How-To Buy An Existing Business: Federal Government Venture Capital

SBA-licensed one-stop funding shops SBICs and SSBICs are looking for businesses to fund. Could your business be next?

What It Is: Small Business Investment Companies (SBICs) and Specialized Small Business Investment Companies (SSBICs), which target entrepreneurs who have been denied the opportunity to own a business because of a social or economic disadvantage, are licensed by the Small Business Administration (SBA). These investment companies have their own private capital of several million dollars and may borrow additional funds from an SBA-sponsored trust at favorable rates. SBICs tend to be more risk tolerant than banks or regular venture funds, specialize in a particular industry, and target young companies that aren’t ready for a traditional venture deal.

Appropriate for: Companies that are capable of repaying a loan. This typically means established to early-stage companies with good sales and earnings, or companies about to turn the corner toward profitability.

Supply: SBIC financing is abundant. According to the National Association of Small Business Investment Companies, there are more than 400 SBICs and SSBICs with more than $21 billion under management.

Best Use: For activities that generate cash flow in a relatively short period of time, such as product rollout, or for additional manufacturing or service capacity for which there is a demand.

Cost: Expensive. SBICs and SSBICs charge interest, but in addition, many look for some kind of equity compensation in the companies they finance. This equity compensation is usually in the form of stock, as well as options or warrants that allow the holder to buy stock at predetermined prices for a predetermined period of time.

Ease of Acquisition: Challenging but attainable because the company must submit itself to traditional credit analysis to prove it can repay a loan. This difficulty is countered by the fact that these investment companies are hungry for new business and can be helpful in shepherding companies through the application and due diligence process. In addition, an SSBIC or SBIC generally represents a one-stop shop, and companies need only satisfy the requirements of this single investor to obtain funding.

Range of Funds Typically Available: $150,000 to $5 million.

First Steps
The affiliation SBICs and SSBICs have with the federal government through their SBA license tends to mislead many entrepreneurs. This is because many labor under the mistaken idea that there is an arm of the government that gives money to businesses that cannot secure financing from traditional sources of capital. Unfortunately, SBICs and SSBICs are not this elusive Holy Grail. Second, many entrepreneurs believe that the SBA, through a mechanism such as an SSBIC or SBIC, lends money to businesses with no visible source of repayment.

Unfortunately, this is not the case; SBA-licensed investment companies tend not to finance companies that do not exhibit an obvious source of repayment or that show a high degree of risk.

In fact, briefly exploring the financial structure of these SBA-licensed investment companies is helpful because it shows not only the kinds of deals they won’t do, but the kinds they will, and what types of companies should spend their time pursuing this option.

For example, Freshstart Venture Capital Corp., an SSBIC in New York City, gets its money from two places. The first is equity capital, which Freshstart founder Zindel Zelmanovitch raised from public and private investors. But the second and far more substantial source of capital for Freshstart is funds from an SBA trust fund.

The interest Freshstart must pay on the funds it borrows, as all SSBICs and SBICs do, means the investment company must become involved in deals in which it receives interest as well. Otherwise, there is a massive mismatch between the investment company’s sources and uses of funds. After all, how can an SBA-licensed investment company make investments in which it receives no interest but still pays interest on its own borrowings? The answer is investment companies can’t because the difference between the interest they pay and interest they receive is precisely how it makes money.

And because their cost for funds can be quite low–from 4 percent to 7 percent–and the price SBICs and SSBICs charge on loans can be quite high–from 9 percent to 17 percent–these lenders can be pretty profitable. Freshstart, for instance, earned about $781,000 on about $1.8 million in interest income for the 12 months ending November 30, 1997.

If SBA-licensed investment companies are primarily lenders, what makes them different from a bank? There are two differences, really. First, SBICs and SSBICs tend to take slightly more risk than a bank in terms of collateral. That is, whereas a banker needs a loan to be fully collateralized, and/or guaranteed, at an amount that is equal to or greater than the loan value, an SSBIC or SBIC may not. Most investment companies specialize in a particular industry. As a result of their specialized focus, they tend to assign higher values to collateral than does a general commercial lender.

Second, SBICs and SSBICs take a larger interest in smaller loans that range from $150,000 to $1 million. Large commercial banks like to make large loans. It’s that simple. The systems these banks have installed to analyze, disburse and monitor loans are so expensive that for many, a large loan is the only way they can hope to make money.

By contrast, many SBICs and SSBICs are smaller partnerships. They have limited capital and are careful not to make investments that will outstrip their financial resources. Some SBICs, however, are affiliated with large commercial banks. These SBICs are capable of making substantial loans, and many have investment minimums of $1 million.

To find SBICs and SSBICs in your area, The National Association of Investment Companies (NAIC) in Washington, DC, represents SSBICs as well as other investment companies focusing on minority investments. The NAIC doesn’t have a referral service but sells its membership directory for $35. Or try the National Association of Small Business Investment Companies (NASBIC), a trade group that consists of SBICs and SSBICs exclusively.

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