Small Business Investment Companies Are a Good Alternative to VC Funding
You know about the major pros and cons of venture capital funding; However, there are also alternatives to traditional venture capital that would be better sources of funding for many small businesses.
Back in 1959, the Federal government needed inventors and private companies with good ideas to help create technology for the fledgling space race and cold war. Back then, venture capital firms as we know them today extremely rare. In order to entice capital into companies that were creating technology for NASA and defense purposes, Congress passed a law establishing what are now known as SBICs, or Small Business Investment Companies. Through significant tax benefits and later guarantees from the Small Business Administration, investors in SBICs were not only protected from failure of the investment fund, but also reaped (and still do) additional profits and capital gains from various programs supported by the SBA. Really, SBICs were the first venture capital firms to really provide significant benefits to society via technology creation.
It really isn’t important to know how the SBICs work internally, but there are many common characteristics about SBICs that make them more attractive funding sources than traditional venture capital firms. Currently there are over 350 SBA licensed SBICs in the U.S. All of them must follow a core set of rules to operate and obtain the benefits of being an SBIC
SBICs are private equity funds. Much like a traditional VC, SBICs are funded by institutional investors and individuals. However, because of investor protections provided by the SBA, many banks either have their own SBIC or invest with others in one. The purpose of an SBIC is to obtain a significant return on investment for its investors, just as a VC does, but they often don’t need to obtain all of their return from companies they invest in because a pretty substantial amount of their returns are created by contributions by the SBA.
SBICs must apply for a charter from the SBA and the capital requirements and process of obtaining SBA approval is as hard as the approval process to start a Federally insured bank. In exchange for the SBAs support, SBICs agree to follow a common set of rules.
Whereas a traditional VC often want a controlling interest in a company, SBICs are prohibited from owning over 49% of a company.
Nearly all VCs want significant board of director rights, while most SBICs will want minimal board seats, or will only require board visitation rights.
SBICs have several different models they can operate under. For start-up companies that receive SBIC investment, it is often in the form of equity, similar to that of a VC. For more mature companies that are generating strong revenues and profits, SBICs will often make their cash injection in the form of a loan (usually 7 years) with warrants. The rate of interest is set at a maximum rate by the SBA and is usually changed semi-annually. Warrants are securities that allow a warrant holder to buy a share of stock similar to an stock option. When the loan has matured or the company has sold the SBIC exercises its warrants and gets additional cash for its involvement which increases its return on investment to the SBIC shareholder.
In my career, I have found SBICs a much more preferable choice to traditional VCs and if your company is seeking equity from a VC, you should most certainly look at SBICs as a good alternative.
SBICs tend to either operate in a regional or geographic area, or they specialize in a vertical market. To find an SBIC near you or in an area that would be interested in your company, go the National Association of SBIC Web site for a listing.
Sam Thacker is a partner in Austin Texas based Business Finance Solutions.
You may contact Sam directly at: sam@lesliethacker.com
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