The Venture Capital Infusions

It’s not often that America’s small businesses get $2 billion in federal funds set aside just for them. But that’s what happened when President Obama signed the American Recovery and Reinvestment Act this February. 

Better known as the stimulus bill, the ARRA changed the rules for a little-known SBA program that loans money to qualified VC firms called Small Business Investment Corporations, or SBICs. SBICs, which are licensed by the SBA as federally funded VC firms, can tap SBA funds to supplement the venture capital they’ve raised privately, taking twice as much federal money as they’ve raised on their own, up to a limit.

The 50-year-old program pays for itself through fees and loan payments by the SBICs. The program has loaned more than $50 billion over the years to companies including Apple, FedEx and Outback Steakhouse.

All of the funds given to an SBIC must be used to fund small businesses, which the SBA defines as companies with no more than $18 million in net worth, or $6 million in after-tax income in the prior two years. Any business fitting this description can approach SBICs for funding. Within this pool, some of the funding each SBIC gets must go to “smaller” businesses, which the SBA defines as having no more than $6 million in net worth and an after-tax profit cap of $2 million.

Another plus to the program: the SBA makes sure a diverse group of venture firms are included in the SBIC pool, so there are VCs interested in funding small businesses in virtually every sector and funds focused on every investment stage—from startups needing seed capital to mature companies seeking money for growth initiatives.

$2 Billion Rule Changes

Restrictions on the SBIC program meant only $1 billion of the $3 billion available for loan to the SBICs was used last year. Few new SBICs have been approved in recent years due to a long and difficult qualifying process. Plus, funding limits stopped existing SBICs from borrowing more.

Among the rule changes intended to put more SBIC money into circulation:

• Previously, an SBIC could get a maximum of $137 million in federal money for a single fund. It’s now $150 million.
• Large SBICs operating multiple venture funds can now borrow up to $225 million between all their funds.
• Before, SBICs could invest only 20 percent of an SBA-backed fund in any one company. The ARRA upped that to 30 percent, giving SBICs more flexibility to back companies they think will succeed.
• SBICs had to invest in smaller businesses to an extent determined by a complex formula that changed as their investment volume rose. The ARRA simplified this requirement to a flat 25 percent, streamlining the process for SBICs and likely directing more money to smaller businesses.

Established SBICs that were tapped out under the previous rules say they will move swiftly to leverage additional SBA capital for small business investment. John Harrison, senior managing director of Nashville, Tenn.-based Harbert Mezzanine Partners, which invests in a variety of business types, including software developers, service providers and manufacturers, says his firm has two qualified SBIC funds but had borrowed the old maximum of $137 million with its first fund.

With the raised limit, Harbert’s second fund can immediately borrow nearly $60 million more from the SBA instead of waiting years for its initial fund to pay its SBA loan back. “That’s money I can get today and have the ability to go ahead and invest today,” he says. “That’s a real change.”

Patriot Capital managing partner Charles McCusker says his Maryland firm, which focuses on growth-stage service businesses in a variety of sectors, has three SBIC-approved funds. A $180 million fund the company raised in July 2008 included $120 million in SBA money and put Patriot at the limit at the time. With the rule changes, Patriot can access additional capital to invest without waiting for those funds to be paid off. “We think we can invest up to $225 million now,” he says. “We couldn’t have done that in the past.”