10.1.

22: Creatures of Statute: SBICs and BDCs

Some investment capital pools are creatures of statute, organized as Business Development Companies
(BDCs) or Small Business Investment Companies (SBICs).
[1]
As such, they are subject to a number of
special rules, certain of which are highlighted in the following discussion.
SBICs: Existing Program
The Small Business Administration provides financial assistance to small business investment companies,
as outlined in Chapter 6, which are licensed pursuant to 301(c) and 301(d) of the Small Business
Investment Act. SBICs licensed pursuant to 301(c) are general purpose SBICs (not limited, as the 301
(d) vehicles are, to facilitating minority ownership)
[2]
and can be corporations or limited partnerships.
They are limited to investing in small business concerns, as defined in the Small Business Administration
regulations.
[3]
Up until recently, SBICs obtained financing, if they obtained it at all, by issuing 10-year,
current pay debentures guaranteed by the SBA. An SBIC seeking to participate in the current pay program
is required to raise capital from private investors of at least $2.5 million. Because of the current pay
obligations, the participants (other than bank-affiliated organized solely to obviate certain suffrage issues
in the Federal Reserve Act) are largely mezzanine players, participating in late rounds of financing and
high-yield debt.
SBICs: General Restrictions
Subject to exceptions, an SBIC is not permitted to own or control more than 50 percent of the voting
power of the issuer,
[4]
rarely a concern in a traditional investment financing and relatively easily managed.
For example, if the SBIC wants control to reside in the investors (versus the founder), it usually brings in a
sympathetic partner and the two of them may own a majority of the stock in the aggregate as long as
there is no express agreement between them vis--vis control. The Regulations contain broad prohibitions
on conflicts of interest,
[5]
covering quite remote relationships. Thus, any partner of a director of an SBIC is
an Associate
[6]
of the SBIC and, as such, may not indirectly borrow money from a director of a firm
that the SBIC in question is financing. Simply outlining the reach of that rule illustrates how unwitting
violations could occur: Smith, a law partner of an SBIC director, buys a house from Jones, a director of one
of the SBICs portfolio investments, and gives back a purchase money mortgage. The entire notion of co-
investment-the SBIC and one of its shareholders investing in the same opportunity-is less popular than in
the investment world generally because of the conflicts rules.
[7]

A number of relatively harmless but annoying rules further constrain the business activities of an SBIC
enrolled in this debenture program. Thus, debt financings must be for a minimum of five years and only a
reasonable prepayment penalty may be involved.
[8]
The aggregate amount of funds loaned and/or
invested in any one firm cannot exceed 20 percent of a leveraged licensees private capital, a number
calculated according to quite detailed SBA rules.
[9]
An SBIC cannot become a general partner in any
Page 1 of 10 10.1.22: Creatures of Statute: SBICs and BDCs - Encyclopedia - Lib...
unincorporated concern or become jointly or severally liable for the obligations of the concern;
[10]
it may
purchase options or warrants expiring no later than six years from the termination of the financing.
[11]
For
some curious reason, an SBIC can invest in preferred stock redeemable at the option of the holder, but no
such redemption privilege can be exercised for five years and the redemption price must be determined by
a legal and reasonable formula based on book value and/or earnings of the concern.
[12]
In short, the
price of government assistance is over regulation, often harmless but always a nuisance.
SBICs under the Participating Securities Program
In 1994 the SBA amended its regulations respecting SBICs in regard to, among other things, leverage, so-
called participating securities and SBA remedies in the event a licensee runs into trouble.
[13]
The
amendments also liberalize the size standards for eligible investments by SBICs. The most significant
change is the advent of the participating securities program. The system is that the agency will buy from
301(c) licensees an equity-flavored security known as a participating security and resembling a preferred
stock ultimately redeemable at the option of the holder.
[14]
The SBAs leverage will be in the form of
equity and not debt, meaning that the SBIC will pay dividends only out of profits, prior to redemption no
later than 15 years from date of issue (which will be 10 years for all practical purposes).
[15]
The classic
SBIC problem-that SBICs were borrowing short and investing long-will thereby be cured. The new SBICs,
using equity leverage, will be able to match up asset and liability maturities and invest, therefore, in
classic venture and buyout opportunities that pay off, if at all, over five to ten-year periods. The SBAs
money, albeit equity-oriented, is not free. The SBA charges an initial placement fee of 2 percent,
[16]

