for an equity fund.

It’s a rigorous process, and not everyone wins approval. But those with a proven track record may find it is worth the effort.