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BusinessLINC: Learning, Information, Networking, and Collaboration
Business-to-Business Relationships that Increase the Economic
Competitiveness of Firms
A Report to Vice President AI Gore (December 1998)
Report prepared by:
US Department of the Treasury and US Small Business Administration
Case studies prepared by:
Initiative for a Competitive Inner City (ICIC)
1. Chase Manhattan Bank's Business Resource Center
2. Turner Construction's James Walker Construction Management Training Program
3. GM Minority Mentoring Program
4. McDonald's Corporation's Franchise Support Program
5. NCR Corporation's Business Advisory Programs
4. McDonald's Corporation's Franchisee Support Program
McDonald's relationship with its independent franchisees exemplifies a version of business
advisory programs that is quite different in scope from many of the mentor-protege programs
discussed in this report. Far from an auxiliary function, the support that McDonald's provides
for its franchisees is one of its core functions.
Close to 85 percent of McDonald's 12,000 U.S. restaurants are owned and operated by
individual entrepreneurs who have invested their own capital. These are independent small
businessmen and women who run restaurants with average sales of $1.5 million in their local
communities. On average, the typical McDonald's franchisee owns 3.5 restaurants.
In the early days of its expansion into economically distressed markets, McDonald's made an
extensive effort to offer special services to inner-city operators. For example, McDonald's
offered special training in the late 1960's to African-American operators in isolated inner-city
neighborhoods in Chicago. This outreach began with consulting services focused on the unique
challenges associated with doing business in urban environments. An Urban Operations
Department was formed, and has since been incorporated into McDonald's comprehensive
business development strategy.
McDonald's corporate commitment to expand into economically distressed neighborhoods
demonstrates the company's core belief that market principals can be applied in these areas.
The company's standard procedures in the recruiting and training of franchisees, as well as its
standard support structure for franchisees, have been sufficient to develop and maintain stores
in the inner city.
FRANCHISEE DEVELOPMENT PROGRAM
Recruiting
McDonald's actively seeks racial, ethnic, and gender diversity among its franchises. In the
United States, women and minorities represent about 35 percent of all McDonald's franchisees,
while minorities make up 65 percent of the company's candidates in training to own future
franchises. McDonald's also encourages residents of the inner city and other traditionally under-
served areas to work toward franchise ownership.
McDonald's has an active and continuous outreach program to attract a diverse range of
individuals with the potential to own and operate a McDonald's franchise. As McDonald's CEO
Jack Greenberg says, "It's not just the right thing to do from a moral and ethical point of view,
it's also the right thing to do from a business standpoint." Some of the qualifications
McDonald's looks for in prospective franchisees include:
Entrepreneurial spirit and a strong desire to succeed;
B-22
Appendix B
A strong business background with special emphasis on interpersonal skills and financial
management;
Willingness to devote full-time and best effort as an "on-premise" owner/operator;
Willingness to participate in a training program that may take 12-24 months to complete.
The course time can be accelerated if a candidate masters the skills more quickly.
Training
Over the years, McDonald's has developed and refined an extensive training and support
program for its franchisees. The training program is one of the most rigorous in the business,
including part-time hands-on training in a McDonald's restaurant interspersed with classroom
training, culminating in the Advanced Operations Course at Hamburger University (HU). This
course focuses on management skills such as accounting, finance, human resource management,
and marketing.
McDonald's Franchisee Development Program
1. Restaurant Orientation
5. Intermediate Operations Course
Learning different operations, managing food
A four-day course covering such areas as im-
production and directing employees.
proved restaurant performance, managing costs
and crew labor and training.
2. Basic Operations Course
6. Restaurant Training
A five-day class covering communications,
training, food safety, product quality, customer
Addressing advanced supervision, planning,
satisfaction and other areas of restaurant opera-
quality, service and cleanliness, people skills and
tions.
financial management.
3. Hands-on Restaurant Training
7. Advanced Operations Course
Includes managing crew shifts.
A six-day course at Hamburger University focusing
on effective people practices, staffing and reten-
4. Basic Management Course
tion, management skills and building market share.
The four-day class includes tests in handling
customer issues, employee hiring, equipment
knowledge, time planning and basic
management practices.
As part of the training program, applicants must master all of the crew and management
functions at the restaurant. The training in restaurants is free-of-charge, and participants work
without compensation. This training is the same for all applicants, and applies equally to urban,
suburban, and rural restaurant settings.
B-23
Appendix B
McDonald's makes a number of other training courses available to its franchisees. Additionally,
since HU is accredited by the American Council of Education, franchisees may earn up to 32
college credit hours. Franchisees who successfully complete the training are approved to acquire
a McDonald's restaurant.
Ongoing Development and Support
Candidates who successfully complete the training program and become independent franchisees
continue to benefit from support through the McDonald's network. McDonald's assigns a
business consultant to each franchisee, who assists them in developing annual business plans and
consults on the application of appropriate strategies to achieve their individual goals. Business
consultants evaluate franchises on an ongoing basis, and assign their restaurants a letter grade
based on their overall performance and progress during the entire year. Franchisees also have
access to the expertise of a cadre of regional, divisional, and corporate staff members in
marketing, operations, and finance.
Many franchisees receive personal business-to-business assistance by working with a fellow
franchisee who has the needed experience and expertise. Because of the mutually dependent
relationship between McDonald's and its franchisees, continuous two-way communications is a
top priority. The company strongly supports the creation of franchisee advisory groups, whose
individual leaders and members are elected by the franchisees. As a result, franchisees have
established the National Black McDonald's Operators Association, the Women's Operators
network, the Asian Operators Association, and the McDonald's Hispanic Operators Association.
These independent, grass roots organizations voice the needs, concerns and ideas from the
franchisee community directly to McDonald's company officials.
New franchisees can also draw support from other franchise owner-operators. McDonald's often
facilitates this business-to-business assistance by pairing a franchisee in need of assistance with a
fellow owner-operator who has achieved success in that geographic area.
While McDonald's makes an effort to attract restaurant owners who possess both the desire and
the resources to succeed, an applicant for a conventional franchise should have a minimum of
$125,000 in non-borrowed personal assets. However, candidates with a minimum of $75,000 in
such assets may become eligible through the company's Business Facilities Lease (BFL)
program. Through the company's Business Facilities Lease program, they enter an agreement
with McDonald's whereby they lease the seating, interior restaurant decor, kitchen equipment,
and outdoor signs that franchisees ordinarily buy outright. McDonald's typically grants them an
option to buy these items at a later date.
B-24
Appendix B
McDONALD'S AND WILLIAM EDWARDS, AN OWNER-OPERATOR
On November 17, 1992, William Edwards became an owner of a McDonald's in the Northeast
section Washington, DC, which at the time was a highly distressed neighborhood. Throughout
the 1980s, he owned and operated a national chain service station in Miami's Liberty City.
Edwards decided that becoming a McDonald's franchisee would give him the economic stability
he was looking for. When he took the first step to contact the company's franchising manager in
Boca Raton, Florida, he had already decided on McDonald's. Competition to become a
franchisee was very intense, Edwards was warned. McDonald's is one of the most sought after
franchise companies, with more than 10,000 inquiries every year.
Over three interviews, Edwards convinced McDonald's that he had the right attributes to become
a franchisee. "They were looking for people who had some business knowledge. But the thing
they were most interested in was to see if I was a people person. They could teach me the
business part. But they wanted to make sure I could deal with people," recalls Edwards.
Most of the training took place on site in the stores. Edwards moved around quite a bit between
independent operator stores and company stores as well as urban and suburban locations,
exposing him to a wide variety of issues and challenges of running a McDonald's store. He says,
"I had experience running a store in a distressed area, so the exposure to the suburban clientele
helped me learn to deal with a completely different type of customer."
The training progressively built up Edwards' capacity to operate a store. By the time he was in
the Advanced Operations Course he was running an entire store by himself. "The operator
agreed to step aside for the period I was there, and I was responsible for running the whole thing.
This level of trust also put a lot of pressure on me," says Edwards.
McDonald's provided Edwards with information about McDonald's restaurants for sale, and he
settled on a company-owned store in Washington, DC. To buy the $500,000 store, Edwards
needed to make a down payment of $125,000. "I was $50,000 short on the down payment,"
recalls Edwards. McDonald's offered to give him a loan to close the deal until he could liquidate
a personal asset. "I stalled a bit because I wanted to come up with all the cash," says Edwards.
Unable to raise this amount in a short period, Edwards accepted McDonald's financing offer. He
was, however, able to liquidate his asset to repay this note within 30 days.
"The first year of running the business was difficult, but there was a lot of support from the
company, recounts Edwards. "Especially the first 90 days the company provided some
financial assistance for instance." He continues, "There were a lot of business consultants
coming in and out all the time."