deducted from the proceeds remitted to the licensee. And, the SBA has a first call on profits and then a
back-end share of profits. The preferred return is styled as the prioritized payment and the back-end
sharing arrangement is the profit participation.
The hurdle rate (called the prioritized return) is a bit low by current PIV standardsthe rate on 10-year
Treasury billsbut the profit participation can be any number, not less than 12 percent if maximum
leverage is utilized, and even higher if interest rates should spike up. An investor who is conceding a 20
percent carried interest in profits to the managers, plus a placement fee of 2 percent on the SBAs piece,
plus a 2.5 percent annual management fee, must factor in significant dilution, particularly if the managers
carried interest is earned at full rates on the SBAs money as Well.
[17]
On the other hand, if one looks at
comparable rates in the high-yield market, a nonrecourse, interest only when earned, 10-year loan at
Treasury Bill rates, coupled with warrants on 12 percent of the equity at a nominal strike price, is a
competitive instrument.
Maximum Amount of Participating Securities.
The maximum amount of participating securities outstanding under any circumstances is $75 million,
which, if obtained, implies eligible capital from other sources of $45 million. (Eligible capital for purposes of
the program requires some triangulation-see below.) The breakdown is as follows: SBICs with eligible
capital up to $30 million may obtain participating leverage on a 2 to I basis, meaning an SBIC with $30
million in eligible capital can issue $60 million dollars of participating stock to the SBA. If eligible capital is
more than $30 million, then the maximum availability, measured on a one-to-one basis, becomes $75
million, $30 million doubled and $15 million matched dollar for dollar. Eligible capital
[18]
over $45 million
does not make any difference in terms of availability of leverage. More leverage is obtainable if the SBIC
also issues debentures (another $15 million in fact).
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Investor Commitments
The commitments of eligible investors have to be binding,- which apparently means at least (1)
unconditional, except for the right of an ERISA-governed investor to chicken out if the law is unfavorable
and (2) backed by reasonably Draconian remedies in the case of a default. Eligible investors are culled on
the basis of wealth and/or by institutional status.
[19]

Limitations on the Sources of Regulatory Capital.
Further, there is a diversity requirement, meaning a bias against an SBIC that is owned and managed by
the same individual or institution. This requirement is not particularly onerous. Foundations or pension
funds, for example, may own 100 percent of an SBIC. Moreover, banks and bank-holding companies are
eligible parents despite the so-called diversity requirement because they are publicly owned and the
diversity requirement is imposed either on the licensee or its ultimate parent. If a single individual,
however, or a corporate parent which is largely owned by a single individual were to apply, the so-called
diversity requirement could be a problem. Moreover, in addition to the accredited investor standard,
there is a limit imposed on the amount a state or local government (versus a state employee pension plan)
can invest for credit (as seed money for local development, for example)no more than 33.3 percent of
private capital, any excess not being counted as private capital.
Use of Proceeds.
Proceeds of participating securities may be invested only in securities issued by small business concerns, of
course, and then only in equity flavored securities-common stock, preferred stock and fluffy debt with
equity features (meaning debt, the interest on which is payable only from earnings) the idea being that
UBTI-sensitive investors can now invest in SBICs because the portfolio will not be debt-financed. Query,
of course, the deductibility of interest on the fluffy debt. An SBIC that uses SBA leverage (debt or equity)
may only invest up to 20 percent of its private capital in a single portfolio opportunity.
[20]
An SBIC that
eschews government money is not subject to any such limit (except, of course, that imposed by the
investors). There are also specific enterprises in which SBICs generally are not permitted to invest. Thus,
SBICs may not invest in other SBICs, investment companies, financial leasing companies, and entities with
less than half their assets, operations and employees in the United States. SBICs are not allowed to invest
directly in real estate, and there are limitations, in terms of portfolio percentages, on real-estate-related
investments.
Calculation of Prioritized Payment.
The SBAs preferred return (the prioritized payment) is calculated in accordance with the pass-through
trust certificate rate the SBA issues to fund the program, which rate is in turn fixed from time to time by
the Secretary of the Treasury, taking into consideration the current average market yield on outstanding
marketable obligations of the United States with maturities comparable with maturities with the trust
certificates being guaranteed by the SBA. Obviously, the idea is to match the rates on the participating
securities with the cost of money raised by the pool in which they are aggregated. If it is necessary to
issue trust certificates at a discount from par, apparently that fact will not affect the prioritized payment
rate. To figure the prioritized payment due in any year, one multiplies the rate by the redemption price of
the participating securities outstanding. It would appear that the calculation of the prioritized payment rate
is made only once, when the participating securities are issued.
[21]

