Nearly eight years after pulling the plug on its first effort to increase access to early-stage venture capital, the U.S. Small Business Administration has jumped back in the game, saying it has learned from its past mistakes.
The new program allocates $1 billion over the next five years and is modeled on the successful Small Business Investment Company, or SBIC, debentures program, which is used mainly by lower-midmarket buyout shops. Selected venture funds can obtain leverage of up to $50 million from the SBA to match commitments from private investors. These “early-stage innovation funds” must deploy at least 50% of their capital into early-stage small businesses.
Part of President Obama’s Start-Up America Initiative, the new SBIC program aims to address two problems. The first is a general shortage of venture capital for emerging companies looking to raise between $1 million and $4 million, which, the SBA notes, is known in the venture industry as the “Valley of Death.”
Although Internet start-ups in Silicon Valley often seem to be wallowing in seed-stage investors, other types of companies have a harder time and venture firms typically want to see market traction before making a significant commitment. “There’s a huge funding gap in early stage,” said Suzette Dutch, a managing partner at Triathlon Medical Ventures, a life-sciences venture firm based in Cincinnati. The other problem the new SBA program looks to ease is one that is very familiar to Triathlon: Most venture capital flows to the East and West Coasts.
“Small businesses are facing meaningful challenges getting access to capital in all forms but particularly long-term, more-patient capital,” said Sean Greene, the SBA’s associate administrator for investment and architect of the new program. “It would have been easier to say the participating securities program failed, let’s head for the hills and never go there again, but there is need.”
The SBIC participating securities program was the SBA’s original attempt to infuse capital into the venture industry, the so-called 1.0 version. It began in 1994, in time to catch the dot-com wave, and was suspended in 2004, when the SBA stopped issuing new licenses. Under the program, the SBA matched up to twice the amount of private capital raised by a qualified firm. Some venture firms, such as Triathlon, which raised its debut fund under the initial program, have made a go of it, but others foundered.
As of May, there were 89 participating securities funds like Triathlon’s in active operation, meaning they have completed their time for making new investments and are winding down. But another 66 funds, deemed to be in trouble by the SBA, are under control of its Office of Liquidations. By way of contrast, that office is handling only 18 debenture funds, and half of them were licensed before 1995 when the SBA tightened its approval standards, said Thomas Morris, director of the office. Most of the participating securities funds in liquidation are in a supervised wind-down with current managers in place, Mr. Morris said, but 16 were in receivership in federal court as of early May.
What went wrong with the participating securities program, aside from timing that left it vulnerable to the dot-com crash? The short answer is complexity.
“At the end of the day it was the flawed structure,” said the SBA’s Mr. Greene, who is a former entrepreneur and venture capitalist. Distribution was complicated and sometimes created perverse incentives. “Basically the profits were distributed before the return of capital,” Mr. Greene said.
With a proper distribution model, one-third of the participating securities funds the Office of Liquidations is trying to unravel would never have landed there, said Mr. Morris.
Ms. Dutch said that from a general partner’s perspective, the participating securities program was a good source of leverage, especially for Midwest life-sciences firms looking to raise a debut fund. Triathlon collected $44 million from institutional investors for its $105 million 2004 fund and locked in the balance from the SBA.
The program’s biggest problem from her perspective was that the SBA failed to comprehend the funding mechanics of venture capital. “It didn’t really understand the volatility of performance within the asset class,” she said. For LPs with diversified venture portfolios, profits from the top performers should more than make up for the funds that lose money. But the SBA limited its profits, typically getting about 8%, says the agency. As a result, LPs and GPs in winning funds took most of the gains, leaving the SBA with little to cover its other losses.
This time out, the agency isn’t looking to participate in a fund’s profits, it’s just providing limited leverage. It’s also taken other steps it hopes will enable it to swim in what is inherently a much riskier business than middle-market buyouts, where companies have revenue and are usually profitable.
To start, the program is relatively small, with $200 million a year allocated for early-stage venture coming out of the $3 billion annual allocation for the entire SBIC debenture program. Still, Mr. Greene thinks that’s enough to make a difference, especially since the SBA has the authority to distribute the money to underserved parts of the country.
Early-stage venture funds can only borrow from the SBA an amount equal to what they can raise privately, up to a maximum of $50 million for 10 years. This is less leverage than in the standard debenture program where funds can borrow twice what they can raise, to a maximum of $150 million. Venture funds have to raise a minimum of $20 million in private capital. Although the program does involve leverage, SBIC licensees can still qualify for the venture capital exemption from Securities and Exchange Commission registration, the SBA said.
The SBA also simplified the distribution formula so that if a fund is healthy, returns are distributed pro rata on a cumulative basis. If the SBA determines that a fund is impaired, the agency gets distribution priority. Also, the fund, not the SBA, is responsible for paying the interest on the debt, which is currently around 3% annually. The loan can be repaid at any time without penalty, which means a fund with early gains can exit the program after only a few years.
And finally, unlike the rolling admissions used for the main debenture program, the early-stage piece has an annual call for submissions so that the SBA can evaluate the entire pool of applicants. This year’s call has two categories so the SBA can pump out the money before the Sept. 30 end of the federal fiscal year. Funds with at least $15 million in signed commitments and a balance to reach $20 million “soft-circled” could apply by May 25 for fast-track approval. Others have until June 19 to apply and must round up the $20 million minimum by May 15, 2013.
“It’s an extremely thoughtful and carefully crafted design,” said Michael Wyatt, a partner at Foley Hoag LLP and former SBA counsel whose specialties include SBICs. “It shouldn’t create any significant new risk.” He said the quick launch of the program caught people off guard, but that there is “modest enthusiasm” in the market despite the tight deadlines this year.
Triathlon is one firm that is contemplating accessing the new program if necessary to raise a fund of sufficient size. Dutch said many of Triathlon’s LPs “are skittish about any kind of leverage” because of the history of the participating securities program, concerned that they might face capital calls to repay leverage on an investment that is underwater. Nonetheless, she said, “we think this program now makes the debenture plan appropriate” for venture capital.
Management fees, which the SBA does not pay, are another potential issue for LPs if a fund uses SBIC leverage. While SBA rules allow for fund management fees of up to 2.5%, Mr. Wyatt said, most LPs of SBIC funds let general partners collect fees only on drawn-down leverage.
Mr. Greene said the SBA got feedback from venture firms offering a range of possible strategies for applying leverage. Some suggested leveraging as little as half their private capital while others proposed using the leverage for follow-on investments to double down on successful companies.
Since its start in 1958, the SBIC debenture program has been healthy and profitable, said Brett Palmer, president of the Small Business Investor Alliance, a trade group representing lower-midmarket private equity investors. While the SBA has taken a number of steps to reduce the risk of adding early-stage venture to the mix, the jury is out, he said. “This program holds promise,” he said. “It’s just not clear if the market is going to buy into it.”
“I think the SBA is trying its best in this regard,” said Mark Heesen, president of the National Venture Capital Association. “But so many of these programs are so regulated because of the fear of losing money that the hoops you have to go through to get this money really make you question whether it’s worth it at the end of the day.”
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