SBIC funding boosts good for VCs

SBIC Funding Boosts Good for VCs, Entrepreneurs

By Jeff Thomas
Business Report Correspondent

Boulder County Business Report, June 2, 2003

Uncle Sam is a becoming a big player in the venture capital market through Small Business Investment Companies (SBICs), which have been funded to the tune of about $77 million in Colorado through 2002. And that’s good news for both entrepreneurs looking to fund their business ventures, and venture capital funds looking to get a foot up during pressing economic times.

“It’s harder to raise capital now, so I think the program has become even more popular,” said Catherine Merigold, a founder and general partner of Vista Ventures in Broomfield. “It is a very good thing for smaller venture capital funds -- we can leverage out capital to invest in more companies. That way, you kind of spread your risk.”For most venture capital firms -- specials regulations apply to banks -- the Small Business Administration requires a minimum private capital investment of $5 million to obtain an SBIC license. A minimum of 30 percent of this private capital must come from sources unaffiliated with the management of the VC firm.

Initial SBIC licensing allowed a VC firm to borrow up to 300 percent of its capital fund through issuance of debentures, up to $107 million, which are SBA-guaranteed and paid back at low-interest rates determined by current market conditions. Pools of these SBA-guaranteed debentures are formed and sold to investors through public offerings.

Over the years, the program was widened and in the mid-1990s was streamlined to encourage even more participation. Those last changes, apparently, helped to grow the program enormously, especially in Colorado.

“The big changes in Colorado seem to come with that streamlining,” said Chris Chavez, the regional communications manager for the SBA. “It was really a matter of finding enough people with enough private capital. We didn’t really see a big increase (in participation until the mid-1990s) especially when you started to get a push from the dot-coms and the more technology-based companies.” The biggest change in the program essentially allowed VC firms to issue participating securities that actually put the SBA in an ownership position with a preferred stock position, said Al Valenti, the chief financial officer for Roser Ventures of Boulder, which has managed a $53 million SBIC fund since 1999.

“In this program you can only borrow at 2-1 (200 percent of the private investment) with participating securities,” he said. “What that means is the SBA has almost a preferred stock in the fund, while the private investment is more like common stock.” The SBA is then the first to get back its capital, interest (usually at a 6 to 7 percent rate) and an additional 6 to 7 percent of the fund profits, Valencia said. Most venture funds, however, are looking to get a 30 percent return on their funds, and the private investors would get all of the profit above the 14 (or so) percent that the SBA would take out first.

“The government doesn’t have control over our investments -- it just puts the money in,” Merigold said. “For a technology company looking for funding -- they don’t particularly care. Green is green.” Vista raised $20 million privately for its first portfolio, and then turned it into a $60 million fund through SBIC financing. In turn, it has participated in financing in a number of technology start-up companies, such as Boulder’s Lefthand Networks and Dante Software. For Dante, Vista actually led the early financing round, which was participated in by more established Boulder County VC firms, including Mobius and Sequel Ventures.

“Colorado always gets a lot of VC money from out of the state, but it really helps to have more money available locally, especially in early rounds,” Merigold said. “The more money we have locally, the more it will attract more out-of-state money.” The SBIC program serves several different levels of financing, from start-ups through mezzanine rounds, somewhere in the $3 million to $6 million range. The program was begun in 1958 as a way to promote venture financing for all small businesses and also encourages financing in economically disadvantaged geographic and market areas, including minority-owned business, through the Special Small Business Investment Company (SSBIC) program.

But all the SBIC licenses look at the geographic location of the planned investments, Valenti said, in order to increase investment in what the government views as undercapitalized locations. Roser’s SBIC fund (leveraged at the 2-1 rate) has more than half of its money invested in Colorado-based businesses.

The program also has been a winner for the SBA, sources said, returning more to the SBA coffers than taken, making it an oddity for the federal government.

“It’s a very viable program,” Chavez said.

Merigold said streamlining SBIC licensing and funding had a lot to do with increasing the number of VC companies involved in the program. While the licensing process is no longer onerous, she said, it might take up to a year to complete.

Besides sufficient capital, the SBA reviews and approves prospective management teams based upon professional capability, character and the investment strategy -- including geographic location -- the firm proposes to pursue. Once licensed, each SBIC is subject to annual financial reporting and biennial onsite compliance examinations by the SBA, and is required to meet certain statutory and regulatory restrictions regarding approved investments and operating rules.

“Just as we expect our portfolio companies to have a business plan, we also had to have a plan,” Merigold said. Vista itself concentrates on what Merigold calls “enabling technology for established business markets.” Roser has a somewhat more diversified plan for its SBIC fund, including start-ups in medical technology, various software markets and capital equipment in high-tech.

Valenti said some of the regulations, such as limiting the amount of capital that can come from any single fund partner, may keep larger venture capital firms from seeking SBIC financing. However, the fund does increase early stage investment with almost $2.7 billion invested nationally through 2002.

“SBICs have become a very valuable source of early funding for companies that may be too new for more traditional venture capital investment,” he said.