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SBA Participation in Profits.
The base profit participation rate is 9 percent of accumulated net profits, minus any prioritized payments,
and adjusted according to the amount of leverage used and variations in Treasury borrowing rates.
[22]
Net
profits are conventionally calculated except that (1) the licensee is limited in the amount of management
fee which can be charged to profits (probably redundant in that a licensee with a greater-than-allowable
fee will not be licensed anyway), and (2) the basis of a portfolio investment, for purposes of computing
gain, is the original cost and does not include accrued but unpaid interest on the securities issued by the
portfolio concern. The latter exclusion stimulates comment. First, accrued but unpaid dividends are,
presumably, not to be included in basis for this purpose. Secondly, if the portfolio security is debt with an
earned-only interest component, presumably net investment income does not include accrued but unpaid
interest, or the SBA will enjoy a double count.
The profit participation rate is determined annually, or more often if necessary. Moreover, the participation
rate is calculated based on the highest ratio of leverage to leverageable capital which has ever been
outstanding, regardless of any repayment or redemption. Further, the S B A participates in profits from
the entire portfolio with certain exceptions. The Regulations provide that investments existing when
participating securities are issued or acquired while participating securities are outstanding (presumably
meaning any such securities are outstanding) are earmarked assets, which give rise to earmarked profits,
which in turn give rise to the SBA profit participation. And those assets retain their character (as
earmarked) until they are sold, even if no participating securities are outstanding at the time of sale. In
fact, if portfolio company A merges into IBM, for example, after the participating securities have been paid
off, the SBA shares in the gain on the IBM stock. In short, when a licensee starts up, the initial portfolio
investments are part of the base for purposes of measuring the SBAs profit share even though leverage is
not deployed until later, and the SBAs interest follows the investments until ultimate disposition. The only
exceptions are (1) new investments made after complete redemption of the participating securities, and
(2) investments sequestered as a result of an election to immunize the existing portfolio made by a
licensee in business prior to March 31. 1993, both such exceptions having been ignored for purposes of
this general discussion. Income from idle funds is included in net income for purposes of measuring the
SBNs share.
[23]

SBIC Shareholder Distributions.
Distributions from the SBAs accounts will be made at the same time profits are distributed to the other
investors. If and to the extent that the distribution is measured by assumed federal and state tax liabilities
(say 40 percent of realized profits) the distributions are made in accordance with the partners (including
the SBAs) respective interests in profits. Any excess is to be distributed
[24]
in accordance with a formula
based on the ratio of the SBICs total outstanding preferred securities (and debentures, if any) to private
capital at the time of distribution, viz:
If the ratio is more than 2:1, distributions to the SBA and investors will be made according to the
actual ratio of leverage to leverageable capital (e.g., at a ratio of 3:1, distributions will be 75
percent to the SBA and 25 percent to investors).
If the ratio is more than 1: 1 but not more than 2: 1, the distributions to the SBA and the investors
will be made 50-50.
If the ratio is 1:1 or less, distributions to the SBA and the investors will be made according to the
profit allocation formula (e.g., 9 percent or less) to the SBA and 91 percent or more to investors.
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Distributions of profits received by the SBA will be applied first to the SBAs profit share, with the balance
applied as a redemption of outstanding preferred securities.
[25]

