This article was published as part of the July 2009 Sub-Debt Report.
Introduction
Each year the United States Small Business Association (the “SBA”) grants a number of licenses to newly formed, privately owned and managed investment funds known as Small Business Investment Companies (“SBICs”). SBICs are qualified investment management firms with expertise in distinct industries acting as vehicles to deliver private capital and funding received from the SBA to small businesses throughout the United States. The function of SBICs is analogous to venture capital, private equity and private debt funds with respect to their method of operation and their ultimate goal of yielding higher rates of return to investors. The defining characteristics of the program require SBICs to be regulated by the SBA and limit their investments to qualified small business concerns.
With a lack of “willing and able” private alternatives in the current economy, public sources are likely to become increasingly important to small businesses seeking capital. One such source of public funding is the SBA. To obtain leverage, an SBIC issues debentures, which are then guaranteed by the SBA, pooled together and sold to investors through periodic public offerings. Through the SBA's funding program, the SBIC has access to leverage of up to 3:1.[1] In addition, SBA leverage is available at very attractive rates, making for an increasingly appealing business model. Not unlike many private financing alternatives, the debentures have ten year maturities and require semi-annual interest-only payments with the final principal being paid in a lump some at the debenture’s maturity. However, unlike most private financing alternatives debentures may be prepaid without penalty. Interest rates on debentures are determined by market conditions of 10-year treasury securities at the time of the sale. The coupon rate tends to be approximately 200 basis points above 10-year treasuries. On April 1, 2009, the rate would have been as low as 4.68% plus fees.
In order to take advantage of available funding under the SBA program, any company desiring to operate as an SBIC (referred to throughout the article as the “Applicant”) must first obtain a license from the SBA. The purpose of this article is to offer an introduction and overview of the process involved in qualifying for, and obtaining, an SBIC license.[2] Being approved for a license requires a significant investment of time and effort that can be expected to take between 12 and 18 months from the time the Applicant’s management team (the “Management Team”) submits its initial request.[3] In addition to being costly[4], the process involves an extremely comprehensive and time consuming review of the Applicant’s qualifications, business plan and fund structure.
Getting Started
How should the Applicant proceed once it has determined that the SBIC program is an attractive alternative for its leverage needs?
Before applying for a license, the Applicant will need to develop a business plan and fund structure and, most importantly, determine the members who will make up the Management Team leading the Applicant’s initiative to obtain an SBIC license. The one factor that is most likely determinative of an Applicant’s ability to obtain an SBIC license is its Management Team. The Management Team must have experience investing and be prepared to learn and understand the regulations governing SBICs.
How do you create and pull together a qualified and successful Management Team?
Section 681(c)(3)(A)(ii) of The Small Business Investment Company Act of 1958, as amended (the “Act”) requires that “the management of the applicant is qualified and has the knowledge, experience, and capability necessary to comply with [the Act]…” and to assess “the probability of successful operations of the applicant, including adequate profitability and financial soundness.” In addition, the Management Team will need to familiarize itself with the specific regulations and requirements in order to demonstrate and ensure that the Applicant has the ability and qualifications to operate an SBIC in compliance with regulations promulgated by the Investment Division of the SBA.[5] The Management Teams should consider whether potential desired portfolio companies will likely qualify as small business concerns and meet eligibility requirements necessary to receive funding from the Applicant.
The SBA tends to favor three to four member teams consisting of highly qualified and diverse managers who are able to demonstrate evidence of past successful investments. It will be necessary that the team demonstrate a record proving its ability to make profitable use of the leverage it plans to obtain through the SBA program. The Management Team will need to be prepared for the comprehensive review of its qualifications, business plan and fund structure.
What factors have historically been indicative of a highly successful SBIC?
The Investment Division of the SBA has stated that the following factors, in its experience, indicate the Management Team’s likelihood for success:
- Substantive and comparable investment experience;
- An experienced profile of superior returns;
- Evidence demonstrating deal flow in the specific investment area proposed by the Applicant;
- A cohesive Management Team comprised of members with complimentary skills and a successful history of working together;
- Managerial, operational, technical and other experiences that demonstrate the Management Team’s ability to offer support and add value to prospective portfolio companies; and
- A history of the Management Team’s ability to responsibly manage cash flows that demonstrates assurance that the SBA leverage will be repaid in a timely fashion.[6]
Collectively, these factors should be used when considering the composition of a Management Team and to evaluate the strengths and weaknesses of the team before beginning the application.
In what form should an SBIC be organized?
Under the Act, SBICs may be organized as a corporation, a limited partnership or a limited liability company. The Applicant may be organized under any state’s laws, except that those organized as limited liability companies are required to be organized under Delaware law. Although there have been a few SBICs formed as corporations with publicly traded stock, the majority of SBICs are formed as limited partnerships.
