[Federal Register Volume 80, Number 52 (Wednesday, March 18, 2015)]
[Proposed Rules]
[Pages 14034-14037]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-06182]



13 CFR Part 107

RIN 3245-AG68

Small Business Investment Companies--Early Stage

AGENCY: U.S. Small Business Administration.

ACTION: Advance Notice of Proposed Rulemaking (ANPRM).


SUMMARY: The U.S. Small Business Administration (SBA) is seeking input 
and comments on its Early Stage Small Business Investment Company 
(SBIC) initiative, promulgated in the final rule on April 27, 2012. The 
intent of the initiative was to license and provide SBA leverage to 
SBICs over a 5-year period (fiscal years 2012 through 2016) that would 
focus on making investments in early stage small businesses. Although 
58 investment funds applied to the program, to date SBA has only 
licensed 5 Early Stage SBICs. SBA is seeking input from the public to 
determine whether existing market conditions warrant SBA continuing to 
license Early Stage SBICs past fiscal year 2016 on an ongoing basis 
and, if so, what changes should be made to the program to attract 
qualified early stage fund managers.

DATES: Comments must be received on or before May 18, 2015.

ADDRESSES: You may submit comments, identified by RIN 3245-AG68, by any 
of the following methods:
     Federal Rulemaking Portal: http://www.regulations.gov. 
Please follow the instructions for submitting comments.
     Mail, Hand Delivery/Courier: Javier Saade, Associate 
Administrator for the Office of Investment and Innovation, U.S. Small 
Business Administration, 409 Third Street SW., Washington, DC 20416.

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    SBA will post comments on this Advance Notice of Proposed 
Rulemaking on http://www.regulations.gov. If you wish to submit 
confidential business information (CBI) as defined in the User Notice 
at http://www.regulations.gov, please submit the information to Theresa 
Jamerson, Office of Investment and Innovation, 409 Third Street SW., 
Washington, DC 20416. Highlight the information that you consider to be 
CBI and explain why you believe this information should be held 
confidential. SBA will review your information and determine whether it 
will make the information public.

FOR FURTHER INFORMATION CONTACT: Theresa Jamerson, Office of Investment 
and Innovation, (202) 205-7563.