Perhaps the most controversial aspect of the program is the threat that leverage will be lost when and as a
licensee harvests investments because the distribution policy set out in the statute and Regulations is out
of step with the profit-sharing arrangements. To illustrate, assume that the prioritized return has been
paid currently and that significant profits are realized in a given year. Assume further, for sake of
simplicity, that the SBA is allocated 10 percent of realized profits and the private investors, therefore, 90
percent. Finally, assume that the leverage ratio is between 100-200 percent, which means that
distributions to be made between the SBA and the private investors will be (after the tax distribution) on a
one-to-one basis.
The operative section of the Regulations is 107.245(c), which is entitled Returns on Capital. Section
245(c), as indicated above, makes distributions of realized profits mandatory, subject to withholding by
the licensee for reasonable reserves necessary to protect the licensees investment or relative position in
portfolio companies, but under no circumstances shall such reserves be used to make investments in
additional portfolio companies. The notion of mandatory distributions is conventional enough, but the
idea, which is driven by the Agencys concern for ultimate repayment of principal, that distributions will be
out of proportion to profit participations is novel.
The historical reason behind this anomaly is the so-called empty basket syndrome, a phenomenon
occurring in the current-pay debenture program, where the Agency found itself being paid currently, along
with the private investors, on an interest-only basis. However, when the Agency went to collect its
principal, it often found only an empty basket. To prevent unpleasant surprises of that sort, the Agency
is insisting on disproportionate distributions, the obvious result of which will be, if profits are healthy, to
retire the participating securities prior to their 10-year maturity, in turn upsetting the models of those
investors who planned to enjoy the benefits of leverage throughout the program.
[26]

The only piece of good news in the formula from the investors standpoint is the opportunity to make tax
distributions. Again, the Regulations are mimicking the culture of private PIVs, which generally require
mandatory distributions of realized profits up to amounts necessary to allow the investors to pay taxes
occasioned by the fact that taxes are assessed in a partnership upon the allocation of profits as opposed to
the distribution of profits.
[27]
Generally speaking, the investors may make a tax distribution out of the
Retained Earnings Available for Distribution (READ) account, the tax rate being calculated on an investor-
by-investor basis assuming that each investor is a resident of the state in which his principal office is
located and that all investors, even though in fact nontaxpaying, hypothetically pay tax at the highest
marginal federal and state rates. If those rates are in the 40 percent area on income and something less
on capital gains, then a significant amount of profits can be distributed in accordance with the 90-10 profit
participation ratio rather than the one-to-one ratio obtaining based on leverage.
[28]

Investments in Buyouts.
The liberalization of the size standards is likely to remove most of the controversy or confusion from
investments in so-called traditional venture capital, start-ups and emerging growth companies generally.
The issue, however, which has percolated under the surface of the entire program for some time has to do
with SBIC investments in buyouts. Bank-affiliated SBICs do not generally borrow from the government and
are usually oriented towards what used to be called leveraged buyouts and now (albeit often leveraged)
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are referred to euphemistically as buyouts. The oddity has been that the definition of small business
concern, keyed as it is to net worth and annual income, may qualify a giant company arising from a
leveraged buyout as a small business concern because, for example, the new debt eats up the balance
sheet and depreciation deductions (leveraged buyouts are often tax-driven) entails red ink on a GAAP basis
for the first few years. Despite expectations that the SBA, urged by the Federal Reserve and the
Comptroller of Currency, would step in to curtail bank-affiliated SBIC participation of this sort, nothing
dramatic has happened since the Federal Reserves well-known action against Citibank in the Del Monte
transaction. Indeed, a new regulation, 711, has been adopted which specifically addresses financing
concerns when a change of ownership ... will promote the sound development and preserve the existence
of the small concern; or will assist in creation of a small concern as a result of a corporate divestiture. For
concerns with 500 or fewer full-time employees and full-time equivalents, any SBAIC can finance a buyout
if the target meets the number-of-employees test and (if necessary) the $18/$6 million net worth and net
income tests. (Note that, under the industry-specific standards for small business concern, the only
qualifier is often the number of employees.) If the portfolio concern has more than 500 fulltime employees
(including full-time equivalents), then a licensee who obtains leverage from the SBA can invest only if the
buyout targets debt-to-equity ratio is no more than 5:1. If the licensee does not obtain leverage (such
being the case with bank-affiliated licensees), the debt-to-equity ratio cannot exceed 8:1.
BDCs
BDCs are Business Development Companies organized under the 1980 amendments to the Investment
Company Act of 1940.
[29]
The amendment was designed to release investment funds electing to be
treated as BDCs from some of the strictures of the 40 Act, which had theretofore prevented most of them
from offering their shares to the public. The new animal is defined in the statute as a closed-end fund
which invests 70 percent or more of its assets in Eligible Portfolio Companies, meaning, generally,
privately held companies as to which to the BDC renders significant management assistance. The
amendment was designed to lure investment funds into the public markets but the scheme has not as yet
worked. The 40 Act still poses significant problems for BDCs,
[30]
and only a handful of new entrants
[31]