SBICs must be formed for the sole “purpose of performing the functions and conducting the activities contemplated under [the Act].”[7] Section 681(a) of the Act requires that if incorporated, the Applicant must have a succession for not less than 30 years unless dissolved by its shareholders and if organized as a limited partnership, the Applicant must have a succession for not less than 10 years. Section 681(b) of the Act sets forth guidelines for the articles of the Applicant. Similar to most entities, the articles “shall specify in general terms the objects for which the company is formed, the name assumed by such company, the area or areas in which its operations are to be carried on, the place where its principal office is to be located, and the amount and classes of its shares of capital stock.” The remainder of provisions included in the articles must also be consistent with the Act and will require inclusion of certain provisions specific to SBICs as required by the SBA.
For example, Section 687(d) of the Act prescribes that certain specific regulations are required to balance the risks associated with potential conflicts of interest. Although most state statutes include laws regulating interested transactions among officers, directors, partners, members or shareholders and a company, Section 687(d) requires regulations governing “transactions with any officer, director, shareholder, partner, or member of any small business investment company, or with any person or concern, in which any interest, direct or indirect, financial or otherwise, is held by any officer, director, shareholder, partner, or member of (1) any small business investment company, or (2) any person or concern with an interest, direct or indirect, financial or otherwise, in any small business investment company.” The SBA provides a model agreement designed to function as a basic form of agreement intended to comply with these regulations to which an Applicant can add a limited number of provisions and adapt for their own individual situation. Any deviations from the model agreement, however, will increase the amount of time required to review, negotiate and finalize the Applicant's partnership agreement. The decision to form an SBIC as an entity other than an LP may also result in the SBA requiring more time than necessary to review an LP’s model agreement. If time is of the essence, it may be best to form the fund the Applicant by using the model agreement and later amend the limited partnership agreement if necessary.[8]
How much private capital is required up front?
The minimum private capital investment required by the SBA to form a debenture SBIC is currently set at $5,000,000. At least 30% of the initial private capital investment (which may be a great deal larger than $5,000,000) must be funded from sources that are unaffiliated with the Management Team (discussed in detail below). As indicated above, licensed SBICs in good standing have access to a maximum amount of leverage equal to up to 300% of its private capital, but no more than $150,000,000 in the aggregate.[9] The maximum amount of leverage available to multiple SBICs under common control may not exceed $225,000,000.[10]
The SBIC Application Process
Program Development
Applying for an SBIC license is a two-part process. The first part (“Part 1”) of the process begins with the completion of the Management Assessment Questionnaire (the “MAQ”)[11] followed by the Investment Division’s review and approval. If the Investment Division approves the MAQ, the Management Team will be scheduled for a formal interview at the SBA’s headquarters in the District of Columbia. If the Management Team successfully completes the Part 1 of the application process, it will receive a “Go Forth” letter inviting the Applicant to complete the second part of the application process (“Part 2”) by submitting its license application (the “License Application”).
The SBIC Application Process: Part 1
Submitting Your Management Assessment Questionnaire
The first step of Part 1 begins with completion of the MAQ, which consists of SBA Forms 2181 (MAQ) and 2183 (Exhibits).[12] The Investment Division indicates that the Applicant should plan to spend at least 100 hours to complete Forms 2181 and 2183. Keep in mind that the purpose of the MAQ is to provide information necessary to determine if the Management Team has the requisite qualifications to manage an SBIC. In other words, the MAQ is essentially a detailed and outlined resume that the Management Team must submit in order to secure an interview. Since the SBIC is applying for financing, the Management Team must also remember that the evaluators are examining the level of credit risk associated with the business model.
Section 1 of the MAQ asks for highly detailed information on the managers, their experience working together and other key characteristics of the fund, including the total estimated private capital, predicted expenses and percentage of time the principals will devote to the SBIC. Section 2 is made up of a number of distinct investment related short-answer essay questions including descriptions of: (1) industry preferences; (2) unique elements of the SBIC’s investment strategy; (3) the Applicant’s characterization of the current economic environment and the climate 12 months following the application; (4) ideas related to pricing and structuring deals; and (5) how the Applicant plans to comply with specific regulations. Section 3 of the MAQ requests detailed information on planned operations, decision making and oversight, and Section 4 moves into the legal provisions of the fund, such as profit sharing plans and distributions, and the organizational structure and relationships (if applicable) of “drop-down” funds.
MAQ Review and Approval by the Investment Committee
Once the MAQ has been submitted to the Investment Committee, the Management Team will receive a notice within 3 to 5 business days confirming receipt of the MAQ. Each application is assigned to a member of the Investment Committee’s Program Development team. The Management Team will then be contacted by the assigned member of the Program Development team to discuss processing of the application, timing and any items of the application that the member feels are incomplete or unclear. The Program Development team will perform a detailed review and analysis of the MAQ to assess, in light of the minimum requirements, the Management Team’s qualifications; perform initial due diligence, including contacting references; and preparing a written recommendation to the Invest Committee. Only after the MAQ has been thoroughly reviewed by the program development team (“Program Development”) does the Investmentment Committee determine (by vote at a regularly scheduled meeting) whether the Management Team is qualified for a license and will be invited to the SBA Headquarters in Washington for an interview.