B-25
Appendix B
While McDonald's is under no obligation to provide extra assistance to its franchisees, when
McDonald's deems it appropriate, the company can offer additional financial benefits. In 1992,
McDonald's helped Edwards with reinvestments in his restaurant building and facilities, as well
as paying for security so that he could target his resources to help staff his restaurants.
McDonald's regards this kind of assistance as an investment in good owner/operators, a targeted
effort to help them build sales, make themselves more profitable, and ultimately make the
company more profitable, too. This reflects a McDonald's business fundamental - the company
and its franchisees enjoy a mutually beneficial relationship.
The second year, however, proved to be even more trying. "I almost went bankrupt," says
Edwards. With high costs and sinking revenues, selling the store was not too distant an option.
"But I had a sense of responsibility toward both my family and the people working at my store.
If I sell this store, the next person coming in might decide the workers were part of the problem
and get rid of them," explains Edwards. "I owed it to my family and to my workers to try to find
a solution and turn the business around," he says. That's when he asked Mike Hicks, one of
McDonald's field service managers, to come in and offer advice.
Mike Hicks offered to bring in a field service team for four days and assured Edwards that
everything from operations to physical appearance would change fundamentally. "They came in
like a storm," recalls Edwards, "and started cleaning the floors, the walls, changing equipment,
They even changed the roof." Edwards' store was an older model. The repairs and all the
changes cost more than $100,000 dollars, all of which McDonald's covered.
The presence of the field service team also helped boost employee morale at the store. "Here you
had pretty high-level white managers kneeling down and scrubbing the floor, cleaning
bathrooms, making hamburgers and they were doing all of this while being extremely
courteous and friendly to all the workers and the customers," says Edwards. "This just boosted
McDonald's image in the neighborhood." For Edwards, it was also comforting to learn that the
company had the support structure to help him through difficulties when necessary.
Aside from the field service team's help, Edwards attributes his store's turnaround to support
from local and regional operators. McDonald's encourages local councils of operators and local
marketing cooperatives, which provide a strong network of information and expertise for all the
operators. "Despite the problems each of us may have," Edwards says, "we take care of each
other." This mutual support sometimes takes the form of providing crews that have the expertise
to address targeted, specific challenges, helping each other in diagnosing problems and
proposing solutions, temporarily covering for an operator who is having a personal or family
crisis, "and sometimes even helping out financially," says Edwards.
The change in operations and employee morale, combined with the support from field service
and other owner-operators, has helped Edwards turn his business around. This past year he
generated close to $2.5 million in sales from his Northeast DC store alone. On April 20th, he
opened a second store, this time a new one with brand new equipment and facilities, in the
B-26
Appendix B
Federal Plaza Building in DC's Southwest area. "I am hoping to own one or two more stores in
the next year or so,' concludes Edwards.
VALUE CHAIN ANALYSIS
Figure One illustrates the impact of the franchisee support program on the value chains of
McDonald's and the Edwards franchise. McDonald's sees the program as an essential part of its
marketing and after-sales service functions, since the success of its franchisees has a very direct
impact on its ability to sell both its products and its franchises. For the franchisee, the program
offers support for most of the major business functions, including planning, human resources,
operations, and marketing.
LESSONS LEARNED
Pairing new franchisees with other franchisees for support and advice is one of the most
effective ways to help them manage the challenges of new ownership. Through a
voluntary network, like-minded businesspeople can create an invaluable pool of experts
and advisors.
In the case of McDonald's, two factors contribute to the success of the voluntary
networks of franchisees: McDonald's strong brand name and the similarity of issues
shared by its operators have helped foster strong inter-store networking.
The standardization of products and procedures enables McDonald's to have an
"army" of experts out in the field who can move around and provide acute support to
operators in need.
Requiring candidates to commit to a rigorous training program -- which they do not pay
for, nor are they compensated for -- allows the company to find the strong franchisees,
and allows the candidate to make an informed business decision.
Training of franchise candidates in multiple settings allows the trainees to become
familiar with management and marketing issues and develop a wide network of
relationships with fellow operators, managers, and the company support system.
Developing a network of successful franchises requires substantial investment in training,
financial support, and well-planned support systems.
Franchising may not be for everybody, but linking the right person with the right
company can be a "win-win" business proposition.
B-27
Appendix B
Sources:
William Edwards, McDonald's Franchisee, Washington DC
Herman Petty, McDonald's Franchisee, Chicago, IL
Robert Beavers, Senior Vice President, McDonald's Corporation
Walt Riker, Media Relations, McDonald's Corporation
Lisa Howard, Media Relations, McDonald's Corporation
B-28
Appendix B
Figure 1
The impact of the franchisee support program on
companies' value chain
McDonald's Corporation
Firm Infrastructure (Strategy Planning, Financing etc.)
Human Resources Management
M
Technology Development
a
Procurement
r
g
Inbound
Operations
Outbound
Marketing
After-Sales
Logistics
Logistics
& Sales
Services
n
Strong network of profitable
independents that sell and
market McDonald's products
Success of franchisees keeps
demand for new franchises
strong
Inner-City Franchisee
Strong network of
owner-operators
who share
Firm Infrastructure (Strategy Planning Financing etc.)
information on
Human Resources Management
best practices
Technology Development
M
Extensive training
a
program for owner-
Procurement
r
operators
Assistance with
g
Inbound
Operations
Outbound
Marketing
After-Sales
financing
Logistics
Logistics
& Sales
Services
n
Field service support
Marketing
to resolve major
cooperatives
operating problems
to increase
local advertising
B-29
Appendix B
How Venture Funds Work.r
Page 1
Investment
Division
How SBICs Are Formed & Operate
The Structure of Venture Funds
Venture capital funds do not follow customary corporate organizational structures.
They are usually not infinite life entities that look to sell out or go public in order to
make their investors and managers rich. They are generally limited life entities (10
years with one year extensions that usually lead to 15 year lives). Investments are
made during the first five years and the majority harvested over the ensuing five to
ten years. Often, especially when the stock market is booming, some investments
will mature during the first five years, but this is not within the plan; it is
considered "fortuitous".
For legal and tax reasons, there are usually three entities in the creation of a
venture fund:
1. The limited partnership (LP) into which the investment money is placed, and
this is the entity which makes all the investments. This entity has Limited
Partners (the money investors) who put up 99% to 100% of the funds, and
get about 80% of the profits. The other 20% goes to the general partners.
The limiteds are insulated from personal liability for the activities of the
partnership.
2. The general partners, in turn, insulate themselves from liability by forming a
General Partner of the limited partnership, historically a corporation, but
nowadays is starting to tend toward LLCs (Limited Liability Companies).
3. The third entity is a management company which contracts with the general
partner to conduct the day-to-day activities of the limited partnership. Almost
always, the general partners own and manage the management company.
The management company also usually employs a part-time bookkeeper and
an administrative assistant, and if the fund is larger, a CFO (Chief Financial
Officer), associates, and junior analysts. As with the general partnership, the
management company isolates both the limited partnership and general
partner from the everyday liabilities encountered in the daily conduct of
How Venture Funds Work.rtf
Page 2
business that the management company may incur.
The financial goal of investors is to obtain cash-on-cash returns from their
investments, taking into account the time value of money. Thus, venture funds not
only like to obtain high profits on their investments, they ideally like to achieve
them as soon as possible, even though in their heart-of-hearts they plan on a five
year time horizon, and even longer for early stage deals.
The Goals of Investors
Investors in a venture capital fund are seeking risk-adjusted returns. They are
seeking returns that exceed those found in the stock market. Please keep in mind
that all returns are relative. If stock market returns are 16%, venture investors will
be seeking 23% per year internal rates-of-return (IRRs). If stock market returns are
lower, a 15% IRR to investors may be sufficient. In today's world, the most
successful SBICs are achieving IRRs of 30%.
While most SBICs hold out the prospect of 16% to 23% IRRs, we only expect an
average of about 10.25% to be achieved overall within the program, after allowing
for failures. Nonetheless, for a well-run SBIC, investors should have a low
probability of suffering a loss of capital.
There is a critical difference between SBIC investing and stock market investing. In
stock market investing, if a stock doesn't go up, it usually goes down, and the
action of the stock is often independent of the company itself. The market may
take a tumble or an industry sector may fall out of favor.
With venture investing, losses almost always flow from bad management selection,
and rarely from any other reason. Profits, on the other hand, can flow not only
from good management selection (or luck), but also from the pricing of a deal when
it was made, as well as the overall business climate when one seeks to exit. (Exit
strategies will be discussed later.)
Forming a Venture Fund
Typically, three people get together (normally middle-aged white guys) and decide
to form a fund. The majority of SBICs are first funds, and the average amount of
capital that is raised for a leveraged fund in FY98 was around $16 million, which
included second and later funds. We don't have breakdowns, but the average first
fund size is probably around $12 million of private capital.