have registered.
[1]
Regulation E under the 33 Act provides a simplified format-registration by notification-for public
offerings ($5 million or less) of the securities of an SBIC or a BDC.
[2]
Minority driven SBICs, called Specialized Small Business Investment Companies or SSBICs, do not
require minority ownership, 15 U.S.C. 68 1 (d), but, rather, that the investments of the SBIC will be
made solely in small business concerns which will contribute to a well-balanced national economy by
facilitating ownership in such concerns by persons whose participation in the free enterprise is hampered
because of social or economic disadvantages.
[3]
The small business concern definition was expanded in 1993 from companies with a maximum net
worth of $6 million and after-tax net income of $2 million to maximum net worth of $18 million and after-
tax net income of $6 million, an increase which the Agency says updates the existing standard for
inflation since the last adjustments in 1979, and permits the larger SBICs to provide follow on
investments in equity-oriented financing to growth-oriented small business concerns. The size standard is
conjunctive versus disjunctive, meaning the concern is not a small business concern unless it passes both
tests-its net worth is not in excess of $18 million and its average net income after federal income taxes
Page 6 of 10 10.1.22: Creatures of Statute: SBICs and BDCs - Encyclopedia - Lib...
(excluding any carry-over losses) for the preceding two completed fiscal years is not in excess of $6
million. A small business concern is, however, eligible if it meets the $18 million/$6 million standard or is
able to meet the size standard for the industry in which it is primarily engaged. These latter size
standards key either into gross receipts or number of employees. Gross receipts cluster in the $3.5 million
to $17 million range; the number-of-employees standard ranges generally from 500 to 1,000. The size
standard by SIC code is alternative. In other words, a meat packing plant is measured by the number of its
employees; general contractors for single family homes are measured by annual revenues.
[4]
Under the rule, an SBIC may own rights to purchase more than 50% of a firm on a fully diluted basis,
but that privilege should be exercised with caution. Chase, Shields, Lambert, Baker & Shillito, Small
Business Financing 142 (1983). The SBICs permissible quantum of the vote shrinks to 20% if the portfolio
company has 50 or more shareholders and no other stockholder owns a larger percentage. An SBIC can
control a portfolio company temporarily if necessary to protect its investment. Miller, Small Business
Investment Companies: Licensing, Tax and Securities Considerations, 36 Bus. Law. 1684 (July 198 1)
[hereinafter Miller].
[5]
Id. 107.903.

[6]
C.F.R. 107.3 (1987).

[7]
The terms of the transaction for the SBIC must be at least as favorable as for its affiliate. See Miller at
1686.
[8]
13 C.F.R. 107.30 1 (a) (1987). The term can be less if reasonably necessary as part of an overall
sound financing, whatever that means. Id. 107.301, 107.504(b)(1).
[9]
Id. 107.303.

[10]
Id. 107.320(a).

[11]
Id. 107.320(b).

[12]
Id. 107.321(b).

