Takeaways
- The U.S. Treasury Department’s SSBCI program provides a potentially significant source of capital for venture capital fund managers.
- In particular, venture capital funds focused on targeted geographies may find SSBCI funding attractive.
- Fund managers seeking SSBCI capital need to account for additional complexity and expenses in accepting any such funding.
In 2021, the U.S. Congress appropriated $10 billion in funding for “SSBCI 2.0”—a second phase of the State Small Business Credit Initiative originally introduced in 2010. The initial SSBCI program leveraged approximately $1.4 billion into well over $8 billion of private small business loans and investments. As part of SSBCI 2.0, the U.S. Treasury Department permits states to invest a portion of their allocated funding to venture capital funds for investment in small businesses within their state (“SSBCI capital”), which opens up significant opportunities for venture capital fund managers to attract commitments from states that are leveraging SSBCI Capital.
As part of the SSBCI program, the U.S. Treasury set forth a set of policy guidelines detailing requirements to which recipients of SSBCI capital are required to adhere. While a number of these guidelines are not applicable for venture capital fund managers, there are a number of requirements, some of which can be onerous and may require significant structural changes to a fund.
Key Requirements Regarding Portfolio Companies, Fees and Capital Commitments
Eligible Investments
SSBCI capital can only be used for investments (1) in targets that employ fewer than 750 employees, with managers required to target companies with fewer than 500 employees, (2) that have an average investment amount of $5 million or less, and (3) that do not exceed $20 million in aggregate investment. Given SSBCI capital is given by state-sponsored agencies, such agencies often have additional requirements (e.g., location-based or industry-based requirements) that must be followed in addition to the SSBCI program requirements.
Service Fees
SSBCI investors are limited in the types of fees and expenses they can pay in each case when using SSBCI funds. In particular, SSBCI investors are only allowed to pay services fees (as opposed to management fees), which are capped at 1.71% of the annual average of the federal contribution (i.e., capital contributions, not based on commitment size). While this is a cap on the overall level of fees, there is flexibility on the timing and structure of fee payments.
Minimum 1:1 Equity Match
Statute requires that each venture capital program that takes SSBCI capital must demonstrate that each dollar of SSBCI capital will cause and result in, at a minimum, $1 of new private credit. For a venture capital fund, this means that the manager will need to arrange for an equity match at least equivalent for any SSBCI capital committed.[1]
Fund Structuring Considerations
Due to the economic requirements—particularly around the required investment ratios—fund managers should carefully consider structural considerations with respect to a number of key factors.
Accounting for Limited Eligible Investment Universe
Fund managers seeking SSBCI capital should be aware that such capital is limited to participating in investments that meet eligibility requirements set by the U.S. Treasury and the relevant state. There are a number of ways to accommodate such a requirement including:
- Creating a separate entity for SSBCI-eligible investments;
- Providing for excuse rights in the fund’s governing agreements; and
- Using an alternative investment vehicle structure for SSBCI-eligible investments.
Each of these (and potentially other) approaches creates additional complexity that should be discussed in detail with corporate, tax and regulatory counsel. Any fund manager structuring for SSBCI investments should carefully consider disclosure items (including around conflicts of interest), allocation and expense mechanics, and administration.
Required Investment Ratios
In addition, the U.S. Treasury requires funds to set a ratio between SSBCI capital and private investment, which cannot be changed on a deal-by-deal basis. It may not be possible for funds to manage excuse rights and participation ratios in a traditional manner due to a variety of factors, given that certain portfolio companies may be ineligible to receive SSBCI funding and the above-described fee and expense considerations.
Fund managers will need to consider the method by which they will allocate an SSBCI-eligible investment between the SSBCI investor and the other investors. There are a number of options, including:
- Fixed Ratio: Fix SSBCI participation based on relative capital commitments;
- Variable Ratio: Vary the ratio based on relative remaining capital commitments; and
- Contracted Ratio: Negotiate a ratio at the time of the SSBCI commitment.
The preferred structure will likely depend on the investment expectations for the fund manager. For example, if the fund is focused on the particular SSBCI jurisdiction and will only make SSBCI-eligible investments, a fixed ratio may provide the simplest approach. The variable ratio may make sense for a situation where the SSBCI investor’s capital commitment is relatively low compared to the other investors’ capital commitments and the fund manager expects to make a number of eligible investments. Situations where the SSBCI investor is closer to an “anchor” investor and/or where the number of SSBCI-eligible investments is expected to be low may be best suited for a contracted-ratio setup.
It is important that a manager adheres to a formula that does not permit cherry-picking of investments with respect to amounts of SSBCI funding. In addition to being administratively burdensome, it creates substantial conflicts of interest. If a manager does not implement the correct arrangement, it risks leaving a substantial amount of SSBCI capital on the table, as it would not be able to deploy the capital with sufficient coverage to meet the 1:1 minimum match requirement.
In addition, a manager will need to account for differences in management fee payments vs. service fee payments and expense allocation to ensure that such factors are accounted for in their methodology and governance documents.
Other Material Considerations
Conflict of Interest Standards
SSBCI capital may not be used to make an investment in a business in which an “SSBCI insider” has a personal financial interest, and each jurisdiction participating in the SSBCI program is required to maintain conflict of interest policies consistent with the U.S. Treasury guidelines. While each jurisdiction’s policies may differ, managers seeking SSBCI capital should be prepared to perform diligence on their own personnel and the relevant portfolio companies to check against lists of SSBCI insiders. Managers must also create and execute conflict of interest policies on a go-forward basis to update and monitor such lists.
Sex Offender Certifications
Any business that receives SSBCI funds through a venture capital program is required to make a certification that no “principal” has been convicted of a sex offense against a minor. This applies to both the investor (i.e., the venture capital fund) and investee (i.e., the portfolio company).
Final Thoughts
While the amount of capital allocated to the SSBCI program (and thus available for investments in venture capital funds) is substantial, the capital comes with significant strings attached. Prior to accepting an SSBCI investor, a venture capital manager should be aware that accepting SSBCI capital will likely create increased complexity in its structure, costs (including in the form of formation, negotiation and administration expenses), and reporting and compliance burdens. Further, the venture capital fund manager will need to accept the required service fee structure and the potential inability to recover expenses from the SSBCI investor for any ineligible use of capital. Any fund manager considering accepting SSBCI capital should consult legal counsel familiar with SSBCI requirements in accordance with such arrangements.
[1] The statute requires a “cause and result” and while the policy guidelines give some examples (e.g., limiting investments to anchor investments or prohibiting SSBCI participation after the initial closing or investment with funds for which private capital is likely to be catalyzed by SSBCI participation based on the fund’s age, size or experience), it is not an exhaustive list. Managers may find it simplest to ensure that sufficient capital is raised for the fund or for the strategy through co-investment SPVs.
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