The passage of the Small Business Investment Act of 1958 expanded the availability of venture capital to growing businesses.
In 1958, a Federal Reserve System report titled Financing Small Business
Prior to 1946, the venture capital industry was composed primarily of wealthy individuals and groups providing risk capital to projects on a relatively informal basis. An earlier example of this type of funding would be that raised by Thomas Alva Edison
Edison developed new technology to crush, separate, and briquette ore to make it usable in the steel mills of the day. Sixty-two patents related to these efforts were granted, more than 6 percent of Edison’s total. His expectations about the market went unfulfilled, and the plant closed in 1900 after more than a decade of sporadic operation. Investors lost their entire contributions. Edison himself lost about $2.3 million, raised mostly through the sale of stock of a previously successful venture, Edison General Electric. Examples of early family venture capital organizations active prior to World War II include Venrock Associates (Rockefeller) and J. H. Whitney and Company. American Research and Development, founded in 1946, was the first institutional, professionally managed venture investment firm in the United States.
Venture capital is often thought of as funding for firms in their early stages that have the potential for rapid growth. It can range from investment in a start-up firm with a limited operating history through financing that enhances the growth prospect of a firm in later stages of development. A leveraged buyout of a firm by new owners is another use of venture financing.
Venture capital deals have several typical characteristics. An equity instrument is normally involved, such as the sale of common or preferred stock or a loan to the company with options to buy a certain percentage of the firm’s stock at a set exercise price. Straight loans are the exception, as venture capitalists want to profit from any extraordinary successes. Venture capital deals typically have a time horizon of five to seven years before the venture capitalist can liquidate his or her position to realize returns on the investment. Investors commonly stipulate active interaction with the management of the firm to provide assistance and direction. Over the life of the investment, multiple cash injections may be required either to spur growth or to prevent the failure of the firm.
As late as 1958, even with the development of a more professional venture capital industry, the Federal Reserve concluded in its report that wealthy individuals, whether on their own or as partners in investment-banking houses or as corporate officers, were the backbone of the venture capital market. Sometimes equity investments were made for noneconomic reasons. Investors might want to take a risk, to defy calculated probability. Investment might provide the opportunity to become involved in business operation and management problems. Some wealthy people, the report added, take seriously the social responsibilities of wealth, believing that they should invest in and otherwise assist small businesses as a civic gesture.
This private venture capital market was thought to be inadequate, and changes were to be made. Financing Small Business apparently was the impetus for the establishment of the Small Business Investment Company system under the umbrella of the Small Business Administration
The venture capital market had changed in the face of losses and as the time required rose for initial screening and the follow-up work needed after an investment was made. Some firms would no longer consider start-up or smaller firms, and others raised their minimum investment requirements. The “hurdle rate,” the minimum expected compounded return below which a venture capital firm would not invest, commonly was 20 to 30 percent. Only 1 to 2 percent of firms seeking equity financing actually received it.
Most wholesale, retail, and service firms had no chance of meeting the required criteria, as the growth required was so rapid. Only a few manufacturing firms with innovative products could potentially qualify. The rest usually had to limit their search to the local community, to firms seeking diversification, or to individuals who would invest funds in exchange for an equity position.
This gap in availability was filled when the Small Business Investment Act was passed on August 21, 1958. Congress attempted to fill a perceived need in the financial spectrum for institutional sources of equity-type financing. By allowing borrowing at advantageous rates from the Small Business Administration (SBA) as well as some tax benefits, private capital was to be drawn into the equity investment sector of the financial market.
The Small Business Investment Company
Advantageous tax provisions induced investors’ participation in the SBIC system. Both an SBIC and its individual stockholders were entitled to unlimited ordinary loss deductions. The SBICs were allowed a 100 percent dividend before calculation of their income tax, compared to 85 percent deduction on dividends for other corporate entities.
The Small Business Investment Act of 1958 exacted requirements in return for these inducements. SBICs had to issue reports to the government about their operations, their loans to small businesses had to have a minimum five-year term, and size restrictions limited their potential clientele. Clients could have no more than $5 million in assets, $2.5 million in net worth, and $250,000 in average net income for the last two years. No more than 20 percent of an SBIC’s funds could be placed with any single entity, nor could the SBIC own more than half of any firm. Inexperienced venture managers, unrealistic expectations, declining market conditions in 1962, and early legislation that favored very small firms ($150,000 or less in capitalization) forced a consolidation of the SBIC system to a low of 248 active SBICs in 1973. Many of the SBIC licenses that were granted between 1960 and 1962 would not have been issued after that time because of the more stringent regulations enacted after the shakeout.
