I recently had a SBIC (small business investment company) come to us to perform their audit. They are trying to transfer the SBIC license to a newly formed entity and raise capital in a private placement.
One of the documents they were required to file asked for regulatory capital. The purpose for the question is to make sure the SBIC has enough capital to serve its purpose, which is to lend funds to certain qualifying small businesses. In the SBA guidelines is the following:
CAPITALIZING AN SBIC
§ 107.200 Adequate Capital for Licensees
You must meet the requirements of this § 107.200 to qualify for a license, to continue as a Licensee, and to receive Leverage.
(a) You must have enough Regulatory Capital to provide reasonable assurance that:
(1) You will operate soundly and profitably (2) You will be able to operate actively in accordance with your Articles and within the context of your business plan, as approved by SBA.
The definition of regulatory capital is defined in the SBA (Small Business Administration) guidelines as follows:
§ 107.50 Definitions
General. (1) Regulatory Capital means Private Capital, excluding non-cash assets contributed to a Licensee or a license applicant, and non-cash assets purchased by a license applicant, unless such assets have been converted to cash or have been approved by SBA for inclusion in Regulatory Capital. For purposes of this definition, sales of contributed non-cash assets with recourse or borrowing against such assets shall not constitute a conversion to cash. (2) Exclusion of questionable commitments. An investor’s commitment to a Licensee is excluded from Regulatory Capital if SBA determines that the collectability of the commitment is questionable.
Here is the capital structure of my client (rounded of course):
Common Stock $ 100,000
Additional paid in capital 2,500,000
Accumulated deficit (1,000,000)
Total stockholders’ equity $ 1,600,000
Now is regulatory capital $2,600,000 or $1,600,000?
I asked this question to the SBA. The answer was $2,600,000. They referred me to the guidelines and stated I should always refer to these guidelines, as if to say, “Hey dummy, read our rules.”
Well, what if the SBIC had accumulated losses in excess of the “regulatory capital”? This could mean the SBIC is insolvent. Therefore, I think regulatory capital has no bearing on whether the SBIC can operate soundly and profitably and the questionnaire should be focusing on net capital (regulatory capital less accumulated losses). I know you are saying, why not add retained earnings? Well, retained earnings can be distributed out to the shareholders and thus should not be counted when determining the “soundness” of a company unless the shareholders have request to re-invest those funds.