On September 19, the U.S. Small Business Administration (SBA) released a Proposed Rule making changes to SBA’s Early Stage Small Business Investment Company (SBIC) Initiative. SBA created the Early Stage SBIC in 2012 as part of the “Start-Up Initiative” announced by the White House to foster American innovation and job creation by promoting high-growth entrepreneurship. The proposed rule reflects SBA’s intent to continue licensing and providing SBA-guaranteed leverage to Early Stage SBICs beyond the initial five-year term previously announced and proposes regulatory changes that:

• Improve the Early Stage SBIC application process: The proposed rule would eliminate the limited “call period” application process currently utilized and allow applicants for Early Stage SBIC licenses to apply at any time on a rolling admissions basis. The proposed rule would also eliminate the prohibition on Early Stage SBIC applicants under common control with another Early Stage SBIC with outstanding leverage or leverage commitments from applying for an Early Stage SBIC license application.

• Remove restrictions on certain third-party debt for Early Stage SBICs: The proposed rule would eliminate the requirement that Early Stage SBICs must obtain SBA’s prior written approval to obtain and use capital call lines of credit if they are unsecured and satisfy the other conditions more particularly described below.

• Increase leverage available to Early Stage SBICs: The proposed rule increases the maximum amount of leverage available to Early Stage SBICs from $50 million to $75 million. This proposed increase is available to the five existing Early Stage SBICs as a well as to new applicants.

Comments on the proposed rule are due on or before October 19, 2016.

This alert provides a summary of the existing Early Stage SBIC Program and highlights SBA’s proposed changes.

SBA’s Early Stage SBIC Program

An Early Stage SBIC is required to invest at least 50 percent of its invested capital in “early stage companies.” An “early stage company” is one that has never achieved positive cash flow from operations in any fiscal year prior to the SBIC’s first investment in the company. An Early Stage SBIC must be a limited partnership and have a minimum of $20 million of Regulatory Capital to be licensed. Regulatory Capital is the sum of paid-in capital from private investors plus unfunded commitments from private investors that qualify as “Institutional Investors” as defined in SBA regulations (both entities and individuals can qualify as Institutional Investors). After being licensed, the Early Stage SBIC will be able to draw leverage from SBA in the form of 10-Year Debentures, with no required amortization. The amount of leverage that can be reserved for draws by an Early Stage SBIC is presently limited to an amount equal to the SBIC’s Regulatory Capital, capped at $50 million. If the proposed rule is implemented as written, the $50 million cap will be increased to $75 million.

Interest on drawn Debenture leverage is payable quarterly. An Early Stage SBIC must reserve the first five years of interest payments either by (1) having binding unfunded commitments in that amount from its Institutional Investors that can only be drawn to pay that interest or (2) maintaining that amount of cash in a separate bank or investment account. Alternatively, the Early Stage SBIC may draw discounted Debentures from which the first five years of interest have been deducted from principal.

A variety of regulations govern the investment and operations of SBICs. An SBIC can generally only invest in U.S. companies that are “small businesses.” A “small business” is one that has a tangible net worth not in excess of $19.5 million and average net income after federal income taxes for the preceding two completed fiscal years not exceeding $6.5 million. A small business can also be one that meets an alternative size test for its industry, based on number of employees or annual receipts (the alternative test). An SBIC must also have 25 percent of its financings in “smaller enterprises,” which are companies with net worths of no more than $6 million and average net incomes after federal income taxes for the preceding two completed fiscal years of no more than $2 million, or are companies that meet the alternative test. Distributions by an Early Stage SBIC cannot be made to investors unless all payments on outstanding Debenture leverage are current, and, depending on certain ratios, distributions may require a simultaneous repayment to SBA of outstanding leverage. SBA has a series of graduated remedies for failure to comply with its regulations.

An Early Stage SBIC may not reduce its Regulatory Capital without SBA’s consent and must obtain SBA approval to incur third-party debt (even if unsecured), other than accounts payable from routine business operations. However, if implemented as written, the proposed rule would allow Early Stage SBICs to obtain an unsecured line of credit without SBA approval if all of the following conditions are satisfied:

• The line of credit has a maximum availability limited to the lesser of (1) 20 percent of the Early Stage SBIC’s Regulatory Capital or (2) the amount of the Early Stage SBIC’s unfunded binding capital commitments (less the amount of any such commitments used to establish or fund the interest reserve required to be maintained for the first five years of interest payments).

• The line of credit has a term of no more than 24 months (although the term can be renewed so long as each renewal is no longer than 24 months).

• The lender is a federally regulated financial institution (e.g., a bank).

• All borrowings under the line of credit must be (1) for the purpose of maintaining the Early Stage SBIC’s operating liquidity (i.e., borrowings can be used for fund expenses) or providing funds to a particular financing, (2) be fully repaid within 90 days after they are drawn, and (3) fully paid off for at least 30 consecutive days during the Early Stage SBIC’s fiscal year.

Although SBA will continue to license and provide SBA-guaranteed leverage to Early Stage SBICs, SBA is limiting the annual amount of SBA leverage commitments it intends to issue. Beginning with the 2017 federal fiscal year (which began on October 1, 2016), SBA expects to allocate no more than $200 million in leverage commitments to Early Stage SBICs in any federal fiscal year. SBA set this targeted allocation for the purpose of keeping down the annual “charge” paid by all SBICs to have the SBIC program operate on a zero-subsidy basis. This annual allocation limitation is consistent with the initial annual allocations announced when the Early Stage SBIC program was launched in 2012 and could reduce the amount of leverage available to Early Stage SBICs, depending on the number of Early Stage SBIC licenses granted. It is presently unclear whether this aggregate annual limit on leverage commitments will result in there being insufficient leverage available to satisfy all requests for leverage commitments in full for any given federal fiscal year. To date, the limited allocation of leverage to Early Stage SBICs has not been a problem because there have been only five Early Stage SBIC licenses granted since 2012. SBA stated that it may modify the $200 million per year targeted allocation depending on demand for the program, Early Stage SBIC performance and other factors that may alter the risk profile of Early Stage SBICs relative to conventional Debenture SBICs.

A more detailed description of the Early Stage SBIC Program is available from Pepper Hamilton LLP (see Description of the Small Business Investment Company Early Stage SBIC Program).