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Home > About BNE > Press Room > 2012 Archive > February > S.B.A. Readying Program to Invest in Start-Ups

S.B.A. Readying Program to Invest in Start-Ups

By ROBB MANDELBAUM

With its legislative agenda for job creation stuck for the foreseeable future, the Obama administration has turned inward, looking to the federal bureaucracy for new ways to jump-start the economy.

Lately its gaze has settled on the Small Business Administration. Yes, it has proposed merging the S.B.A. into a much bigger government agency dedicated to business and trade. But an arguably more consequential decision came in December, when the S.B.A. unveiled a new $1 billion program to invest in young companies by loaning money to venture capital funds. Unlike the reorganization, which faces long odds in coming to pass, the new investment program, part of the administration’s Startup America campaign, is likely to commence this spring. But what remains unclear is whether it can win over the venture capital industry that it is meant to assist.

The new program would allow venture funds licensed by the S.B.A., known as small-business investment companies, to borrow money from the agency to augment the capital they have raised from private investors. A successful fund that borrows money generates higher returns for investors when it sells those stakes, since the lenders don’t share in the profits. Companies seeking financing would not contact the S.B.A. directly, but instead — as with any venture financing — would approach the small-business investment company, which would judge prospects on the strength of their business plan and management.

The new effort, christened the Early Stage Innovation Fund, fills a gap in the S.B.A.’s menu of assistance. For all of the different kinds of financing a small company can obtain from the S.B.A., the agency has not had a way to nurture fast-growing start-ups since 2004. That earlier program, which allowed small-business investment companies to essentially sell equity stakes in their portfolio companies to the agency, collapsed with big losses in the wake of the tech bubble a decade ago. The program’s complex terms, set by Congress, ensured its failure, said Brett Palmer, president of the Small Business Investor Alliance, a trade association for the investment companies. When a fund went belly-up, the government’s claim took priority for recovering assets, alienating other investors. However, the government saw very little of the profits on successful investments.

“The taxpayer had too much downside risk and not enough upside risk,” said Mr. Palmer. “It was overly complicated so nobody really understood how it worked, candidly. It still has people baffled.”

The new fund is more straightforward, and is an in fact a variation on another, much more successful, S.B.A. program, in which the investment companies loan the money they’ve borrowed from the S.B.A. to their portfolio companies. But investment companies can seldom reach the youngest start-ups, because these businesses often lack the cash flow required to make the quarterly interest payments, so the agency has tweaked the rules for the Early Stage Innovation Fund to make it easier for venture funds to use debt to buy equity.

The S.B.A. plans to use the Innovation Fund to channel investment into growth companies normally overlooked by venture capital funds. It turns out there is a gap in the venture economy that mirrors the agency’s own: venture funds typically invest in more established companies. In the first nine months of 2011, they reported directing just $727 million to companies in the so-called “seed” or conceptual stage, or 3 percent of the total $21 billion invested in the period, according to the National Venture Capital Association. Early-stage companies, usually those still testing a product or service, received $6 billion, just over a quarter of the total. At least half of the investments venture funds participating in this program make must be in companies without positive cash flow from operations.

Moreover, nearly three-quarters of venture financings go to companies in just three states: California, Massachusetts and New York, said Sean Greene, the S.B.A.’s associate administrator for investment and special adviser for innovation “There are places all over the country — Raleigh-Durham, Minneapolis, Austin — where there already is a big innovation ecosystem and there are already funds that are investing in those ecosystems,” Mr. Greene said. “But those firms are facing great challenges raising capital right now.” The new fund “will have a significant impact on the seed investment activity in the other 47 states.”

Mr. Greene said the S.B.A. had taken steps to minimize taxpayer risk in the new fund. Leverage is limited to the amount of private capital a fund has raised, up to $50 million. (In the regular S.B.I.C. program, the limit is three times the investment capital, up to $150 million.) A fund must also raise at least $20 million privately. In effect, then, only between four and 10 funds can participate in any year.

But Mr. Palmer said that could create other problems. “It’s a question of whether this innovation fund is too small to gather enough attention from the players who would invest in such a fund,” he said. “The limited partner community is very cautious — they really want to do a deep dive before they put their money into any investment class. Is it worth limited partners’ time to learn about the new product for which there may only be four or five funds, and of which they’d only be a fraction of each?”

Clay Thorp, of Hatteras Venture Partners in Durham, N.C., said that the poor track record of the S.B.A.’s earlier program could make investors wary of the new one. But, he added, “the changes they’ve made answer a lot of problems from the prior program. I think there really needs to be an education program for the limited-partner community and others about why this program is better. And the S.B.A. is doing that.”

One concern that remains, Mr. Thorp said, is that the new program, like the old, is “a debt structure underneath an equity fund” — an inherent mismatch, since interest and debt payments are predictable while an equity investment is anything but. “The perfect policy would have been an equity program where the S.B.A. would be a limited partner in the S.B.I.C. fund.” But Mr. Thorpe acknowledged there is little appetite in Washington for something so ambitious — and risky. “Within the constraints that they have, they’ve done the very best that they can.”

That, he added, may be good enough for his own fund. “The way they’ve modified the program makes it much more attractive to early-stage venture capital groups like Hatteras, and we’ll continue to evaluate whether this might be a program for us,” he said.

Mr. Greene said that the S.B.A. hoped to solicit applications from investment companies in April and issue its first licenses by the end of September.