[13]
The Regulation, promulgated pursuant to the Small Business Equity Enhancement Act of 1992,
appears at 13 C.F.R. pt. 107.
[14]
Participating securities are, in fact, defined as preferred stock, preferred limited partnership interests
or debentures paying interest only out of earnings. 13 C.FR 107.3 (1987).
[15]
Under the statute, 683(g)(1), participating securities must be redeemed by the issuer no later than
15 years from the date of issue at par plus accumulated preferred dividends. For the view that preferred
stock redeemable at the option of the holder is considered debt for some purposes, see Ch. 13.
[16]
The placement fee is low by PIV standards, except that most PIVs do not use a placement agent. If the
licensee elects to ask the Agency for a forward commitment of leverage10 to 22 months into the future-
the commitment fee works out to another 1%.
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[17]
It is assumed the managers carried interest will generally be calculated as a percentage of profit to
the private investors versus profit to the vehicle; that is, if the SBA profit share is 12%, the carried interest
will be 20% of 88%.
[18]
The definition of capital varies, depending on the context. To get an SBIC license of any kind, the
applicant needs $2,500,000 in private capital, which means paid-in capital and surplus plus unfunded
binding commitments from qualified sources. For all practical purposes (and assuming all capital is
contributed in cash), private capital and regulatory capital are synonymous. To be eligible to sell
participating securities to the SBA, the applicant needs $10 million in private capitali.e. including
commitments. The agency may in specific instances reduce that requirement to $5 million if the Licensee
can show that it has a reasonable prospect of being profitable over the long term. The specific instances
given are (1) a licensee affiliated with a bank or bank holding company or other large organization which
undertakes to subsidize management expenses of the licensee and to provide management personnel and
operation support; and (2) an SBIC that operates in a rural area within a specific geographic area or a
reasonably compact focused urban area. The Regulations also point out the obvious-that simply raising $
10 million does not automatically entitle one to participate in the program. The applicant will have to
demonstrate financial viability and qualified management. Moreover, it is interesting to note that the
Agency expects that the optimum size of SBICs electing to issue w security [participating securities] is
expected to be $15 million to $20 million in private capital. Perhaps this is a hint as to which applications
will be favored. To draw down SBA leverage, however, the key is leverageable capital, which means cash
actually committed to the business and invested in portfolio companies.
[19]
The SBA scheme borrows from the accredited investor notion under 33 Act, Regulation D-institutional
investors (of all but the smallest size) and high net worth individuals, the classic investors in PIVs. The
standard for individuals is keyed only to net worth (not an income test) and it is $2 million exclusive of
ones most expensive residence, provided the SBIC investment is not more than 10% of net worth.
Individuals with $ 10 million or more of net worth can bet the entire farm if they wish. Private, state and
local pension plans are eligible players but the status of offshore investors is cloudy. All in all, the types of
eligible players track the PIV universe.
[20]
Note an important feature. Under 13 C.F.R. 107.101(i), at the end of the licensees first fiscal year,
10% of the portfolio investment must be in firms which qualify under the old size standards-i.e., $2 million
in profits and $6 million in net worth. That percentage increases to 20% for all succeeding fiscal years.
[21]
Since prioritized payments will not be made, presumably, in the early stages of the SBICs existence,
prioritized payments due are held in a memorandum account and the amounts notionally credited thereto
compound at the trust certificate rate. As profits are earned, the prioritized payment is deposited (debiting
the memorandum account) in a funded account, entitled the distribution account, and payments made
therefrom to the SBA, assuming the payment does not cause the SBIC to become insufficiently liquid
under the tests laid down in the Regulations.
[22]
If the leverage is one to one, meaning that the outstanding participating securities are equal to the
leverageable capital, then the 9% figure stands. If the leverage is less than then 100%-for example,
outstanding participating securities represent 50% of the leverageable capital-then the 9% rate is
proportionally reduced, in this case by one-half, or to 4.5%. If the leverage is in excess of one to one, the
9% rate is adjusted but not linearly; that is to say, if leverage is 1.5 to 1, the 9% rate does not go up
50%, from 9% to 13.5%. Rather, the formula is the ratio of participating securities to leverageable capital
Page 8 of 10 10.1.22: Creatures of Statute: SBICs and BDCs - Encyclopedia - Lib...
(1.5 to I in our hypothesis) minus I (or .5) times 3%. The result is 1.5%, which is added to 9% to bring
the number to 10.5%. The maximum profit-sharing rate is 12% under this formula, subject to the second
adjustment resulting from an indexing calculation, indexed off the yield to maturity rate on Treasury bonds
with a remaining ten-year term, (presumably matching the maturity of the trust certificates the SBA is
selling). The notional Treasury rate in the Regulations is 8%, which then gets adjusted up or down
depending on the ten-year bill rate. Without doing extended calculations, let us assume for current
purposes the ten-year bill rate is currently 10% and the profit participation rate is 9% (implying one-to-
one leverage). Indexing for the increase in the Treasury rate raises the profit participation rate to 11.25%.
There is no cap on adjustments to profit sharing resulting from increases in interest rates.
[23]
In calculating the SBAs interest in profits, there is an aberration. In most private investment
partnerships, the documents take into account the possibility of year-to-year variations, which in turn can
produce distortions unless profit participations are measured on a cumulative basis. For example, in a
typical investment or LBO partnership, a distribution of profits early in the PIVs existence to the party with
the carried interest (the general partners) needs to be netted against the possibility of subsequent losses,
or else the general partners are in the end, likely to be overpaid.
The SBA recognizes, in its discussion, that its profit participation may result in an overpayment unless
profits and losses are accumulated and netted over time; however, it reads the statute as prohibiting a
recharacterization of amounts already allocated. Thus, the SBIC sponsors are at risk, if there is
significant profit in year X followed by a significant loss in year Y, that the lack of an accumulation feature
will result in the SBA earning more than its stated profit participation.
[24]
The fact that the SBA does not pay taxes does not mean it eschews tax-driven distributions.