However, a venture fund is not usually viable with less than $30 million of capital.
Thus, the attractiveness of the SBIC program to a management group with only
$12 million of private capital, is the prospect of $24 million of leverage which leads
to economically viability. It appears that there is a glass ceiling in raising venture
capital. When you go above $20 million, it becomes dramatically more difficult for
How Venture Funds Work.rt
Page 3
a first fund than under $20 million. Why is this?
Money for larger funds, particularly those over $70 million comes mostly from
institutions. In 1999, institutions are quite sophisticated in selecting fund
managers and, with only a few exceptions, almost exclusively invest in second or
later funds where the management team has been together for a few years and
have a demonstrated track record as a team. (In the SBIC program, we demand
demonstrated individual competence, but not a team track record.)
The money for first fund SBICs comes mostly from wealthy individuals who often
are not as sophisticated in venture fund investing as are institutions. Furthermore,
in today's world, skilled fund managers with an excellent track record are turning
money away and private individuals who are not supremely wealthy would not even
be accepted. For whatever the reason governing the dynamics of money raising,
perhaps because of the limits of personal networks, there is a void between $20
million and $70 million in fund size (excluding SBA leverage).
Organizational Idiosyncrasies of Venture Funds
A major idiosyncrasy of venture funds is that as they become larger, they don't do
more deals, the merely scale up the size of the deals they do. In other words, an
SBIC with $15 million of private capital (plus $30 million of leverage) will probably
make investments that center around $2 to $2.5 million, with a maximum of $3
million. During its lifetime, the fund will make around 20 investments.
If a fund raises $100 million of capital, instead of now making 40 investments, it
scales up and makes the same number of investments, but each will be twice the
size. Why is this?
A first fund, as previously noted, has three partners. When they add a second
fund, these partners still have to spend time with investments from their first fund.
They don't have to invest the 80 to 140 hours per investment that they might
when leading a new investment, but they have to attend board meetings of
companies in which they have invested, and they have to spend large amounts of
time with companies that have problems and which they wish to save from
collapse. These companies are often referred to as the "living dead".
Because some, or much of the partners' time is absorbed with prior investments,
they then will add an analyst or two to their staffs, and the more promising
analysts will become associates, meaning that they will not just crunch numbers
and perform due diligence, but may negotiate smaller deals, and get bigger
bonuses.
If this were a law firm or an accounting firm, the most capable associates would
look forward to becoming partners. Not so, for most of the venture industry.
How Venture Funds Work.
Page 4
Why?
In 1995, when I took one of the country's most successful venture capitalists to
visit with folks over at OMB, one of the people there asked the question, "As your
funds grow, why don't you just do more deals rather than scaling up in size?" The
totally honest response was, "We don't want to share the profits."
Thus, most capable associates save up their annual bonuses, and after five or more
years, when they've accumulated sufficient funds and contacts, leave to form their
own funds, most often SBICs. The process of raising money is grueling and
expensive. The projected out-of-pocket expenses are often in the $250,000 on up
range for lawyers and travel expenses. The process takes at least 18 months
during which time one is drawing no salary. This activity is often referred to as
"groveling", which is why so many venture capitalists wear knee pads.
Obtaining an SBIC License
At SBA, we have recently changed our licensing process to make the process more
transparent, and to enable potential licensees to learn whether or not they would
probably qualify for a license before they have made the huge time and money
commitment previously mentioned.
Potential applicants have the option of answering an approximate 30 question
questionnaire called the Management Assessment. This gets to the core of their
competency. We do an analysis and then invite the participants to meet with us to
discuss their strategies and capabilities. We then give them guidance as to their
strengths and weaknesses and their likelihood of obtaining a license, all with the
caveat that there are no guarantees.
There is no charge for this, and this process will normally be done when a potential
applicant has about $5 million of what are termed "soft circles" on his fund. A soft
circle is strong verbal interest by an investor for a certain amount of investment in
the fund. When the applicant has firm commitments of $8.5 million (or $4 million
if doing a debenture fund with a local orientation), the managers will file a formal
application. This has a fee structure of a base of $10,000 plus $5000 additional if
a partnership or LLC plus $5000 more if utilizing participating securities.
As soon as an application is received we forward the personal biography and
fingerprint cards to the Inspector General's office who forwards the material to the
FBI for a background criminal investigation.
There is currently a queue before other processing can begin, but once processing
is begun, it is our goal to have the entire application processed within four months,
although six months seems to be closer to the norm. (Responses to our questions
and legal issues by the applicants and their counsel often take time. We're quite
responsive once processing has begun.) The processing focuses on two primary
How Venture Funds Work.rtf
Page 5
activities:
§ Due Diligence. We do background checks on the competency and character
of the managers/general partners, as well as any non-institutional investors
who own 10% or more of the fund.
§ Legal. A partnership agreement with certain annexes that tie to leverage
must be approved by the Office of General Counsel.
During this process, the fund's general managers must all attend a one-day
regulations training class that we give. The Investment Division Investment
Committee meets bi-weekly to discuss the status and issues regarding every
applicant and potential applicant.
When all of the due diligence is completed and all the legal work is satisfactory, the
application goes for a vote to the Division Licensing Committee; if it passes there, it
goes to the Agency Licensing Committee, composed of the top level officers of the
SBA, and finally it is sent to the Administrator for approval.
Managing an SBIC
Once an SBIC is licensed and is in operation, there are five main tasks that
management must devote itself to:
§ Marketing
§ Due diligence
§ Negotiation and deal structuring
§ Oversight, and
§ Exits.
Marketing. A typical venture firm makes about 4 to 5 new investments a year, and
they only invest in 1% or 2% of all the proposals that they look at. Therefore, if a
firm does not have around 350 deals per year to review, it is likely that they will
start to make lower quality investments than their strategy calls for. This then
leads to future problem companies and subsequent losses.
It used to be that one could build a deal flow network over three years and then
count on it to perpetuate itself. This is no longer the case. It is now necessary for
the general partners to make marketing a key and integral part of their management
activities. Good deal flow leads to good deals which lead to high profits.
Due Diligence. In-depth due diligence is critical to success. There is a saying in the
venture industry that there are three things that you look for when making an
investment: management, management, management. In contrast to bankers who
How Venture Funds Work.r
Page 6
lend against cash flow and against assets, when bank lines are all tapped out,
venture capitalists provide high-risk unsecured financing. Therefore, the quality of
management of a small enterprise is the most critical element. There's another
saying in the industry, "Given the choice between a superior product and mediocre
management or a mediocre product and superior management, choose the latter."
The amount and depth of due diligence that is performed has a dramatic bearing
upon one's investment results. For success, one is looking at 80 to 140 hours of
due diligence per deal that is closed.
Before a venture capitalist will even look at a company, the entrepreneur must have
prepared a credible business plan. It doesn't have to be perfect; before an
investment is made, the strategies may change and the forecasts will surely be
modified, but without a business plan almost no SBIC will enter into conversations.
This is a dramatically different the environment in which New Markets Entrepreneur
Funds would operate where the level of sophistication and preparedness is much
less.
Deal Structuring. A former boss of mine used to say that "bought right is half
sold". In other words, you can't afford to overpay for an investment. If you
overpay, it becomes very difficult to achieve the types of returns that one seeks,
even if the company is successful. The most skilled venture capitalists tend not to
overpay. This is also a function of your deal flow. If deal flow is insufficient, one
tends to overpay because one cannot be idle and not make investments without
having unhappy investors.
Oversight. This is another element that has a heavy bearing upon one's ultimate
returns. The industry is replete with aphorisms, and another one is "Twenty-five
percent of your success is based upon making the investment and seventy-five
percent on what takes place afterwards." Venture capitalists, although often
referred to as "vulture capitalists" are actually, for the most part, amazingly tolerant
of management mistakes and bad behaviour, perhaps too tolerant.
At a conference I attended in San Francisco, when a panel of the superstars of
high-tech investing were discussing mistakes they had made and they talked about
how they had often waited too long before sacking incompetent management,
there was a big roar of knowing laughter and approval of what had been said.
Venture investors are semi-active, or semi-passive, depending upon whether you
say the glass is half-full or half-empty. Above all, they do not want to run
businesses, but they do provide guidance, and they should step in forcefully and
take corrective action when things start to go awry. Some are good at this, and
many are not. Those who are not have less ability to recover from down-drafts.
In the venture business, there are only four exit mechanisms.
How Venture Funds Work.rtf
Page 7
§ The most common successful exit is to sell or merge the company to another
firm at a profit.
