The granddaddy of VC

Editor's note:
This article, and others in this issue, are a follow-on discussion to the entrepreneurship and venture capital articles published in the July 2001 fedgazette.

Although many government programs relating to venture capital are in their infancy, such programs are not without historical precedent. In fact, the public sector has been making equity investments in young companies and providing incentives for others to do so for more than four decades.

Most of this activity has been through the Small Business Investment Co. (SBIC) program. Run by the Small Business Administration (SBA), it started in 1958 after research from the Federal Reserve Bank of Boston showed that small companies faced a critical lack of early-stage capital. The program allows SBICs—SBA-licensed financial institutions—to leverage their existing capital to borrow up to four times as much capital from the federal government at below-market rates. The program requires that this capital then be invested (either as equity or debt) in small, young companies.

In some ways, the SBIC has helped nurture and grow the VC industry itself. "It helped institutionalize the venture capital industry. It brought the government's imprimatur," said Harry Haskins, the program's deputy associate administrator for investment.

Patrick Von Bargen, executive director of the National Commission on Entrepreneurship, said SBICs "made [equity] investing in high-risk [companies] acceptable in banking," and had the added benefit of training some people that would later become today's venture capitalists.

ALL SBIC PROGRAM LICENSEES
FINANCING TO SMALL BUSINESSES

Reported for Fiscal Years 1991 to 2000
(Millions of Dollars)

Fiscal Year Ended September	Total Financing Number	Total Financing Dollars	Equity Only Number	Equity Only Dollars
1991	1,983	490.4	323	223.5
1992	1,999	544.3	364	245.7
1993	1,992	806.3	338	376.0
1994	2,348	1,000.6	390	454.5
1995	2,221	1,249.0	438	641.2
1996	2,107	1,616.0	551	893.5
1997	2,731	2,369.0	711	1,372.9
1998	3,456	3,239.4	935	2,170.7
1999	3,096	4,220.9	1,189	3,057.0
2000	4,639	5,466.3	1,966	4,021.3
Source: Small Business Administration

The program targets the start-up phase of a company's development, where ideas are honed and products are designed—a stage often deemed too risky even by venture capitalists, whose focus is investment return and not economic development. According to PricewaterhouseCoopers, last year almost 60 percent of venture capital deals and total dollars went to companies in the so-called expansion stage (when a product is ramped up for wide distribution and sale). Another 30 percent of deals and money went to companies in the early stage (when products are test-marketed). Just 7 percent of deals and 3 percent of the $88 billion in venture capital investments in 2000 were for companies in the startup or seed stage.

The SBA doesn't calculate deal making in the same terminology, but about 60 percent of SBIC deals in 2000 involved companies that were in business three years or less. Very young firms typically have lower capital demands as well, which is how SBICs managed to make almost 50 percent of all venture capital deals from 1995 to 1999, but doled out less than 20 percent of all money during this time (see charts).

Source: Small Business Administration

Ups and downs and ups

The first 30 years of the program saw some ups and downs. After an early rush, the number of companies financed fluctuated between 1,500 and 3,000 through 1990, and total capital invested in these deals grew steadily to about $500 million in the mid-1980s and then plateaued. Default rates rose and the program was considered for the chopping block. In 1992 alone, 22 SBICs were transferred to liquidation, still holding more than $120 million in government loans, according to SBA figures.

Shortly thereafter, the SBA added a new "participating security" license for venture capital-type financial institutions, and introduced a new wrinkle of postponing loan repayments on equity deals until such investments made by an SBIC had "cumulative profitability"—or when the entire portfolio showed investment gains, according to Haskins. He said the main reason for doing so was because "you had to have revenue to make [semiannual] debt payments," but equity-based investments don't typically generate any revenue in their first few years.

To rein in high default rates, the program also increased minimum standards for private capital and management experience necessary to receive an SBIC license, Haskins said. In return for postponing payments—typically two to three years, although four or five years "was not unusual," Haskins said—the SBA receives 10 percent of SBIC profits and to date has earned better than $250 million.

This simple shift has made equity investments more attractive for venture capital firms, banks and other financial institutions with an SBIC license. The program has since exploded in unison with the private venture capital market, particularly in the last few years. Total financings doubled from 1998 to 2000, reaching their highest point in 35 years, and the total capital involved in these deals grew almost 15-fold from (fiscal years) 1992 to 2000, reaching $5.4 billion.

Though SBICs offer both debt and equity financing, equity deals are responsible for most of the growth in deals and money committed by SBICs. From 1992 to 2000, the total value of SBIC equity deals grew from $245 million to over $4 billion (see chart on previous page). From 1995 to 2000, the number of SBIC licenses grew better than 40 percent, and the amount of outstanding SBA leverage tripled to more than $3 billion.

Yet while it has helped expand the equity capital pool, the SBIC program has done little to shift its geographic dispersion. There are 16 SBICS in Minnesota, four in Wisconsin, one in North Dakota and none in either Montana or South Dakota, according to the SBA. In contrast, there were 66 SBICs in California and more than 100 in the Massachusetts-New York corridor.

Although SBICs can cross state borders to finance a deal, this ability also hasn't managed to shift larger distribution patterns of the venture capital industry. A cumulative analysis of nationwide deal making by SBICs from 1996 to 2000 showed that Minnesota and Wisconsin ranked 13th and 24th in total deals, and 19th and 20th in the total amount of money received, respectively. In this five-year period, Montana and the Dakotas saw a combined 21 deals worth about $28 million. California saw roughly six times the amount of SBIC money, and New York had about eight times the number of SBIC deals, as all Ninth District states combined (excluding Michigan).

"We do tend to mirror the venture capital industry as a whole in many respects," Haskins said. "We'll exhibit the same concentration but not to the same extent."

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