We work with many firms that have or would like to invest in small businesses. One of the biggest issues for an investor in a small business is the potential that the investment will create an affiliation between the investor and the small business. An “affiliation” under SBA’s rules can cause the small business to lose its small business status. For example, to protect its investment, the investor may require certain protections or veto rights over the day-to-day operations of the small business. Depending on the circumstances, SBA may view such investor protections as giving the investor too much control over the small business, which creates an affiliation between the two firms. And that affiliation may jeopardize the target entity’s small business status.
One way to work around SBA’s affiliation rules is to make the investment through SBA’s Small Business Investment Company (“SBIC”) Program. SBA’s affiliation rules contain an exception from affiliation for small businesses that are owned in whole or substantial part by an SBIC. For current or potential investors in small businesses, the SBIC exception from affiliation is a significant advantage because it means that one of the key assets of a small business–its small business status–will not be affected by the investment.
The SBIC Program was created in 1958 and has been used to help fund many name-brand firms, such as Apple, Tesla, FedEx, and Whole Foods. The SBIC Program creates a public-private partnership, whereby a fund of private investors raises capital and then for every $1 raised, SBA will commit up to $2 of debt, to a maximum of $150 million. Statistics from SBA indicate that, over the last five years, the SBIC Program has led to more than $21 billion of capital invested into over 6,400 small businesses. Nearly one-third of that capital was invested in 2016 alone, helping 1,200 small businesses to sustain 122,000 jobs this year.
Private investors participate as limited partners in the SBIC, which must first be approved by SBA. An SBIC must have an experienced fund manager. SBA assesses the fund manager’s qualifications as part of the application process and, if acceptable, will issue an SBIC license. There are three types of licenses: standard, impact, and early stage, with different rules and investment terms for each. Most applicants go for the standard license. With a standard license, the SBIC must invest in “small” businesses, which are firms that qualify as small under SBA’s NAICS code size standards. Investments may be made using loans, debt securities with equity features, and equity. The small businesses must be located in the U.S. or its territories, and the SBIC may control the small business for up to seven years. Target small businesses must be in manufacturing, transportation, consumer products, or other sectors not contrary to the public interest; targets cannot be in project finance, real estate, or financial intermediaries.
SBA touts many advantages of using the SBIC program for investors, including the fact that SBICs are exempt from SEC registration. SBA-guaranteed capital is also low cost and does not participate in profit. And, as noted above, the SBIC is exempt from affiliation with the small businesses in which it invests. There are potential downsides, including the seven-year control limitation noted above and the application process, which can take 7-8 months of processing by SBA, not to mention the intervening time to raise the necessary private capital once SBA gives an initial green light to the application. But despite some drawbacks, this is a process worth exploring, with many potential benefits, for investors interested in decreasing risk when investing in small businesses.
About the Author: Jon Williams is a partner with PilieroMazza and a member of the Government Contracts Group. He may be reached at [email protected].
Image credit Joe The Goat Farmer.