§ The most highly publicized exit which can be the most profitable is through
an initial public offering (IPO). Recent years have been uncommon in the
number of months that IPOs have remained popular. Normally, the IPO
window lasts about 18 months every few years. While IPOs gather a great
deal of press coverage, they are not a common exit mechanism, and even
when there is an IPO, terms of the offering often prohibit private investors
from selling shares for 6 months after the offering, by which time, the stock
may be below the offering price.
§ When an investment winds up in the living dead category, the exit
mechanism is to sell shares back to the company. After 8 years, one tends
to realize about an 8% IRR.
§ The final exit mechanism is the least desirable -- scrounge what you can from
the assets after a company has failed, or sell your shares at a loss. This is to
be expected and goes with the territory. At a conference that we sponsored,
one highly successful SBIC manager who was a speaker said, "If you don't
have failures, you're not making deals."
Directing SBICs to LMI Investments
Earlier it was stated that marketing networks were critical to deal flow and
ultimately to success. One tends to network with those people with whom you are
familiar -- normally other venture capitalists, investment bankers, merger and
acquisition brokers, lawyers, and accountants. Practically no investments that are
made come into an SBIC directly; practically all come through third parties.
Why is this? The third parties prepare the entrepreneur for the financing. They not
only may assist with the business plan and with the pricing of an investment, but
they also prepare the entrepreneur mentally for dealing with outside investors.
The way that SBICs will start to make LMI investments is if deals come to them
through networks to LMI communities. This becomes the role of community
development organizations to prepare the entrepreneur for a financing, and to
introduce businesses with good growth prospects to SBICs. In my experience,
SBICs merely want good deals -- they are not particularly choosy about where in a
city a firm is located or whether a minority or woman is the principal in the firm.
They just want high growth prospects and entrepreneurs that can manage growth
or be willing to hire people who can. In fact, most SBIC managers would prefer to
make investments that are within easy driving distance of their offices rather than
ones that require boarding a plane. Thus, insofar as SBIC managers can be
introduced to community development folk, which is a prime purpose of the
How Venture Funds Work.rtf
Page 8
outreach workshops, LMI investments will start to flow naturally.
Sperling Briefing.
Page 1
Investment
Division
SBIC Briefing for Gene Sperling
1/13/99
Program Purpose
The Small Business Investment Company (SBIC) program was created to address
the particular needs of small high-growth companies which are small today but
intend to become large tomorrow. The financing needs of such companies typically
exceed what traditional, lending and leasing can provide. To support their growth,
these high growth firms must have equity-type capital -- what is generally termed
"venture capital". This involves unsecured, high risk investments where
participation in the rewards of equity ownership are expected to represent a
significant element of the investor's ultimate financial return.
SBICs are privately-owned and operated venture capital investment companies,
organized with a minimum of $5 million to $10 million of private capital, which
agree to restrict their investments to what is permitted under SBA regulations in
exchange for SBA's supplementing their investment capital. The SBA's role is
§ To license them
§ To regulate their operations for compliance with the public policy objectives
of the Small Business Investment Act and to protect the government's
creditor interest, and
§ To supplement their private capital through public offerings of
SBA-guaranteed securities (termed "leverage").
A fundamental strength of the program lies in the fact that all investment decisions
are made by private investors with their own money at risk ahead of SBA's;
however, this also limits SBA's ability to direct SBIC investments toward specific
target areas.
SBICs tend to serve small businesses whose venture capital needs fall in the
$500,000 to $5,000,000 range. This exceeds the amount usually available from
so-called "angel investors" but falls short of the minimum typically required to
Sperling Briefing.
Page 2
interest institutionally-funded private venture capital firms.
A June 1996 study commissioned by the SBA Office of Advocacy estimates that
the number of entrepreneurial ventures that need equity financing includes about
50,000 start-ups per year (5-10 percent of total start-ups) and 300,000 ventures
growing faster than 20 percent per year (including 80,000 growing at faster than
50 percent per year). In that year, SBICs and private venture firms together
invested in only about 4,000 firms, or just over 1 percent of the estimated need.
Program Statistics
§ During FY98, SBICs invested a record $3.2 billion in 3,456 small business
financings, more than 90 percent of which were equity-oriented.
§ The smaller average investment size of $937,000 for SBICs versus more
than $6.8 million for private venture capital firms, demonstrates the SBIC
program's success in serving its target market.
§ Over 55% of the financing dollars were invested in businesses 3 years old or
less.
§ Over the past 40 years, SBICs have provided more than $20.7 billion in
approximately 118,000 financings to about 88,000 small business concerns,
including such national successes as Apple Computer, Intel Corporation,
Federal Express, and Cray Research, as well as America Online, Sun
Microsystems, Callaway Golf and Outback Steak House which can trace their
early financings to SBICs.
Less spectacular but equally important are the thousands of small concerns which
have been able to develop into sound businesses as a result of SBIC funding and
the contribution of experienced SBIC managers who share their knowledge as true
partners, with a shared risk and commitment.
It is estimated that SBIC investments have contributed to the creation of more than
one million jobs in the manufacturing and service sectors of the economy. Because
all investment decisions are made by the SBIC's private management, SBIC
investments address many financing needs and cover a broad spectrum of business
activities.
During FY98, SBICs invested in companies located in all 50 states plus the District
of Columbia, Puerto Rico, and the Virgin Islands. Ninety percent of the funds
invested had equity features, and 49 percent was to firms less than 3 years old.
The attached SBIC program overview provides additional detail on program
financings.
Sperling Briefing.
Page 3
1998 SBIC INVESTMENT ACTIVITY
TYPE OF SBIC
Number of
Total
Average
Median Size
Investments
Amount
Size of
of
Invested
Investment
Investment
($millions)
Participating Security
651
$510.2
$783,000
$350,000
Debenture
1576
492.8
313,000
150,000
Bank SBICs
590
2127.0
3,605,000
1,300,000
Specialized SBICs
639
109.4
171,000
129,000
Total SBIC Program
3,456
$3,239.4
$937,000
$195,000
HISTORY
The SBIC program was created in 1958 in response to a Federal Reserve Bank of
Boston study indicating a significant gap in the availability of long-term debt and
equity for small business. Since institutional venture capital largely did not exist at
the time, the program was an experiment without precedent on which to draw.
After many years of mixed results, culminating in significant failures in the 1989-91
period, the program was restructured in 1992 and has demonstrated remarkable
success since.
The Small Business Equity Enhancement Act of 1992, and its implementing
regulations rejuvenated the SBIC program. Besides addressing a number of
structural problems in the program, the 1992 Act created "participating securities"
as a funding mechanism for those SBICs that concentrate on equity-type investing
(where the SBIC is investing to achieve long-term capital gains and receives very
little current income to defray the interest cost of its own debenture leverage). With
participating securities leverage, an SBIC defers paying the quarterly interest-like
costs ("prioritized payments") until it realizes sufficient gains through the sale of its
investments to achieve cumulative profitability.
In exchange for making the prioritized payments on behalf of the SBIC, SBA
receives approximately a 10 percent participation in the SBIC's profits. Because of
the increased financial risk, SBA has been very selective in the licensing of such
SBICs and has generally required a $10 million minimum of private capital.
Since September, 1994, 72 SBICs with total initial private capital of $1.3 billion
have been licensed to use participating securities leverage. Their average private
capital was $15.3 million which compares with the $2.3 million average for SBICs
licensed during the four years prior to 1994. Although the first participating
Sperling Briefing
Page 4
securities leverage was only issued in February 1995, 20 of these licensees have
already realized sufficient investment gains to be making their prioritized payments,
and through January, 1999, 12 of them have also paid $16 million of their profits
to SBA.
The 1994 implementing regulations also corrected a number of other program
weaknesses. In addition to implementing the Act's statutory provisions, SBA's
1994 regulations significantly strengthened the licensing, oversight and
administration of the program. They increased the minimum private capital required
for licensing (to $5 million for SBICs utilizing debentures and $10 million for those
utilizing participating securities) and required that SBIC managements have
demonstrated investment experience appropriate to the proposed SBIC's operating
plan.
The regulations also introduced the concept of "management/ownership diversity"
which requires that, under most circumstances, at least 30 percent of an SBIC's
private capital is from non-management investors. This eliminates "hip pocket"
SBICs, wherein SBIC manager/owners were able to use an SBIC as their own
private bank, and insures that there are investors whose interests in the SBIC's
financial success complements SBA's interests as a partner/creditor. Other
oversight procedures introduced in 1994 include specific guidelines for SBICs to
use for valuing portfolio securities in their financial reports; a credit review process
for granting leverage; more frequent, better focused examinations of licensees; and
a "watch-list" for troubled licensees to insure that prompt action is taken in
protecting SBA's creditor position.
Licensing Activity
Since the new program was introduced and the new regulations were implemented
in FY94, 152 new SBICs have been licensed (including 40 bank-dominated SBICs)
with initial private capital of $2.4 billion. This is more than the total private capital
raised by the program in the preceding 34 years.