I. Background Information

    Early Stage Small Business Investment Company Initiative. In the 
Small Business Investment Act of 1958 (the Act), Congress created the 
Small Business Investment Company (SBIC) program to ``stimulate and 
supplement the flow of private equity capital and long-term loan funds 
which small-business concerns need for the sound financing of their 
business operations and for their growth, expansion, and modernization, 
and which are not available in adequate supply. * * *'' 15 U.S.C. 661. 
Congress intended that the program ``be carried out in such manner as 
to insure the maximum participation of private financing sources.'' Id. 
In accordance with that policy, the U.S. Small Business Administration 
(SBA), through the SBIC program, does not invest directly in small 
businesses, but provides leverage to SBICs, privately-owned and 
professionally managed for-profit investment funds licensed by SBA, by 
guaranteeing the payment of debentures issued by SBICs (Debentures). 
These SBICs in turn make loans to, and investments in, qualifying small 
    Since Fiscal Year (FY) 2000, the SBIC Debenture program has 
operated at zero subsidy cost, meaning that expected losses to the 
program's portfolio must be fully recouped through the collection of 
SBIC leverage fees in order to keep the program at zero subsidy cost to 
the taxpayer. By statute, SBIC leverage fees include a 1% commitment 
fee, a 2% draw fee, and an annual charge set at the time of commitment 
and paid on outstanding leverage in conjunction with interest payments. 
15 U.S.C. 683(i). The annual charge is formulated each year to keep the 
program at zero subsidy cost, but may not, by statute, exceed 1.38%. 15 
U.S.C. 683(b). Because the standard Debenture (Current Pay Debenture) 
requires semi-annual interest payments, most SBICs structure their 
investments as loans or mezzanine debt to finance later stage small 
businesses with positive operating cash flow so that they can meet 
requisite interest payments.
    On April 27, 2012, SBA published a final rule (77 FR 25042) to 
define a new sub-category of SBICs as part of President Obama's Start-
up America initiative. SBA's intent was to license over a 5-year period 
(fiscal years 2012 through 2016) venture funds focused on early stage 
businesses and to guarantee Debentures in an amount up to one-half of 
each fund's total capitalization. SBA allocated $1 billion of its SBIC 
Debenture leverage authorization over these years to this effort.
    Although SBA has received 58 applications to the Early Stage SBIC 
program, to date, SBA has only licensed 5 Early Stage SBICs due to the 
quality of the application pool and SBA's rigorous licensing standards. 
SBA is seeking input on whether a market need for the program remains 
and, if so, what changes should SBA consider in order to attract Early 
Stage fund managers with successful track records.
    Early Stage SBIC Key Requirements Summary. Current regulations 
identify special requirements for Early Stage SBICs to manage the risk 
associated with these funds investing in seed and early stage 
businesses, including the following:
    (1) Licensing Process--Sec.  107.310: SBA uses a call process 
rather than accepting rolling applications as in the regular SBIC 
    (2) Required Investments--Sec.  107.1120(k): Early Stage SBICs must 
invest at least 50% of aggregate financing dollars into Early Stage 
companies, as defined in Sec.  107.50, but generally defined as 
companies that have not yet achieved positive operating cash flow as of 
the date of the initial investment.
    (3) Minimum Regulatory Capital--Sec.  107.210(3): Early Stage SBICs 
must have at least $20 million in Regulatory Capital (qualifying 
Private Capital as defined in Sec.  107.50).
    (4) Leverage:
    (a) Maximum Leverage--Sec.  107.1150: Early Stage SBICs may qualify 
for leverage up to 100% of Regulatory Capital (also called ``one tier 
of leverage''), not to exceed $50 million.
    (b) SBA Leverage Fees--Sec.  107.1130: All SBICs issuing 
Debentures, including Early Stage SBICs, must pay 3% in up-front fees 
(1% at commitment and 2% at draw) and an additional SBA fee, not to 
exceed 1.38 percent per annum, on outstanding Debentures paid at the 
same time as interest.
    (c) Type of Leverage: Early Stage SBICs may choose from two types 
of leverage both with ten year maturities and subject to Early Stage 
Distribution rules:
    (i) Early Stage Current Pay Debenture: Requires quarterly payments 
for interest and SBA annual fees. Early Stage SBICs choosing to use the 
Current Pay Debenture are required to maintain a 5-year interest 
reserve per Sec.  107.1181. The interest reserve may include unfunded 
commitments or cash reserves which could be funded from Debenture 
proceeds. The interest reserve is intended to provide a pool of funds 
from which Early Stage SBICs can pay interest and annual fees while 
their investments mature.
    (ii) Discounted/Accruing Debenture: Debenture issued at a discount 
of 5 years of annual fees and interest charges, so that the amount owed 
accrues over a 5-year period to face value. After the 5-year period, 
quarterly payments for interest and annual fees must be paid on an 
ongoing basis.
    (5) Distribution Rules--Sec.  107.1180: Before an Early Stage SBIC 
with outstanding leverage may distribute to its investors, it must 
first pay all required SBA interest and charges and any leverage 
principal due at maturity. After those payments are made, if the Early 
Stage SBIC's capital impairment percentage, defined in Sec.  107.1840, 
is 50 percent or more, and the SBIC's leverage ratio (defined as 
outstanding leverage to Leverageable Capital) exceeds 0.5, it must 
repay all outstanding SBIC Debentures before distributing to private 
investors. Otherwise, the Early Stage SBIC must repay SBA leverage, at 
a minimum, pro rata (in proportion) with any distributions returned to 
private investors on a cumulative basis.
    (6) Restrictions on Third-Party Debt--Sec.  107.565: Early Stage 
SBICs must seek SBA's prior written approval before incurring any 
third-party debt, except for accounts payable from routine business 
    (7) Capital Impairment Percentage (CIP) Sec. Sec.  107.1830-1850: 
CIP is the primary financial metric SBA uses to evaluate an SBIC's 
ability to repay its leverage. CIP measures the losses incurred by an 
SBIC relative to its Regulatory Capital. If an SBIC exceeds its maximum 
allowable CIP, SBA has the right to, among other things, declare the 
entire indebtedness of the SBIC's Debentures immediately due and 
payable; and institute proceedings for the appointment of SBA as 
receiver of the SBIC. Because Early Stage SBICs are

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limited to one tier of leverage, the maximum allowable CIP ranges from 
45% to 70%, depending on the percentage of equity. If the percentage of 
equity investments at cost exceeds 67%, the maximum allowable CIP would 
be 70%.

II. Market Gap

    (1) Market Need. According to data from PricewaterhouseCoopers 
Moneytree (https://www.pwcmoneytree.com/), financings to seed and early 
stage companies by venture funds has grown from $2.16 billion in the 
first quarter of calendar year 2012 to over $4 billion in the second 
quarter of calendar year 2014, the highest amount in any quarter since 
2000. As a federal credit program, SBA seeks to direct capital to gaps 
in the marketplace. Given the growth in early stage financings since 
2012, SBA is trying to determine whether it should continue to license 
Early Stage SBICs past 2016. SBA is seeking input from the public with 
regard to the following questions:
    (a) Are there barriers preventing promising early stage small 
businesses from being financed, and, if so, what are the barriers?
    (b) Are there gaps in the financial markets with regard to 
financing early stage or seed companies in the United States? If so, 
what evidence exists to identify and verify these gaps?
    (c) If there are no or limited gaps in the financial markets for 
early stage and seed companies in the United States, should SBA 
continue the Early Stage SBIC program past 2016, but issue a call for 
Early Stage SBIC applications only if and when identifiable market gaps 
occur? If so, what evidence should SBA use to identify declining market 
conditions or gaps in the market?
    (2) Targeted Early Stage SBIC Participants. The Early Stage SBIC 
initiative focused on more established and traditional early stage 
venture funds to participate in the program because these funds' 
investment strategy effectively utilizes SBA's leverage to finance 
small businesses. SBA recognizes that many early stage and seed 
businesses may obtain capital from other sources than traditional early 
stage/seed venture funds. Accelerator funds, incubators, angel 
investment funds or other types of similar funds--venture capital funds 
that generally make a substantial number of relatively small-dollar 
equity investments in seed and early stage businesses--have not 
demonstrated significant interest in SBA's Early Stage SBIC initiative. 
Could these funds effectively utilize Debenture leverage as part of 
their investment strategy in a way that would not increase the risk 
profile of the SBIC program. What changes to the Early Stage SBIC 
program would SBA need to make in order to attract qualified funds that 
use this investment strategy? Would the minimum regulatory capital need 
to be changed? Would the leverage terms need to be changed? What data 
is available to assess the risk associated with these types of funds?