[25]
A licensee may permit distributions of capital (versus on capital) to the SBA and investors if regulatory
capital is above the minimum, all priority payments and profit participation payments are up to date and
leverage is in line. Distributions of capital are likely to occur when securities are distributed in kind, the
drill being to hypothesize a sale and calculate gain (or loss) accordingly, the basis of the security becoming
a charge to capital; the SBA is not interested in seeing in-kind distributions unless the securities are
publicly traded and marketable.
[26]
One planning possibility is for the licensee to calculate significant holdbacks for follow-on investments
in portfolio companies-i.e., no distribution until the end. This practice could theoretically be defended, and
in quite large amounts because, in the private sector, follow-on investments play a large part in a PIVs
investment strategy. However, since profits in the retained earnings account (aka READ-for retained
earnings available for distribution) cannot be reinvested in new portfolio companies, the opportunity cost
of holding back reserves is significant. As later indicated, the SBAs model suggests that leverage is good
news when the compounded rate of return is north of 11 % and bad news when the rate of return is south
of that number; and, since 11 % is not achievable on the investment of idle funds under current
circumstances, then sequestered reserves are not sensible. Moreover, even though distributions are
mandated only out of the READ account, and that account is netted against unrealized depreciation (but
not appreciation) in the portfolio, the current rate of return for private investors is driven in very large part
by the rapidity with which cash or liquid securities are returned to the private investors. Consequently,
even without the Agencys mandatory distribution provisions in 245(c), the investors have every
motivation to return profits as soon as they are realized.
Page 9 of 10 10.1.22: Creatures of Statute: SBICs and BDCs - Encyclopedia - Lib...
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[27]
Allowing distributions out of a suspense account, which is marked to market only on the downside,
may result in the private investors winding up with negative capital accounts while assets, measured by
unrealized appreciation, suggest there is plenty of money to go around.
[28]
Note one liberalizing factor: Investments may count against private capital if they are made after the
license application has been filed, even though the license has not been approved. For a warehoused
investment to be counted as leverageable capital, the investment must be approved by the SBA-approval,
which, presumably, will be coincident with approval of the application.
[29]
15 U.S.C. 80a-53-80a-64 (Supp. 1981). For a full discussion of the statutory scheme, see 1
Halloran, Ch. 4.
[30]
The most difficult section in the 40 Act is 17, the transactions with affiliates section, which retains
significant fangs, particularly in the co-investment area. On 17 generally, see Bartlett & Dowd, Section
17 of the Investment Company Act-An Example of Regulation by Exemption, 8 Del. J. Corp. Law. 449
(1983).
[31]
For a helpful discussion, see Testa, Federal Regulation of Venture Capital Companies, in Venture
Capital After the Tax Reform Act of 1986, at 123, 131 (PLI Course Handbook Series No. 422, 1987).
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