Combined with additions to the private capital of existing SBICs, this has resulted
in a nearly tripling of private capital in the program over the past five years, from
$2.26 billion at the end of FY 1993 to $6.64 billion through January 6th. At the
same time, committed SBA-guaranteed leverage has increased from $860 million to
$3.0 billion, bringing the program's total capital resources to $9.6 billion. The SBIC
program today consists of 325 licensees located in 42 of the 50 states, plus the
District of Columbia and Puerto Rico, with concentrations in New York, California,
Texas and Massachusetts.
Sperling Briefing.rt
Page 5
SBIC LICENSEES (As of 1/13/99)
TYPE OF SBIC
Number
Private
Committed
Total Capital
$ in thousands)
Capital
Leverage
Participating Security
73
$1,312.5
$1,601.9
$2,914.3
Debenture
93
914.1
1,115.5
2,029.6
Bank SBICs
87
4372.8
50.0
4,322.8
Specialized SBICs
72
165.3
195.1
360.3
TOTAL
325
$6,664.6
$2,962.5
$9627.1
Bank-dominated SBICs are typically operated as subsidiaries of commercial banks to
enable them to make equity investments otherwise prohibited by the Glass-Steagall
Act. They typically do not utilize SBA leverage, and many of them are very large
(several with private capital in excess of $100 million). Bank SBICs represent 67
percent of the private capital in the program, and they serve the SBIC program's
public policy objectives without a leverage cost to the taxpayers.
Specialized SBICs were licensed under Sec. 301(d) of the Act and are restricted to
investing only in companies owned by persons who are socially or economically
disadvantaged. The 1996 Small Business Programs Improvement Act repealed Sec.
301(d) but grand-fathered existing 301(d) licensees.
PROGRAM FUNDING LEVELS (Committed)
Program Levels
1995
1996
1997
1998
1999
(thousands)
(Estimated)
Participating
$219,940
$267,777
$410,942
$700,000
$1,000,000
Sec.
Debentures
104,430
106,144
256,426
488,000
700,000
SSBIC
25,410
O
O
0
0
Debentures
SSBIC Pref.
5,623
O
O
0
0
Stock
TOTAL
$355,403
$373,921
$667,368
$1,188,000
$1,700,000
Sperling Briefing.rtf
Page 6
Sperling Briefing.rt
Page 7
APPROPRIATIONS
Appropriations
1995
1996
1997
1998
1999
(thousands)
Participating Sec.
$19,575
$24,100
$13,520
$11,582
$16,620
Debentures
15,299
16,410
8,180
8,648
3,000
SSBIC Debentures
7,077
0
O
O
SSBIC Pref. Stock
2,423
O
O
O
TOTAL
$44,374
$40,510
$21,700
$20,230
$20,280
SUBSIDY RATES
Subsidy Rate
1995
1996
1997
1998
1999
Participating Sec.
8.90%
9.00%
3.29%
2.54%
2.19%
Debenture
14.65%
15.46%
3.19%
2.30%
1.38%
SSBIC Debentures
27.85%
29.03%
--
--
--
SSBIC Pref. Stock
43.10%
42.85%
--
New legislation in FY 1996 further strengthened the program. In 1996, the Senate
Small Business Committee introduced legislation intended "to insure the safety and
soundness of the SBIC program as it grows." This was enacted in the Small
Business Programs Improvement Act of 1996, and essentially codified into law
many of the regulatory provisions that SBA had previously introduced. In addition,
the legislation increased fees charged for leverage which permitted SBA to cut its
appropriations in half while doubling the leverage available to SBICs. (The up-front
leverage fee was increased from 2 to 3 percent and a 1 percent annual charge was
added to all new leverage.)
Other notable provisions of the 1996 legislation included repeal of section 301(d)
which created Specialized SBICs; reauthorization of the 3% SSBIC preferred stock
repurchase program, with the proceeds available as budget authority for additional
debenture leverage; a provision for the licensing of SBICs as limited liability
companies; clarification that for size status determinations of eligible SBIC
investments, the ownership by venture-type investors would be ignored; a
requirement to process new license applications promptly without regard to
leverage availability and to inform applicants of the status of their applications
Sperling Briefing.
Page 8
within 90 days.
Since funds for SBIC leverage are provided by private investors who purchase the
debentures or participating securities issued by the SBICs and guaranteed by the
SBA, a Congressional appropriation is required only equal to the "cost" of the
guarantee. In FY99, an appropriation of $20.2 million will enable SBA to guarantee
almost one billion dollars of SBIC leverage. Since such leverage typically requires
one-half that amount in underlying private capital, the $20.5 million appropriation
will have generated $1.5 billion of equity-type investments in small businesses.
Because these types of investments are almost always subordinated to bank
borrowings, such levels of investment can support an additional 50% in
commercial credit, providing $2.25 billion in total financing dollars, or over 100
times the $20.2 million of government "cost". By way of comparison, the $20.2
million is less than one-tenth the annual taxes paid by just the corporate SBICs
($242 million in 1996), without taking into account the taxes paid by investors in
partnership SBICs, much less the small businesses themselves.
Spch0199.rt
Page 1
SMALL BUSINESS INVESTMENT COMPANY
PROGRAM
Outline of Comments
By
Saunders Miller
Senior Policy Advisor
U.S. Small Business Administration
Spch0199.rtf
Page 2
FOR INFORMATION
General Telephone Number
(202) 205-6510
Web Page:
www.sba.gov/INV/
I.
Introduction
A.
In 1958, the Federal Reserve Bank under William McChesney Martin did a
study of access to the capital markets by small businesses. Findings:
inadequate.
B.
Venture capital industry did not exist. The phrase had not even come into
use. Only a dozen or so very wealthy families using professional managers, plus
one public company, American Research and Development, made venture
investments routinely.
C.
Small Business Investment Act of 1958 was passed.
D.
First SBIC licensed On March 19, 1959.
E.
Public/Private partnership in which profit-driven IRRs of 15% or greater
should be attainable for an SBIC over a 10 year period.
II.
What Is an SBIC?
A.
Privately managed venture capital firm in which the managers make all the
investment decisions.
B.
They must finance only small businesses and cannot, except for start-ups and when
a company is heading south, control them.
C.
Each SBIC management team identifies the target market they wish to reach, that
is, types of industries, hi-tech or low tech, and life-cycle of the business --
early-stage or late-stage
D.
Purpose of the program:
1.
Meets a market need for risk capital that is typically in the $300,000 to $5 million
range which is the minimum size preferred by totally private venture
capitalists are straight equity, preferred stock, or debt with warrants
2.
90% of investments made have equity features
3. Program designed to finance active small operating companies having no
more than $6.0 million of after-tax income and no more than $18.0 million of
net worth.
4.
Goal is to finance companies that grow a minimum of 40% per year.
5.
Most don't meet that target. In fact, in an SBIC or any venture firm, 20% of your
investments are responsible for most of your profits; with 20% of your
companies, you lose some or all of your investment, and on the other 60%,
you ultimately earn about 8% per year return-on-investment.
6.
In a well-run SBIC, over a 10 year period of time, you should realize
an internal rate of return of 15% to 23% or more.
III.
Why Invest in an SBIC
A.
All investors invest in all venture firms, including SBICs, because they expect
IRRs in excess of 15%.
Spch0199.rt
Page 3
B.
They choose to invest specifically in SBICs because the SBA supplements
their private capital at very cheap rates.
1. In the SBIC program, SBA supplements the private capital of investors with
what is known as Leverage which are securities sold in the public markets
through underwriters, and carries SBA's full faith and credit guarantee of
principal and interest. Two types of leverage are available:
i.
Debenture Leverage up to 2X or 3X private equity capital:
a.
Has an interest rate of 75 to 95 basis points over the 10 year
Treasury Rate, and
b.
Has semi-annual interest payments.
ii.
Participating Securities Leverage -- A preferred equity instrument --
up to 2X private equity capital:
a.
Similar interest rate spread, but
b.
Dividend payments are only made when an SBIC has positive retained
earnings. This enables the SBIC to make long-term equity type
investments. The SBIC also pays SBA approximately 10% of its profits.
2. For a profitable leveraged SBIC, its IRR can increase by 600 to 800 basis
points. Of course, leverage can cut both ways, and below an IRR of 11% to
13%, an SBIC's investors would be better off without leverage.
3. To be a full-fledged venture firm, generally at least $30 million of capital is
needed in order to support the necessary overhead, which typically is around
$750,000 per year.
i.
The industry standard for management expenses for small venture
funds doing growth and expansion financings is typically 2.5% of total
capital.
ii.
For a full-fledged national or regional venture fund, this normally
means $750,000 per annum, minimum.
iii.
For a more geographically focused lender, overhead as little as
$375,000 is sometimes possible.
iv.
