Small Business Investment Co.’s a Source of Capital By James A. Baldwin Of the few recent growth areas for small businesses, federal government contract set-asides for small businesses offer the most promise. With economic stimulus funds flowing to small businesses, the private equity community is increasingly considering investment opportunities with small government contracting firms. Moreover, small businesses, taking advantage of such government contract set-aside opportunities, are often seeking investment capital in order to fund specific projects or expand the company’s overall business efforts. Due to exemptions granted to investment funds licensed under the Small Business Investment Company Act of 1958 (the “SBIC Act”) and in SBA regulations: (1) small business investment companies (SBICs) should be increasingly regarded as a viable investment vehicle by private equity firms; and (2) small businesses that are planning to seek investment capital should strongly consider SBICs as a potential funding source. SBICs have a decided advantage over other non-SBIC investment funds seeking to tap into the opportunities now available to small businesses. The most significant advantage is their ability to make substantial investments in small businesses without running afoul of the SBA regulations. Under SBA regulations, entities are considered to be affiliates of each other when one entity controls or has the power to control the other, or a third party or parties controls or has the power to control both. It does not matter whether control is exercised so long as the power to control exists. The SBA considers factors such as degree of ownership, management, previous relationships with or ties to another concern, and contractual relationships in determining whether affiliation exists. SBICs are able to exercise control over their portfolio investment companies in ways that non-SBIC investment funds cannot without the substantial risk of having the small business deemed to be affiliated with such fund. In contrast, non-SBICs are presented with the problem of either investing in the small business without the market standard controls normally used to protect its investment or else risk being deemed an affiliate and ruining the small business’s eligibility and potential for sustained growth. A non-SBIC investment fund’s inability to gain customary control provisions from a small business can present hurdles to investment which the parties may not be able to overcome. Small businesses that receive funding from SBICs are able to more freely compete for government contracts without worrying about prohibitions regarding affiliation with larger entities while enjoying an advantage over larger contractors which do not qualify as small businesses. This makes SBICs a potentially more desirable source of funding for investment worthy small business government contractors versus capital sourced from non-SBIC investment funds. Accordingly, small businesses that participate in federal government contract set-aside programs should include and target SBICs when they are planning to attract investment capital. The SBA Investment Division desires experienced investment principals and well-managed funds to become participants in the SBIC Program when such parties share the common, long-term mission of the SBA that SBICs continue to be a significant source of funding for small businesses. Knowing the advantages SBICs have with regard to affiliation, SBICs should be more commonly considered as an additional investment tool in the arsenal of an investment manager who desires to make targeted investments in small government contractors. However, given the various licensing requirements of the SBA, it is prudent to review the elements of the SBIC program in detail if considering forming an SBIC. James A. Baldwin is counsel to PilieroMazza PLLC and practices in the areas of corporate transactions, mergers and acquisitions and private equity with an emphasis on small business investment companies. For additional information, contact jbaldwin@pilieromazza.com or at 202-857-1000.