The major impact that the Small Business Investment Act of 1958 had was to increase the availability of venture capital to ventures with good potential, narrowing or even eliminating the “equity gap,” the difference between the demand for risk capital and the supply of it. For example, for the first nine months of 1991, a total of 2,013 deals were consummated. Of these, 1,033 were done by SBICs and 980 by 301(d) firms (formerly called Minority Enterprise Small Business Investment Companies). The SBICs invested or loaned $324.3 million, and the 301(d) firms contributed $167.3 million, a total of $491.6 million of risk capital that would not have been available if the Small Business Investment Act had not authorized the formation of this new type of financial institution. From the inception of the system to 2006, about 20 million small businesses benefited from SBA programs, including nearly 220,000 loans totaling more than $45 billion.
At one time, the National Association of Small Business Investment Companies
The entire financial system was affected by the advent of the SBIC system. Many banks have ownership interests in SBICs, and many of their SBICs are quite large; most are equity oriented and build diversified portfolios. SBICs make it possible for the traditionally conservative banking industry to channel a small portion of its funds to support innovative new ventures. If the SBIC vehicle did not exist, involvement would be problematic.
Only about 1 to 2 percent of the individuals and firms seeking venture capital actually succeed in their quest, even with the billions of dollars the SBICs have contributed to these ventures. One of the major reasons financing requests are refused is perceived defects in management. Venture capitalists invest in people as well as in products. A key phrase that sums up their attitudes and beliefs is that an “A” management with a “B” product is better than a “B” management with an “A” product; they would rather back a superior management team with a lesser product than vice versa. Obvious problems such as lack of line or managerial experience, unbalanced experience, or general incompetence would be an immediate cause for rejection of a request for funding.
Another important reason for rejection by a venture capitalist is insufficient growth potential. The financier usually wants a minimum compounded expected return of approximately 30 percent per year. Few ventures have the potential to earn these returns. If the SBIC system did not exist, some worthy companies would not have received funding, created new jobs, and made their contribution to economic growth.
The actual documentation on capital gaps has not been definitive, but investors’ perceptions of gaps is real. Gaps may occur if financial markets are not efficient. In order for those markets to be efficient, information about sources of funds and about available investment possibilities must be available to potential investors. Because communication in this area is often not quick and complete, gaps may still exist in spite of the activity of the venture capital funds, the SBICs, and the informal network of small venture investors called “angels.” These last investors often search out prospects in the land of the commercially uninvestable. Firms that cannot meet the return requirements, are in industries that are temporarily out of favor, or fail to meet other criteria of the major firms are often financed by these small investors. It may be that because of imperfections an equity gap still exists. The existence of the Small Business Investment Company system has certainly decreased its size.
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Gompers, Paul, and Josh Lerner. The Venture Capital Cycle. 2d ed. Cambridge, Mass.: MIT Press, 2004. Academic study of the effects of venture capital upon the U.S. economy and businesses. Bibliographic references and index. -
New Enterprise Systems, Inc. Venture Capital in the United States: An Analysis. Wellesley, Mass.: Author, 1970. A comprehensive study of SBICs. Also provides a history of early venture financing from other sources. Provides terms and definitions used in the industry and an analysis of events. -
Noone, Charles M., and Stanley M. Rubel. SBICs: Pioneers in Organized Venture Capital. Chicago: Capital, 1970. A history of the first ten years of the SBIC system. Analyzes the Small Business Investment Act of 1958, provides a comprehensive history up to 1970, and provides statistical data and a directory of SBICs that were members of the National Association of SBICs, the industry trade association. -
Parris, Addison W. The Small Business Administration. New York: Frederick A. Praeger, 1968. A comprehensive history of the SBA from 1953 to 1968. This is a readable summary of the history of this agency and its activities. Interest in any specific function or event would require supplementary sources. Includes the text of the Small Business Act of 1953 in an appendix. -
Premus, Robert. Venture Capital and Innovation. Washington, D.C.: Government Printing Office, 1985. A study prepared for use by the Joint Economic Committee. -
U.S. Congress. Senate. Committee on Banking and Currency. Financing Small Business. 85th Congress, 2d session, 1958. Discusses various aspects of venture capital financing. Includes a survey of venture capitalists that led to the belief that there was a “capital gap” requiring government intervention to close. -
U.S. Congress. Senate. Committee on Small Business and Entrepreneurship. Small Business Act and Small Business Investment Act of 1958 Compilation. Washington, D.C.: Government Printing Office, 2006. Collects two important pieces of small-business legislation.
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