Such overhead expenditures imply certain minimum capital amounts.
$750,000 divided by 2.5% equals $30,000,000.
V.
A glass ceiling exists: to raise above about $15 million becomes
dramatically more difficult for new fund managers.
vi.
The average private capital size of non-bank SBIC applicants is around
$12 million.
vii.
Therefore, firms that can only raise $10 million, but which have
qualified managers, can become economically viable; and thus be able to
help grow small, dynamic businesses, which is the purpose of the SBIC
program.
C.
Why do banks invest in SBICs?
1. The SBIC program provides an exemption to the Glass-Steagall Act, and
therefore, enables banks to make investments in which they are able to own
more than 4.9% of the voting equity of non-financial companies or more than
Spch0199.rt
Page 4
24.9% of the non-voting stock of a non-financial entity
2. In addition, banks can obtain CRA (Community Reinvestment Act) credit on
the CRA investment test if they invest in SBICs.
3. Most importantly, investing in SBICs is profitable. For the 10 year period
ending 1997, bank-dominated SBICs averaged an internal rate of return of
13.1%. They achieved the same IRR for the prior 10 years, too.
D.
Can utilize the SBIC program for economically targeted investments (""ETI").
1. Pension fund investors -- Calpers in California invested in a California
targeted fund; New York City pension funds invested in a New York oriented
fund, and a Maryland state investment was made in a Maryland based fund.
2. Any ETI oriented SBIC must still have a primary profit motivation and
experienced management
3.
However, no more than 33% of private capital can come from state or local
funds; but state and local pension funds are considered "private capital".
4. History has a most important lesson for bankers: experience has shown that
the most successful SBICs are those that are run independently of the bank.
i.
Commercial lenders are not venture capitalists.
ii.
Bankers look at past performance and make loans based on cash flow,
financial statements, and collateral.
iii.
Venture capitalists look at future potential and make investments
based on the quality of management, because the financial statements are
usually pretty weak. If they weren't, commercial lenders would provide all
the financing.
iv.
SBIC managers are usually paid more than commercial loan officers
and the SBIC compensation plan must be long-term oriented in order to
have the SBIC managers nurse their investments along over many years.
In venture investing, 75% of success takes place after the initial closing.
IV.
A Few Key Statistics:
A.
In 40 years, SBICs have invested more than $20.7 billion in 118,000
financings.
B.
During FY98, SBICs invested $3.2 billion in 3,456 financings totaling in
excess of $3.2 billion in most all states plus some territories
C.
90% of the funds invested had equity features, and 55% went to firms zero
to 3 years old.
D.
As of January 13th, 1999, there were 325 licensees with $6.7 billion of
private capital. 87 bank- dominated SBICs represented 66% of that with $4.4
billion. This compares with $2.2 billion of private capital at 1993 year-end before
the new program was implemented, of which 70% or $1.6 billion was
bank-dominated private capital.
E.
That's more new capital in 5years than in the prior history of the program.
Banks and private investors are demonstrating their faith in the program.
F.
Committed program leverage as of January 13, 1999 was $3.0 billion
compared with $860 million at the end of fiscal 1993. For fiscal 1999, $1.7
Spch0199.rtf
Page 5
billion of leverage is estimated to be available
G.
Currently, we have 44 active applications on hand representing
approximately $500 million of private capital
V.
Program has had many successes.
A.
In Fortune's 1996 list of the 100 fastest growing companies, 18 had
received SBIC funding.
B.
Early examples: Federal Express, Intel, Cray Research, and Apple Computer.
C.
More recent well-known companies: America on Line, Staples, Amgen,
Callaway Golf, Microcom, Sierra Semiconductor, and Gymboree.
D.
Was not a smooth road from 1958 to the present.
1. Program shrank during the 1980s with $600 million of gross leverage
liquidations before any recoveries which are at about 60%.
2. In 1990 and 1991, at Senate hearings, the question was raised whether to
eliminate the program.
3. To deal with this issue, in 1991, an Investment Advisory Council was
formed, staffed with non-SBIC venture capital managers. Their findings were:
4. The program was basically sound.
5. It had a high all-in return to the taxpayer, but
6. A number of identifiable problems existed:
i.
Inadequate management.
ii.
Capital base of most SBICs was too small to be economically viable.
iii.
Portfolio valuations were done poorly which led to inaccurate
reporting and inaccurate credit evaluation by the SBA.
iv.
Mis-match of funds flow, i.e., debt leverage was being used to
finance equity investments.
E.
These problems were corrected by new legislation in 1992, and by new
regulations finalized in April, 1994, and fully re-written and modernized in
January, 1996.
1. Admit only qualified management. License hard and regulate rationally. The
key is: management, management, and management.
2. Minimum capital requirements now exist based on economic viability which
encompasses the need for sufficient expenditures on overhead to perform
adequate due diligence and continuing oversight.
3. Thus, to obtain a Participating Security equity license, $10.0 million private
capital minimum is required under most circumstances. Enables the SBIC to
perform sufficient due diligence, oversight, and marketing.
4. For a debenture licensee who may make loans on a smaller geographic scale,
as little as $5.0 million private capital may be acceptable.
5. However, only $3.0 million of private capital is required for a non-leveraged
license because the SBA is not at financial risk, and overhead is often
absorbed by a bank. However, we don't recommend this little an amount.
6. The final major change was curing the mis-match of funds flow with an
Spch0199.rtf
Page 6
equity participating security.
F.
Two kinds of SBICs:
1. Regular -- 301(c) -- which is the only type that can now be licensed, and
2. Specialized -- 301(d) -- which are oriented towards financing firms owned by
persons who are "socially or economically disadvantaged". These types are
no longer being licensed, but existing ones are grand-fathered. In the past
they had access to subsidized leverage such as 3% and 4% preferred stock
which was sold to the SBA. However, this proved to be too costly to the
government, costing 43 cents per dollar of leverage compared with less than
two cents for the regular program.
VI.
Qualifying Investments
A.
Investments made only to small businesses, generally those with no more
than $6 million of after-tax income and no more than $18 million of net worth.
B.
Prohibited uses of funds (other than real estate)
1. Relending & reinvesting.
2. Most real estate unless a majority of the space is used by a qualified
operating company.
3. Passive businesses. Exception: A holding company with operating
subsidiaries are okay.
4. Foreign investments.
5. Activities contrary to public interest, e.g., casinos, even if legal.
6. Project financing, e.g., oil wells vs. oil development companies.
7. Financing other Licensees.
8. Farm land.
9. Associated supplier.
10.
Catchall category: activities not contemplated by the Act, e.g., stock
market investing.
VII. Structuring the Investment
A.
Funds must be furnished directly to the small company unless through an
underwriter.
B.
Maximum of 20% of private capital in any one company, known as "overline
limit". Provides for portfolio diversification which reduces risk.
C.
Initial financings must be long-term: either equity or a minimum term of 5
years, or 4 years for an SSBIC financed investment. Bridge loans permitted under
some circumstances.
D.
SBA sets ceilings on interest rates, known as Cost of Money:
1. 6% spread above a calculated base rate on debt with equity features.
2. 11% spread on straight loans.
E.
Redemption provisions -- 5 year minimum term.
F.
Calls are permitted.
Spch0
Page 7
G.
Commitment fees and closing fees allowed, with certain limitations.
H.
Prepayment penalties permitted.
I.
Interest rate can be boosted 700 basis points for monetary or reporting
defaults.
VIII. Other Aspects of Investing
A.
Control generally not permitted, including control over the checkbook.
Exceptions:
1. Early stage investments to include seed capital and start-ups.
2. When a company encounters major difficulty.
B.
Conflicts of Interest is a major violation of regulations
1. Self-dealing.
2. Co-investing with Associate creates problems, except that normal bank credit
lines are not considered conflicts.
3. However, serving on a board is permitted.
4. Exemptions to conflicts of interest require public notice.
5. Management Services are permitted so long as rates are reasonable, and only
for services actually performed.
IX.
Licensing Process
A.
See web site at www.sba.gov/INV/ (Note that last three letters must be in
caps.)
Spch 1198.r
JAN 13 '99 07:45PM INVESTMENT DIVISION
P.2/7
SBIC Program Overview
printed 01/13/99
-- PROGRAM COMPOSITION
FY End
FY End
FY End
FY End
to date
1995
1996
1997
1998
1999
Number of Licensees
Participating Sec.
31
36
54
69
73
Debenture
87
89
87
92
93
Bank SBICe
69
69
79
84
87
Specialized SBICs
90
88
80
73
72
TOTAL
277
282
300
318
325
Private Capital (millions)
Participating Sec.
