In the United States, lenders to emerging growth companies often fund loans from an entity licensed under the Small Business Investment Company (SBIC) program of the US Small Business Association (SBA).

For both lenders and borrowers, SBIC funds are attractive because the funds typically have a lower cost of capital. SBIC loans, however, require that the borrower meet certain criteria to qualify. The key criteria for borrowers to qualify for an SBIC loan are detailed in the following summary.

Size Qualification

To be eligible for SBIC financing, a borrower must first meet the SBA’s “small business” size qualifications. The borrower must either satisfy financial size standards or industry size standards.

  1. Financial Size
    To meet financial size standards, the borrower, together with its affiliates, must have a tangible net worth of less than US$19.5 million and an average of US$6.5 million or less in net income (after US federal income taxes — excluding any carry-over losses) over the previous two years at the time of investment (i.e., when the loan is funded).
  2. Industry-Determined Size
    A borrower can meet industry-specific size standards based on the SBA’s published table that lists industries by the North American Industry Classification System (NAICS), with accompanying size standards — in either dollars or numbers or employees — for each industry. For instance, in certain “information services” industries, a borrower satisfies the industry-determined size standard by having (with affiliates) average annual receipts of no greater than US$27.5 million. In the “internet publishing and broadcasting and web search portals” industry, a borrower satisfies the industry-determined size standard by having an average of no more than 1,000 employees among the borrower and affiliates.

Ineligible Activities

Notwithstanding a borrower satisfying SBA’s size qualification, SBIC financing is unavailable for companies engaging in prohibited businesses. Proceeds of SBIC financings cannot be used in several capacities, including, but not limited to: relending, reinvesting, passive businesses, real estate, project financing, farm land purchases, and uses contrary to the public interest or inconsistent with free competitive enterprise (although the exact meaning of “free competitive enterprise” is unclear). Most importantly, the SBIC loan cannot be used for foreign (non-US) investments and purposes.

SBIC funds are “licensees” under the SBA — investment funds selected by the SBA and subject to ongoing compliance with the SBA regulatory framework. SBIC funds can include venture and private equity firms and funds (often set up as SBIC-dedicated affiliates).

SBIC funds often require that the borrower comply with covenants and make certifications, representations and warranties to ensure compliance with SBA requirements.

SBIC funds may invest in:

  • Buying equity securities, such as:
    • Stocks
    • Stock options
    • Warrants
    • Limited partnership interests
    • Membership interests
    • Joint venture interests
  • Funding debt (loans)
  • Buying “debt securities,” such as loan-related documents with an option or other right to acquire equity securities, convertible loans and certain loans with the right to receive royalties.

A change in the SBIC-funded borrower’s size has no bearing on the SBIC fund, and the SBIC fund may generally provide additional financing until the borrower completes an initial public offering (IPO). An IPO, however, does not affect loans or investments made prior to the IPO.

Nevertheless, a borrower must continue to meet the SBA-eligibility requirements (as previously described) within the first year after SBIC financing closes. If the borrower cannot meet the eligibility requirements, an SBIC fund may request written approval from the SBA for an extension.

The borrower receiving funds from an SBIC fund will be required to prepare and execute various SBA-mandated documents that are largely factual. The following forms are common SBA documents and depending on particular circumstances, the borrower may need to submit additional forms.

SBA Form 480 — the Size Status Declaration: requires the borrower to certify (and the SBIC fund to confirm) that the borrower meets the size qualification standards for SBIC financing. Form 480 involves various factual questions (mainly yes/no) and worksheets (as applicable) addressing the size qualifications.

SBA Form 652: requires the borrower to comply with SBA regulatory requirements regarding nondiscrimination and related recordkeeping obligations.

SBA Form 1031 — Portfolio Financing Report: requires disclosure regarding terms of the SBIC financing, as well as financial and other basic information. The SBIC fund typically completes Form 1031 and submits it to the SBA.

Side Letter / SBIC Covenants: some SBIC funds require a company to enter into a separate standalone “side letter” whereby the company represents and warrants that the company meets the eligibility and compliance requirements for SBIC financings and that the company will continue to do so. Alternatively, some SBIC funds may include such provisions in the underlying loan agreement (or as an annex thereto).

SBIC-backed funding can offer startups an additional option for financing growth, often at a lower cost.  The detailed requirements to access SBIC-backed funds may pose an additional burden, but most companies find these administrative burdens relatively easy to deal with and well worth the improved access to lower cost funding.

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