The Interview
Once the Management Team has obtained an interview, they will engage in a discussion-based meeting designed to provide the Investment Committee with an opportunity to better familiarize itself with the proposed fund and individual members of the Management Team. Interviews will vary among applicants, but Program Development will provide the Applicant with guidance regarding the content, presentation, location and timing of the interview beforehand. After the interview, the Investment Committee will vote again to determine if the Applicant will receive the “Go Forth” letter inviting the Management Team and its Applicant to advance to the second part of the application process by filing a License Application. The Go Forth letter is not a determination or guarantee that the Applicant and its Management Team are qualified to receive an SBIC license, but rather an invitation to proceed to the next step.
The SBIC Application Process: Part 2
Licensing
Part 2 of the process involves filing the License Application. The formal License Application merely consists of SBA Forms 2181 and 2182 (license application exhibits).[13] If the MAQ has been updated throughout the process and no information has changed, the License Application will be ready for submission at the time the Management Team receives its Go Forth letter. In any event, the MAQ should be reviewed to ensure that all information is current.
Once the License Application is current and ready for submission, the Management Team should review the regulations and prepare the organizational documents necessary to finalize the formation of the Applicant’s entity. The application fee for corporations is $10,000; for limited partnerships and Delaware limited liability companies, the application fee is $15,000. The License Application and fee should only be submitted once the Management Team is confident that the Applicant can meet the minimum requirement for initial private capital, taking into account that the Applicant must have at least $2,500,000 on deposit approximately three weeks after submission, which is the approximate amount of time required for the Agency Licensing Committee and SBA Administrator to approve the Application.
Once the License Application has been submitted and reviewed by a licensing analyst and an attorney in the SBA’s Office of General Counsel, the Applicant will be issued a “comment letter.” The Applicant will then need to respond to the comment letter to resolve any and all issues as quickly as possible.[14] Upon completion of this review, the Investment Divisional Licensing Committee (the “IDLC”) will be presented with the Applicant’s Licensing Application. The IDLC generally meets at least once a month and is composed of the senior managers of the Investment Division. If a majority of the IDLC votes to approve the application, it will be forwarded to the Agency Licensing Committee. As previously indicated, prior to being presented at the Agency Licensing Committee the Applicant must have at least $2,500,000 on deposit at and be prepared to provide a certification by the Applicant’s bank stating that the funds are in the account and unencumbered. If the Applicant receives a favorable vote from the Agency Licensing Committee, it will then fully execute copies of all legal documents and the application will be forwarded to the SBA Administration for final action. Once the Administrator approves the application, the license will be issued.[15]
Conclusion
Different steps involved in forming an SBIC can be accomplished simultaneously, making it important to understand the entire process and plan accordingly. Assistance – from fundraising to forming the Applicant or drafting organizational documents – is available. Effectively delegating responsibilities among the Management Team and any professionals supporting the Applicant is essential to a successful application.
[1] Legislation provides for leverage at a 3:1, but 2:1 is the maximum practically available to most licensed SBICs.
[2] In addition, certain information contained in this article pertains to existing SBICs that desire to change ownership or control.
[3] The initial request is the Management Assessment Questionnaire discussed later in more detail.
[4] In addition to application fees discussed later in this article, the Applicant may require legal or financial assistance throughout the process.
[5] The Management Team should review Parts 107 and 121 of the regulations, with specific attention to the provisions related to conflict of interest.
[6] The SBIC Program: Application Process, available on the Investment Division’s website at http://www.sba.gov/inv.
[7] The Small Business Investment Company Act of 1958, as amended § 681(a).
[8] Note that amendments to the Applicant’s charter or governing partnership agreement will need to be approved by SBA if it receives an SBIC license.
[9] The Small Business Investment Company Act of 1958, as amended § 683(b)(2)(A). The majority of funds are generally not eligible for more than 200% until they become seasoned participants in the program.
[10] Id.
[11] The MAQ is available at the website in footnote [6].
[12] The MAQ and the Licensing Application have been integrated to minimize the need to rearrange and repeat information throughout the application. Therefore, the MAQ requires the diligence and care that would be necessary in the preparation of any final Licensing Application.
[13] Note that Form 2183 submitted with MAQ is a subset of Form 2182.
[14] This is done through written and oral communication to expedite the process. Long response times may result in the application’s priority being decreased.
[15] Even with an SBIC license, the Applicant may not draw down leverage until all SBIC principals (and in some cases, significant investors or members of a board of directors) have completed the SBIC Regulations training courses. Because the regulations play a crucial role in understanding how an SBIC is required to be organized and managed, we recommend taking this class as early in the process as possible.