557.7
571.2
859.5
1,226.9
1,312.5
Debenture
542.3
611.0
631.4
897.2
914.1
Bank SBICe
2.184.5
3,118.3
3,468.0
4,005.4
4,272.8
Specialized SBICs
199.1
220.4
181.6
165.9
165.3
TOTAL
$3,483.6
$4,520.9
$5,140.5
$6,295.4
$6,664.6
Outstanding Leverage (millions)
Participating Sec.
227.9
510.5
720.9
889.4
935.9
Debenture
515.1
586.9
611.1
704.8
716.5
Bank SBICs
35.0
21.0
18.5
23.5
24.5
Specialized SBICe
292.3
248.6
227.0
178.2
173.4
TOTAL
1,070.3
$1,367.0
$1,577.5
$1,795.9
$1,850.3
Total Capital Resources (millions)
Participating Sec.
785.6
1,081.7
1,580.5
2,116.3
2,248.3
Debenture
1,057.4
1,197.9
1,242.4
1,602.0
1,630.6
Bank SBICe
2,219.5
3,139.3
3,486.5
4,028.9
4,297.3
Specialized SBICs
491.4
469.0
408.7
344.1
338.6
TOTAL
$4,553.9
$5,887.9
$6,718.0
$8,091.3
$8,514.9
Program Totale with Commitments Included
Outstanding and Commited Leverage (millions)
Participating Sec.
369.7
603.8
827.2
1,401.2
1,601.9
Debenture
522.3
586.9
624.3
997.5
1,115.5
Bank SBICs
35.0
21.0
18.5
44.0
50.0
Specialized SBICe
292.3
248.6
227.0
186.7
195.1
TOTAL
$1,219.3
$1,460.3
$1,697.0
$2,629.4
$2,962.5
Total Commited Capital Resources (millions)
Participating Sec.
927.4
1,175.0
1,686.8
2,628.1
2,914.3
Debenture
1,064.6
1,197.9
1,255.6
1,894.7
2,029.6
Bank SBICe
2,219.5
3,139.3
3,486.5
4,049.4
4,322.8
Specialized SBICs
491.4
469.0
408.7
352.6
360.3
TOTAL
$4,702.9
$5,981.2
$6,837.5
$8,924.7
$9,627.1
JAN 13 '99 07:45PM INVESTMENT DIVISION
P.3/7
SBIC Program Overview
printed 01/13/99
-- NEW AND RETIRING LICENSEES --
FY End
FY End
FY End
FY End
to date
1995
1996
1997
1998
1999
New Licensees (number)
Participating Sec.
12
6
17
15
15
Debenture
3
7
6
7
7
Bank SBICs
5
7
10
9
9
Specialized SBICe
0
2
0
0
0
TOTAL
20
22
33
31
31
Initial Private Capital (millions)
Participating Sec.
171.3
58.9
232.0
242.4
242.4
Debenture
17.9
60.2
48.9
109.8
109.8
Bank SBICs
117.5
32.5
168.5
226.1
226.1
Specialized SBICe
0.0
9.6
0.0
0.0
0.0
TOTAL
$306.7
$161.2
$449.3
$578.3
$578.3
Liquidation Activity ($ in millions)
Licensees Transferred
7
2
5
2
2
Leverage When Transferred
$15.8
$2.5
$20.1
$7.0
$7.0
Open Licensee Cases
186
160
137
128
128
Outstanding Leverage
$480.8
$302.3
$218.7
$197.9
$197.9
Number of Licensees Closed
15
29
28
12
0
Collections thru 8/31/98
$64.9
$65.6
$65.1
$24.4
$0.0
Write-Offe thru 8/31/98
$11.7
$118.4
$49.5
$4.4
$0.0
Surrenders
Number
18
13
8
6
2
Ending Private Capital
$114.5
$115.1
$43.5
$37.9
$20.6
Mergers
Number
2
1
2
4
0
Ending Private Capital
$26.7
$1.1
$2.8
$34.2
$0
JAN 13 '99 07:46PM INVESTMENT DIVISION
P.4/7
SBIC Program Overview
printed 01/13/99
SMALL BUSINESS FINANCINGS --
FY End
FY End
FY End
FY End
to 12/15
1995
1996
1997
1998
1998
Number of Financings to Small Businesses
Participating Sec.
126
234
495
651
651
Debenture
624
603
768
1,576
1,576
Bank SBICe
318
381
536
590
590
Specialized SBICe
1,153
889
932
639
639
TOTAL
2,221
2,107
2,731
3,456
3,456
Dollar Amt. of Financing (millions)
Participating Sec.
109.6
214.8
360.0
510.2
510.2
Debenture
282.1
312.5
360.0
492.8
492.8
Bank SBICs
703.8
972.1
1,530.7
2,127.0
2,127.0
Specialized SBICs
153.5
116.6
118.3
109.4
109.4
TOTAL
$1,249.0
$1,616.0
$2,369.0
$3,239.4
$3,239.4
Average Size of Investment
All Regular SBICs
$1,025,738
$1,231,005
$1,251,074
$1,111,117
$1,111,117
Participating Sec.
$869,841
$917,987
$727,255
$783,723
$783,723
Debenture
$452,083
$518,167
$468,739
$312,681
$312,681
Bank SBICe
$2,213,208
$2,551,444
$2,855,753
$3,605,132
$3,605,132
Specialized SBICs
$133,151
$131,211
$126,916
$171,240
$171,240
Type of Financing (millions)
Straight Debt
259.2
187.8
240.1
363.4
363.4
Debt with Equity Features
348.6
534.6
756.0
705.3
705.3
Equity Only
641.2
893.6
1,372.9
2,170.7
***,*
TOTAL
$1,249.0
$1,616.0
$2,369.0
$3,239.4
$3,239.4
Age of Financed Small Bus (millions)
Under 1 year
499.7
545.0
692.9
1,220.0
1,220.0
1 to 3 years
199.6
333.2
481.8
570.5
570.5
3 to 6 years
177.0
246.0
441.2
492.8
492.8
6 to 10 years
140.6
195.2
334.0
350.2
350.2
Over 10 years
232.1
296.6
419.1
606.1
606.1
TOTAL
$1,249.0
$1,616.0
$2,369.0
$3,239.4
$3,239.4
Demographics of SBIC-Financed Small Businesses
(recorded from October 1, 1997 through September 30, 1998)
Amount of
Number of
% of
Financing
% of
Financings
Total
(millions)
Total
50% or more Women-Owned
208
6.0
$31.0
1.0
50% or more Black-Owned
315
9.1
$51.2
1.6
50% or more Hispanic-Owned
136
3.9
$43.2
1.3
50% or more Native Am.-Owned
0
0.0
$0.0
0.0
50% or more Asian Pac.-Owned
211
6.1
$30.6
0.9
50% or more Sub Asian-Owned
225
6.5
$47.6
1.5
JAN 13 '99 07:46PM INVESTMENT DIVISION
P.5/7
SBIC Program Overview
printed 01/13/99
-- MISCELLANEOUS --
Participating Securities
Dollar
Number of
Amount
Licensees
Funding (thousands)
Total Pooled
951,280.0
54
Interim Funding Outstanding
155,095.0
Redemptions
(134,584.0)
Total Outstanding
$971,791.0
Prioritized Payments by SBA (thousands)
Historical Total
132,656.8
54
Reimbursements
(53,883.2)
Current Outstanding
$78,773.6
Revenue to Agency (thousands)
Profit Participation
16,048.0
12
Adjustment Payments by SBICe
1,394.4
13
Gain (Loss) on Inkind Securities
(295.0)
4
Net Revenue
$17,147.4
Fees Collected, Licensee Conversions & 38 Preferred Stock Repurchases
FY End
FY End
FY End
FY End
to date
1995
1996
1997
1998
1999
Fees Collected (thousands)
Examinations
na
na
1,326.6
1,594.0
424.9
Licenseing
na
na
380.4
1,043.0
215.6
Total
$1,707.0
$2,637.0
$640.5
Conversion from 301 (d) to 301(c) (millions)
Number
0
0
6
3
0
Private Capital
o
0
$43.6
$19.7
$0.0
Outstanding Leverage
0
0
$15.9
$34.5
$0.0
3% Preferred Stock Repurchase (millions)
Number
19
5
10
2
2
Par Value
46.2
5.4
15.5
3.1
3.1
Amount of Discount
30.0
3.6
10.1
2.0
2.0
Amount Received by SBA
$16.2
$2.2
$5.4
$1.1
$1.1
JAN 13 '99 07:46PM INVESTMENT DIVISION
P.6/7
SBIC Program Overview
printed 01/13/99
-- INTERNAL OPERATIONS --
FY End
FY End
FY End
FY End
To Date
1995
1996
1997
1998
1999
Personnal (FTEs)
Operations
18
18
19
21
21
Licensing
4
8
7
6
6
Examinations*
29
26
25
29
29
Liquidation
18
15
14
15
15
AA Staff
15
15
15
14
14
TOTAL
84
82
80
85
85
*Field Employees
included in Exams above
27
24
23
27
27
Budget (actual)
Compensation & Benefits
6,163,000
5,964,562
5,913,000
6,174,467
638,093
Travel
254,651
196,666
294,500
282,000
282,000
Other Expenses
182,185
36,450
28,000
11,378
331,878
Examination contract
--
84,338
300,000
0
o
Liquidation contract
--
66,648
50,000
--
:
Licensing contract
--
153,800
56,800
|
|
Other contracts
50,456
54,044
20,900
321,000
0
TOTAL
$6,650,292
$6,556,508
$6,663,200
$6,788,845
$1,251,971
-- EXAMINATION OF SBIC LICENSEES --
Examinations
Exam Reports Issued
240
202
217
230
45
Exam Cycle
14.3
13.9
14.5
14.0
13.5
Licensees with Leverage
158
156
151
160
27
Exam Cycle (months)
12.8
13.5
13.0
12.4
11.9
Licensees w/o Leverage
82
46
66
70
18
Exam Cycle (months)
17.2
15.4
18.0
17.9
15.9
Reports with Findings
170
108
77
84
15
Reports without Findings
70
94
140
146
30
JAN 13 '99 07:46PM INVESTMENT DIVISION
P.7/7
SBIC Program Overview
printed 01/13/99
-- PROGRAM FUNDING --
FY End
FY End
FY End
FY End
Current
Projected
1995
1996
1997
1998
1999(a)
2000
Appropriation (thousands)
Participating Sec.
