News Column

Ripple Effects

May 2005, HISPANIC BUSINESS Magazine

Holly Ocasio Rizzo

Hector Barreto
Hector Barreto

Roy and Bertrand Sosa gathered $750 to launch a new company from their one-bedroom apartment in 1998. The company offered a prepaid system to enable people with no credit to buy online. MasterCard came onboard, and the company, named NetSpend, achieved national distribution in 2002.

That initial $750 was bolstered in 2000 by investments from Small Business Investment Companies. SBICs supply equity capital, long-term loans, and management assistance to qualifying small businesses. These privately owned entities use private funds as well as money borrowed from the Small Business Administration (SBA). As profit-seeking organizations, SBICs select the small businesses they fund within SBA guidelines.

But for now, entrepreneurs hoping to duplicate the Sosa brothers' success must wait to see how Congress revamps the popular equity-fund aspect of the SBIC program, which was suspended on September 30, 2004. The problem: Government money used in the SBIC program is intended to be self-sustaining cost taxpayers nothing but the government began losing money with the tech-and-telecom downturn early this decade.

"We are not proposing to reinstate the Participating Securities Program at this time," testified SBA Administrator Hector Barreto at a February 17 Senate hearing on equity-fund SBICs. "In 10 years of operation, this program has resulted in re-estimated losses of $2.7 billion to taxpayers, and that kind of result is unacceptable."

"During the most recent recession, many participating-security [equity-fund] SBICs, like most equity venture-capital funds, lost money in connection with equity investments in small businesses," explains Lee Mercer, president of the National Association of SBICs (NASBIC), the professional group for the industry. "As a result, the government has lost money as well. This is what has led to the agreement to restructure the program."

The SBIC program was created by Congress in 1958. Companies that have benefited from SBIC funding include America Online, Amgen, Apple Computer, FedEx, Jenny Craig, Labor Ready, and Wild Oats Markets. For many years, SBICs only made long-term loans, but in 1994 a new SBIC program was created, giving licensed funds the ability to invest in companies in return for company shares, or equity. From the program's creation through 2002, SBICs provided 8 percent of all venture capital dollars, 64 percent of all seed financing dollars, and 62 percent of all venture financings by number of companies in the U.S. economy.

SBICs have also made significant contributions to companies facing greater challenges in their hunt for funding. More than 27 percent of SBIC financing dollars went to low- and moderate-income areas in FY2002, with 71 percent of the portfolio outside California and Massachusetts two states that received large injections of private-venture dollars during the tech-and-telecom boom of the late 1990s. In FY2004, companies with at least 50 percent Hispanic ownership received 1.7 percent of SBIC investments and 1.6 percent of financing dollars.

In recent years, equity-fund SBICs have become more prominent than debenture-fund SBICs. As of September 3, 2003, there were 190 equity-fund SBICs with $4.6 billion in non-SBA capital and $11 billion in total capital, according to NASBIC figures. By comparison, there were 126 debenture-fund SBICs with $2 billion in private capital and $4.3 billion total.

Until the program was suspended in late 2004, equity-fund SBICs attracted investors with an enticing equation for leveraged financing, because the SBA provided up to $2 for every $1 of private venture capital. As a result, these funds gave their limited partners a multiplier effect on their investment. In fact, an equity-fund SBIC could earn nearly triple the investment from money provided by its limited partners, compared to a regular venture-capital fund. And once the SBA got back its investment plus interest, it could not take more than 9 percent of the profits.

Suppose an investor put $10 million into a $30 million equity-fund SBIC. The SBIC then could get $60 million from the SBA, making it a $90 million fund. The investor would own only one-ninth of the fund's capital, but would be entitled to about 30 percent of the fund's profits, after paying off the SBA's investment and interest.

In 2003, in order to make the program more profitable, the SBA proposed raising its share of equity-fund SBIC profits from 9 percent to 33 percent. Congress did not act on the plan. The Senate Committee on Small Business and Entrepreneurship, chaired by Republican Senator Olympia Snowe of Maine, introduced SBIC revisions again in January 2004.

With the SBA's announcement to drop the SBIC equity program, several senators argued for its continuance at preliminary hearings on February 17. Republican Senator James Talent noted that SBICs were the only federal participation in the venture capital industry, and he told SBIC success stories from his state of Missouri. Ms. Snowe said she was "hopeful that we can successfully restructure the SBIC program this year."

Meanwhile, the SBA's debenture SBIC program remains operating and self-sustaining, and NASBIC's Mr. Mercer predicts it will grow this fiscal year. Typically, debenture SBICs lend money to companies that prove they're capable of repaying a loan. These funds target established to early-stage companies with good sales and earnings or companies about to turn the corner toward profitability. Loans range from $150,000 to $5 million.

With the equity program on hold, no company receiving any type of SBIC funding will lose it, the SBA says. However, the suspension of equity funding leaves a big hole in the capital marketplace. The SBA backs about one-fifth of all venture firms in the United States, according to data gathered by the National Venture Capital Association, NASBIC, and other sources. The SBA is working with many of these companies to see whether they can participate in the debenture program.

According to Greg Wach, banking counsel for the Senate Committee on Small Business and Entrepreneurship, the SBICs have enough investment capital to last until mid-2006. "The clock is ticking for Congress to approve a structure that works," he says.

SBIC: Three Ways It Pays

•Entrepreneur: Early-stage to established companies can get loans from $150,000 to $5 million from SBICs. Equity investments are suspended until Congress reviews the structure of the program.

•Investor: Deals with an SBIC are structured as limited partnerships. Individual SBICs may specialize by sector or region. From FY1994 until the program's suspension last year, more than $5.5 billion in private equity investment flowed into SBICs.

•Licensee: "The SBA is vitally interested in encouraging responsible individuals and organizations to establish SBICs," according to the agency's Web site. Applicants need established expertise in small-business investing and a minimum $5 million in private capital.

Source: U.S. Small Business Administration.


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