Owners of privately-held businesses generally finance their businesses with their own capital, augmented with bank loans. An additional source of funding for government contractors is available from Small Business Investment Companies (SBICs).
The Small Business Investment Company Program was established by Congress in 1958 to supplement the long term capital, both debt and equity, available to small businesses. The SBICs are privately owned and managed investment funds, but regulated and licensed by the U.S. Small Business Administration (SBA). With the SBIC licenses, SBICs can raise public funds at low cost by issuing SBA-guaranteed debentures and are allowed to leverage up to three times the private capital they are able to raise. Despite certain SBA requirements for investment, working with an SBIC is not much different from working with any other private equity firm or mezzanine lenders.
To be eligible for SBIC investment, the business must have a tangible net worth of no more than $18 million and an average of $6 million or less in net income over the previous two years at the time of investment. A business may also be deemed “small” based on its industry using SBA size standards. Moreover, a government contractor wholly owned or substantially owned by an investment company that is licensed under the Small Business Investment Act of 1958 such as an SBIC is not considered affiliated with the SBIC.
This is a major difference between SBIC investments and traditional investments as the former does not create hurdles for the government contractors with small business set-aside contracts or plans to continue to compete in this space. SBIC provides capital in one of three forms: loans, debt with equity feature, and equity. According to the SBA quarterly update on the SBIC program, the majority of SBIC financings use the first two forms. However, the majority of financing for government contractors with median annual revenue of $14 million use debt with equity feature which is also known as mezzanine debt. This form of debt is subordinate to bank loans and is based on the business cash flow. Mezzanine debt provided by SBICs offers the government contracting business owners an additional source of funding for acquisitions, change of ownership or recapitalization.
In addition to the cost benefit, using mezzanine debt in a capital structure provides the necessary capital for a company to grow with little to no dilution to the business owners. Secure More Capital: Financing with a Bank loan is often limited by available collateral. Mezzanine debt with its subordination feature, interest-only period and sometimes deferred interest payments or payable in kind interest (PIK) is treated as equity from banks’ perspective; for this reason, the proposed bank loan amount could be higher with this additional equity-like capital. In the end, the company is able to obtain more capital to finance its strategic objectives.
Retain the Control and Ownership: Mezzanine lenders’ investment horizon is typically up to five years; their goal is not to be a long term shareholder. Whether there is an equity feature such as a warrant or not, a typical mezzanine lender wants to achieve a target return over some specified time and payback the SBA guaranteed debenture that was used to fund the investment.
The most important criterion for the SBIC mezzanine investor is the ability of its client to generate the required cash flow. This means the mezzanine investment applicant must have an established business with a competent management team, proven past performance, a strong contract backlog and potential pipeline. If these criteria describe your business, layering mezzanine debt with bank loans in your capital structure may provide the necessary funding to meet your strategic objectives.
This article was originally published in our First Quarter 2015 Legal Advisor newsletter.
About the Author: Linh Phu is a commercial lender with the Government Contractor Lending Group at Access National Bank, headquartered in Reston, VA. The Group provides various financing solutions to meet the business goals of government contractors from $1 million to $100 million in annual revenue. She can be reached at firstname.lastname@example.org or 703-871-7361.