III. Early Stage SBIC Program Structure

    (1) Fund-Level Debt Versus Equity. Based on discussions with early 
stage fund managers and limited partners, SBA understands that most 
early stage funds would prefer equity rather than fund-level debt. 
However, SBA is only authorized to guarantee SBIC Debentures for its 
licensed funds. SBA also recognizes the potential mismatch between 
Debenture leverage and early stage portfolio company cash flows. 
Because most early stage portfolio companies do not have the cash flow 
to service debt, most early stage financings are structured as equity. 
SBA tried to compensate for this in the Early Stage SBIC program by 
implementing a discounted debenture in which leverage is issued at a 
discount and interest and charges accrue for 5 years before the fund 
would be required to make payments on a quarterly basis. Alternatively, 
Early Stage SBICs could use the Current Pay Debenture and pay interest 
and charges on a quarterly basis using the required interest reserve.
    SBA has heard from members of the venture capital industry that 
many early stage funds are not interested in leverage. SBA seeks input 
from the public on whether fund-level debt is of use to early stage 
fund managers or whether concerns exist with regard to current SBIC 
Early Stage Debenture leverage terms.
    (2) Early Stage SBIC Leverage Terms. Early Stage SBICs are expected 
to have significantly higher losses than regular SBICs, due to the risk 
associated with their portfolios. SBA structured the Early Stage SBIC 
program so that it could be run with minimum impact to the regular SBIC 
Debenture program. This includes limiting the amount of Early Stage 
leverage as a percentage of the overall SBIC portfolio. Key Early Stage 
SBIC requirements are summarized in Section I of this ANPRM. SBA seeks 
input from the public to identify how Early Stage SBIC requirements 
could be improved without increasing SBA's credit risk. In particular, 
SBA has the following questions:
    (a) Minimum Regulatory Capital: Currently, Early Stage SBICs must 
have at least $20 million in Regulatory Capital. Should SBA modify this 
Regulatory Capital requirement in order to improve the number of 
qualified applicants to the program?
    (b) Maximum Leverage: SBA set the maximum leverage for Early Stage 
SBICs at $50 million based on its overall allocation of $200 million 
per year, in order to provide some level of portfolio diversification. 
Should SBA increase the maximum leverage available to Early Stage 
SBICs, for example, to $100 million, approximately half of any year's 
    (c) Maximum Leverage Ratio: Currently, SBA provides up to one tier 
of leverage, not to exceed the maximum, in order to limit its credit 
risk. Should SBA lower the maximum leverage ratio to help further 
reduce its credit risk? What maximum leverage ratio is appropriate?
    (d) Interest Reserve: If Early Stage SBICs use the Current Pay 
Debenture, they must maintain a 5-year interest reserve to make 
interest and annual charge payments. SBA set this interest reserve to 
make sure that Early Stage SBICs would have sufficient funds to make 
required interest payments for the first 5 years and to lower the 
overall loss rate. Would removing the interest reserve attract more 
qualified applicants? If so, since the interest reserve was put in 
place to mitigate SBA's risk and limit the increase to the SBIC 
Debenture annual charge, what actions should SBA consider to help 
mitigate SBA's risk?
    (3) Other Early Stage SBIC Regulations. SBA invites comments on 
other aspects of Early Stage regulations, including the following:
    (a) Licensing Process: Would a rolling licensing process (where SBA 
accepts applications throughout the year) versus the Early Stage Call 
process, identified in Sec.  107.310, be preferred and/or attract more 
qualified applicants to the program?
    (b) Third-Party Debt: Do third-party debt restrictions identified 
in Sec.  107.565 detract from the program and what changes could be 
made to achieve the same credit risks for SBA?
    (4) Other SBIC Regulations and Guidelines. SBA also invites 
comments on other SBIC regulatory requirements as identified in 13 CFR 
part 107 that may be of particular concern to Early Stage SBIC 
applicants. For example, some Early Stage SBICs and potential 
applicants have indicated concerns with SBA's Valuation Guidelines 
(http://www.sba.gov/content/valuation-guidelines-sbics). SBA is 
interested in feedback as to what those concerns are

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and what changes industry members would recommend.

    Dated: March 11, 2015.
Maria Contreras-Sweet,
[FR Doc. 2015-06182 Filed 3-17-15; 8:45 am]