Dealing With an SBIC

Small business investment companies (SBICs), a specialized form of venture capital firms, have become an important source of capital. SBICs are licensed by the federal government to fill a financ¬ing gap for small business. SBICs can borrow up to four times their private capital position from the U.S. government at favorable borrowing rates. Most SBICs attempt to cover only operating expenses on loans, with profits coming from equity participation. Thus, the interest-rate spread is narrow.

Often, a borrower from an SBIC pays no more than one-fourth of 1 percent over the SBIC’s cost of funds. Moreover, because an SBIC does cover operating expenses on the loan portion of its portfolio, it can afford to lower its sights on expected returns from equity participations. For this reason, the terms of an equity deal with an SBIC are usually more favorable for you than would be possible with other venture capitalists. Here are a few additional details:
Length of loan. By law, the term of all SBIC loans must be between five and 15 years. As a practical matter, however, few SBIC loans are made for more than 10 years. Most SBICs prefer loans that mature in about seven years.

Equity participation. Usually, an SBIC makes a convertible loan, under which it reserves the right to convert the loan to common stock at specified, prenegotiated times. Amounts of common stock available for conversion and the conversion terms will, of course, depend on the size of the loan and the inherent risk in your company. In no case, however, can the SBIC assume control of a company—it’s prohibited by law from doing so. As with venture capital companies, most SBICs will offer management assistance, should you need it. Cashing in. Upon conversion, the SBIC might dispose of the stock in a number of ways, including a public offering, a private sale or possibly even selling the stock back to the company. Whatever the case, you will usually explore the alternatives thoroughly during negotiations.

➤ Observation: To get started with an SBIC financing, you will need a detailed business plan. Also, look around for an SBIC that has some familiarity with your industry and its problems. Finally, some SBICs prefer to concentrate only on fast-growing companies, while others are satis¬fied with companies growing at a more deliberate pace.

Virtually all SBICs are members of the Small Business Investor Alliance, formerly known as the National Association of Small Business Investment Companies. This organization can tell you all you want to know about SBICs, including the location of those nearest you. For more informa¬tion, visit www.nasbic.org.

The Role of the Private Investor
For small, closely held firms, private investors are by far their most important source of equity capital. This equity can take a number of forms. Usually, equity capital denotes common stock, but many private financing deals involve preferred stock, debentures or even warrants that are convertible into common stock. Thus, while an ownership interest is almost always involved, it need not start out with common stock.

Don’t expect a private investor to accept a passive role in the firm. They are almost always active investors looking to contribute more than capital. Usually, as part of the investment agreement, they act as consultants or serve on your board of directors. Thus, in a search for investors, managers should attempt to identify those investors with experience and skills that can contribute to the company’s progress.

As a rule, investors in closely held firms are willing to accept a greater degree of risk than investors in public companies. In return, they expect to receive higher rewards. In a sense, then, you are buying capital rather than selling equity. The rewards that you are willing to grant to your investors are, in effect, your cost of capital. Therefore, the higher the risks, the greater the capital costs. Obviously, there can be no hard-and-fast rules for determining the extent of the returns you must offer to attract private investors, but there are some broad guidelines for establishing possible ranges. For instance, in a start-up situation, investors usually expect to earn about 10 times their investment in five years, a compound annual return of 60 percent per year.
Private investors in fledgling firms usually expect to earn about six times their investment in five years, a still-high annual compound return of 43 percent. A relatively young firm would have to offer private investors the chance to quadruple their money in five years to attract capital, and even an established firm would need to offer them the opportunity to triple their money in five years. That works out to compound annual returns of 38 percent and 25 percent, respectively.

➤ Observation: Expensive as they seem, expectations for private investors, even in high-risk, early-stage companies, are significantly lower than those for professional venture capital firms. In part, this seeming discrepancy stems from the “not-for-profit-only” characteristic of many private investors. In most instances, private investors back companies partly for noneconomic reasons, such as achieving a worthwhile social benefit, helping a friend or fulfilling a community need.
Private investors tend to be much less formal than their professional counterparts. Still, on aver-age, they turn down two out of every three deals offered to them. You can improve your chances of making a favorable impression on private investors by following these important guidelines:


● Be specific. Put your proposal in writing. Don’t expect to wing it simply because the potential investor is an individual or a friend, rather than an institution. Most private investors require a well-defined business plan. Even where a business plan is not necessary, you should draw up a well-thought-out financing proposal.
● Be realistic. This includes an objective appraisal of the prospects and problems facing your company, and the risks and potential rewards in the investment itself. Any attempt to minimize risks or problems will almost certainly cause the investor to back off.
● Discuss your management team. In reviewing a small company, nothing is more impressive to a potential investor than a dedicated, competent management team. Make sure you demonstrate that to potential investors.

The primary reason for the increased risk incurred by a private investor is the lack of liquidity in the investment. In other words, it can be difficult to find a buyer for the stock of a closely held firm, particularly for a minority interest in that firm. Therefore, you will probably need to offer an exit formula. Usually, this involves the right to tender the stock to the company at a specified date and at a price related to book value, cash flow or earnings. Another common exit formula sets aside an agreed-on percentage of earnings to purchase a segment of securities held by the investor at a prearranged price.

➤ Observation: When negotiating an exit formula, remember that private investors normally have much longer time horizons than the three to five years favored by venture capitalists. One recent poll disclosed that nearly 25 percent of all private investors either had no time preference or expected to hold their investments for more than 10 years.
How do you find a suitable private investor? This can be a thorny problem: There isn’t exactly a referral service geared toward putting potential private investors in touch with companies seeking equity capital. To locate prospective investors, you will be forced to build your own network. Your most fruitful source of information will probably be your friends and business associates.

Investment bankers are another common source. Your other professional advisers, such as accountants, lawyers and bankers, may be helpful. Finally, be sure to investigate any venture capital clubs in your area, as well as business and community associations. (Note: Venture capital clubs are groups of individual investors, and should not be confused with venture capital firms.) Community associations can be particularly important because private investors tend to concentrate on companies in their geographic areas so that they can maintain close contact with their investment.