the SBA and the modern venture capital era -- 10/5/20

Today's selection -- from American Bonds: How Credit Markets Shaped a Nation by Sarah L. Quinn. The Small Business Administration (SBA) replaced the legendary Depression-era Reconstruction Finance Corporation (RFC), and, with the appearance of Sputnik, launched the modern era of venture capital:

"To end the RFC, Congress had to grapple with what, if any, kinds of credit support for business should remain. For years Democrats had advocated for government loans to small businesses while Republicans had called for the RFC to be closed. In 1953 the two sides struck a compromise: the same legislations that closed the RFC also established the Small Business Administration on a temporary basis. The new SBA’s staff even included RFC loan officers.

"The new agency had three tasks: to provide disaster relief, to help small firms secure government contracts, and to provide business loans through a revolving fund. The name of the agency was always something of a misno­mer, because early SBA assistance also went to medium-size and growing businesses -- manufacturers with 1,000 employees, retailers with sales of up to $1 million. Nevertheless, support for the SBA remained a way for politicians on both sides of the aisle to signal support for the little guy. In 1958 Congress created the SBA on a permanent basis.

"The SBA quickly moved into the field of venture capital. In fact, small business and venture capital shortages had been debated together for decades. Both small businesses and riskier firms had lacked access to long-term capital since the 1930s. Corporations created their own in-house labs for research and development. Guggenheim, Rockefeller, Whitney, Mellon, and Rothschild money made riskier bets in fields like aviation, but this funding stream was more like a patronage relationship than an institutionalized market niche. The capital shortage for small and risky firms was partly a hangover from the 1920s -- investors remained risk averse long after the Great Depression -- and partly the consequence of New Deal regulations and tax regimes. Glass-Steagall drew a line between commercial and investment banking. Commercial banks could not invest in companies. The investment banks, meanwhile, preferred larger and safer bets and tax-advantaged investments like municipal bonds. In theory the RFC could have stepped in to help both small businesses and riskier firms, but the RFC dealt only with less risky medium-sized firms and manufacturers. Since the late 1930s Congress had weighed policy solutions to this problem ranging from capital credit banks to government-backed invest­ment pools to deregulation. None gained much traction.

"The problem of venture capital grew more pronounced as new research opened new opportunities for commercialization. Wartime military pro­grams like the Manhattan Project had generated massive breakthroughs. But in the absence of a working venture capital industry, how would those new technologies become commercialized? In Boston, a team of luminaries from academia, finance, and industry in 1946 formed American Research Develop­ment (ARD), which is generally considered the first successful modern venture capital firm. Not coincidentally, ARD's founders included the president and treasurer of MIT, the university that had received half of the Office of Scientific Research and Development's research funds during the war. It was the start of an industry, but a slow one. By one count, the 1940s ended with fewer than 25 operating venture capital firms.

"After years of debate about venture capital, it was Sputnik that finally spurred Congress into action. The Soviets' show of technological prowess raised pointed questions about the state of U.S research and development. Less than a year passed between Sputnik's 1957 launch and the passage of the Small Business Investment Act of 1958. During that time Congress consid­ered what a reasonable U.S. policy might look like. The Senate Banking and Currency Committee called for a program that was 'private and profitable.' The main concern was that government efforts to fight the Soviets not come across as themselves socialist in bent. Government stock ownership in private firms and 'anything resembling' it was a potential sign of state ownership. In this context, credit programs and partnerships proved crucial. Loans allowed lawmakers to support venture capital at a comfortable distance. The SBA could inject funds into investment groups that would in turn provide long-term debt financing to growing firms.

"Small Business Investment Corporations (SBICs) were the result. The SBICs provided small businesses with unsecured long-term (5- to 20-year) loans, with some of the loans convertible to equity. Before they could make investments, the SBICs needed a capitalization of $300,000, but only half of that had to be raised privately. The rest could be borrowed from the SBA. After the initial $300,000 was distributed, a company could apply for more government funds. Tax expenditures further supported the program. Inves­tors in SBICs could write off losses to stock sales against regular income, for example. To strictly guard against state capitalism, no SBIC could own more than 20 percent of the equity of a supported business. To further mark the limits of federal power, the SBAs were chartered through states. Texas repre­sentative Wright Patman called the program a way 'to help free-enterprise help itself.' Then still a senator, Lyndon Johnson proclaimed that the structure did 'no violence to free enterprise' because it neither competed with nor sought control over private business.

"Problems immediately emerged with the SBICs. Smaller SBICs found that their returns did not cover the considerable expense associated with finding and vetting companies. The larger SBICs did better financially but tended to ignore the smallest businesses. Some SBICs focused on real estate rather than industry and retail, while others were run by neophyte or corrupt in­vestors. These issues led both the media and the SBA to took a closer look at the SBICs in the 1960s. Subsequent investigations exposed extensive rule violations, fraud, expected losses, and even some connections to organized crime. In response, the SBA ramped up regulations and clamped down on rules, which put more pressure on the remaining SBICs. Within a decade, 36 of the 50 publicly traded Corporations had closed.

"Meanwhile, private West Coast firms had started using limited partnerships to make equity investments in private firms, which turned out to be a far more successful organizational form. By 1988, the SBICs represented about 7 percent of the venture capital business, a far cry from the 75 percent share they had held in the early 1960s.

"Before the extent of these problems was revealed, however, the SBICs represented three-quarters of the venture capital industry between 1959 and 1963. These early SBICs acted like a catalyst or 'transitional institution' that helped attract a 'critical mass' of firms. Before the SBICs, much venture capi­tal work had been done quietly and on the margins. In contrast, SBICs spread familiarity with the fledgling industry while also developing expertise. The commercial and investment banks that had started some SBICs helped train new venture capital investors. In his book on how government programs fail, economist Josh Lerner argues that despite their problems, the early SBICs built the modern venture capital industry's infrastructure: 'Many of the early venture capital funds and leading intermediaries in the industry-such as law firms and data providers,' he writes, 'began as organizations oriented to the SBIC funds, and then gradually shifted their focus to independent venture capitalists.' Lerner points out that the premier reporting firm for the venture capital industry, Venture Economics, started in 1961 as the SBIC reporting service. Since the 1960s, SBIC funds have flowed to Costco and Staples, FedEx and Tesla, Apple and Intel, Jenny Craig and Outback Steakhouse."



Sarah L. Quinn


American Bonds: How Credit Markets Shaped a Nation


Princeton University Press


Copyright 2019 Princeton University Press


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