19,575
24,100
13,520
11,582
16,620
Debenture
15,299
16,410
8,180
8,648
3,000
SSBIC Debentures
7,077
0
0
0
0
SSBIC Preferred Stock
2,423
0
0
0
0
TOTAL
$44,374
$40,510
$21,700
$20,230
$20,280
Program Level (thousands)
Participating Sec.
219,940
267,777
410,942
700,000
850,000
Debenture
104,430
106,144
256,426
488,000
600,160
SSBIC Debentures
25,410
0
0
0
0
SSBIC Preferred Stock
5,623
0
0
0
0
TOTAL
$355,403
$373,921
$667,368
$1,188,000
$1,450,000
Subsidy Rate
Participating Sec.
8.90%
9.00%
3.29%
2.20%
2.19%
Debenture
14.65%
15.46%
3.19%
1.94%
1.38%
SSBIC Debentures
27.85%
29.03%
--
--
--
SSBIC Preferred Stock
43.10%
42.85%
--
--
--
Program Level Utilized (millions)
Participating
219.4
237.8
233.8
700.0
$201.1
Debenture
129.7
106.1
138.7
461.6
$128.5
Direct Funding
5.6
--
--
--
--
TOTAL
$355.3
$343.9
$372.5
$1,161.6
$329.6
Public Fundings (millions)
Participating Pool
$227.8
$286.3
$214.2
$222.9
$0.0
Debenture Pool
$128.0
$114.5
$125.5
$97.0
$0.0
Outstanding Interim Funding (millions)
Participating Security
--
--
--
$61.8
$155.1
Debenture
--
--
--
$8.3
$51.1
Outstanding Commitments (millions)
Participating Security
$141.8
$93.3
$106.3
$532.7
$666.0
Debenture
$7.2
--
$13.2
$331.2
$446.2
a The FY 99 program levels are $800,000 for participating securities and $600,000
for debentures. The FY 99 program levels include a $2 million carryover of unused
budget authority for FY 98. The FY 99 appropriation by itself would fund program
levels of $758.9 million for participating securities. Budget authority from
3% perferred stock repurchases is not included.
U.S. Small Business Administration
409 Third Street, S.W
Washington, DC 20416
Contact: Saunders Miller
Senior Policy Advisor
SBA
202-205-3645
[email protected].
Championing America 1 Enirepreneurs
Investment Division
U.S. Small Business Administration
Development
Venture
Capital
Venture Capital to Meet the Needs of
Inner Cities and Rural America
MEETING NOTES - JUNE 5, 1998
U.S. Small Business Administration
Page 2
6/5/98
SBA
Championing America 4 Entrepreneurs
Investment Division
U.S. Small Business Administration
Venture Capital to Meet the Needs of
Inner Cities and Rural America
The Need
Equity type financing is not widely available to basic businesses, particularly
those with modest growth prospects located in the inner cities and in rural
areas, especially encompassing minority-owned companies, and service
businesses which are often the type founded by women entrepreneurs.
The existing Small Business Company (SBIC) program helps to meets the
needs of high growth small businesses, and provides the basis for a variation
that could target the needs of the underserved markets described in the
paragraph above.
The Four Components for Success
There are four components necessary to successfully accomplish the goal of
providing equity type capital for the underserved markets:
1. A financing company that provides funds to the entrepreneur
2. A specialized technical assistance (TA) organization that
provides targeted TA, both before and after a financing has
taken place
3. A regional or local venture capital advisory organization, and
4. Federal government financial assistance, or "leverage".
U.S. Small Business Administration
Page 3
6/5/98
SBA
Championing America i Entrepreneurs
The Core
The heart of the concept is a "development venture capital" fund (DVC).
From a day-to-day operating standpoint, the DVC would be run just like a
regular venture fund. It would:
Have investment officers who review proposals
Make investments on a sound investing basis with a view
towards profitability
Assist in the workouts of troubled situations
Exit profitably from investments, and
Perform liquidations when necessary.
However, a major difference between a DVC and a regular venture fund or
SBIC would be that the structuring of a financing would not be designed to
yield as high a return as within an SBIC. Due to the normal losses that occur
in any venture fund, as well as the fact that most companies do not achieve
plan, such a fund would ultimately have a goal of achieving an overall 8% to
10% internal rate of return for its investors, rather than the 15% to 23% of
regular venture funds.
U.S. Small Business Administration
Page 4
6/5/98
SBA
Championing America & Entrepreneurs
Highlights of the SBIC Program
SBICs are privately owned and operated venture capital investment
companies organized with a minimum of $5 to $10 million of private capital.
SBA's role is to (a) license them, (b) to regulate their operations for
compliance with the public policy objectives of the Small Business
Investment Act of 1958, as amended, protecting the government's creditor
interest, and (c) to supplement their private capital through public offerings of
SBA-guaranteed securities (termed "leverage").
SBICs tend to serve small businesses whose venture capital needs fall in the
$500,000 to $5 million range. This exceeds the amount usually available from
so-called "angel investors" but falls short of the minimum typically required
to interest the institutionally-minded venture capital firms. A June 1996 study
commissioned by the SBA Office of Advocacy estimates that the number of
entrepreneurial ventures that need equity financing includes about 50,000
start-ups per year (5% to 10% of total start-ups) and 300,000 ventures
growing faster than 20% per year (including 80,000 growing faster than 50%.)
The SBIC program today consists of 315 licensees in 44 states. These
licensees have total capital of over $5.9 billion, and over the past 39 years,
SBICs have provided more than $17 billion in approximately 114,000
financings of small businesses. These have included such well-known
companies as Federal Express, Intel, Cray Computer, Callaway Golf, America
on Line, Staples, and Outback Steak House.
In fiscal 1997, there were 2731 financings totaling $2.4 billion in 47 states
plus the District of Columbia and Puerto Rico. A total of 90% of the
financings had equity features, and 49% went to firms less than 3 years old.
During the past four years, more private capital has flowed into SBICs than
during the prior 30 years.
However, the program has had its problems in the past. During the 1980s,
the program shrank and $600 million of gross leverage liquidations occurred
before any recoveries which are about 60%. A number of identifiable
problems existed: (1) there was inadequate management, (2) the capital base
of most SBICs was too small to be economically viable, (3) portfolio
valuations were done poorly which led to inaccurate reporting and inaccurate
credit evaluation by the SBA, and (4) there was a mis-match of funds flow as
debt leverage was being used to finance equity investments. These problems
were cured with legislation in 1992 and new regulations and policies
beginning in 1994.
U.S. Small Business Administration
Page 5
6/5/98
SBA
Championing America's Entrepreneurs
In 1972, the Minority Enterprise Small Business Investment Company
(MESBIC) program was enacted into legislation. It was subsequently
expanded into the Specialized SBIC program (SSBIC). At the end of fiscal
1996, congress abolished the program, but grandfathered all existing SSBICs.
Congress had concluded that the program, with subsidy rates (cost to the
government) of approximately 29% and 43% for various subsidized securities
was too expensive relative to the benefits delivered.
Most SSBICs are too small to strongly achieve the public policy purposes of
the program. The average capital of the 79 SSBICS is $2.3 million compared
with $11.97 million for the 156 regular SBICs which have leverage.
DVCI.doc