PRINT THIS PAGE Using leverage to stimulate investment in small businesses22/11/2006. Source: IVCJ. 
 The use of leverage by investors and technology companies can provide substantial benefits. In this IVCJ article, Sarit Soccary Ben-Yochanan of L Capital Partners explains ways in which leverage works to boost investor incentives and enhance company growth and innovation
Leverage is a technique used in almost every industry to reduce risk and enhance returns. Real estate, for example, is an industry where third-party financing is part of almost every transaction and a major factor in boosting returns and lowering/sharing the risk. But the use of leverage in the venture capital industry is not as common as it should be. (The use of the term leverage in this article refers to both debt and preferred equity financing.)
Most money used in growth companies comes from equity – not leverage. Equity is expensive, however, because it participates not only in the risk, but also in the return. One must ask why leverage is not as common as equity and whether investors and companies are using the right means to maximize returns.
Leverage increases the return on an investment by using borrowed money. So why is its use in the venture capital community limited? The main reason would seem to be that the world of venture capital is high risk, where the best, or only, collateral one can receive is intellectual property that is difficult to value and liquidate.
Existing financing programs for high-risk companies in the United States and Israel include research and development support through the Defense Advanced Research Projects Agency (DARPA); the National Institutes of Health; the Office of Chief Scientist (OCS) in Israel; and loans or mezzanine financing offered by banks such as Bank Leumi and Silicon Valley Bank. If one examines the various programs offered today for high-risk financing, it is clear that early stage is supported by governmental programs, and that the commercial market starts to participate only at later stages.
Government programs carry both a social and an economic agenda. Their main purpose is to promote the growth of small businesses and stimulate the economy. The actual return on the investment is of secondary importance. An additional agenda is the promotion of specific technology or areas of research. While OCS programs in Israel are focused on the growth of technologies or high-tech businesses, in the United States, the Small Business Administration (SBA) is focused on the growth of small businesses – both low and high-tech.
Leverage at the investor and company levels
It is important to distinguish between leverage at the investor and company levels. At the investor level, leverage programs provide investors with matching funds for every dollar they invest. Examples of such programs are the Yozma program, which jumpstarted the venture capital industry in Israel, and the Small Business Investment Company (SBIC) program in the United States, which was started in 1994 to support private equity investments in small businesses. At the company level, leverage financing may be received on a project basis or for research and development (R&D) activities.
Examples are the BIRD and OCS programs. While leverage at the investor level is a very simple and effective instrument for encouraging investments, on the company level it is helpful in promoting the growth of innovation and technology. Companies that can successfully pass due diligence can enjoy OCS participation in R&D costs in return for future royalties.
At the investor level, the OCS offers owners of privatized incubators a higher level of leverage for its early stage companies (up to 85 percent of all expenses). Regular OCS support – up to 40 percent of R&D costs – is for later stage companies. With a similar agenda, the United States Congress established the SBA in 1958 to stimulate long-term investment in small US businesses. Over the years, SBICs have provided funding to approximately 90,000 businesses, including such wellknown firms such as Apple Computer and Federal Express. Today, there are more than 440 licensed SBICs with $19 billion in assets under management.
Like the OCS, the SBA has programs on the company level (SBIR) and on the investor level (SBIC). SBICs are privately owned and managed venture capital, mezzanine and private equity firms that are licensed by the SBA in order to gain access to SBA financing of as much as twice the privately committed capital. Investment decisions are made by the SBIC’s principals, but must comply with the SBA regulatory framework, which requires that portfolio companies be operating businesses in the United States with net assets of less than $18 million and average after-tax earnings of less than $6 million for the prior two years.
Support at the investment level provides a real incentive for two major reasons. It permits investor access to a larger pool of investment capital, enabling the fund to invest reasonable amounts of money in a greater number of companies and thereby spread investment risk. Additionally, the use of leverage, while accompanied by certain risks, offers the opportunity to significantly enhance returns to the private investor. In the privatized OCS incubators, investors have the right to buy back OCS shares by repaying its investment plus interest after six years. In the SBIC Participating Securities program, if the internal rate of return to the fund from its investments exceeds certain specified levels, the rate of return to private investors will be increased. The amount of enhancement increases significantly as the Fund’s IRR increases. However, if the fund’s IRR is less than the specified level, returns to investors will be reduced.
When is leverage effective?
Access to leveraged programs is difficult. The SBA, for example, requires the management team of a fund to undergo a rigorous approval process that reviews its track record, the suitability of the individuals to manage an SBIC, and the cohesiveness of the management team.
There are also restrictions to ensure that funds will be spent properly to meet program goals. In order to receive funding from the OCS, for example, all of the intellectual property developed must be under Israeli ownership. There are also restrictions on manufacturing, and requirements to have R&D activities in Israel. The SBA requires that portfolio companies be registered and have most of their operations in the United States.
Repayment methods vary from royalties under the OCS programs to other mechanisms such as interest plus warrants under debenture programs. The SBIC participating securities program has various fees, such as prioritized payment of 220- 250 basis points over the 10-year T-bill rate on principal and a profit participation of approximately 7 percent to 12 percent on earnings available for distribution.
There are also one-time underwriting and commitment fees. In these programs, the leveraged capital is generally available at a lower cost than commercial capital, thereby mitigating the risk, while leaving most of the upside for the investors.
From a company perspective, using grants and debt to reach milestones and achieve a step-up in valuation is a real opportunity, although one must be sure that the restrictions these programs place on a company’s business are compatible with its interests. Leverage at the company level is a cheap source of capital that enables the company to meet milestones without paying with equity. On the other hand, equity brings on board partners that share the risk and often have the same interests as those of company management. There are circumstances in which it is important to have such partners on board.
Programs that provide incentives for investment in small companies and technologies are highly important. This is demonstrated by what the Yozma program did for the venture capital industry in Israel. Mitigating the risk for investors is an effective mechanism to stimulate growth. The SBA is currently in the process of restructuring the SBIC program, and investors in OCS privatized incubators are signing on for an extension of the program. Those individuals in the position of determining what future governmentsupported programs should be like mus
This article appeared in the Israel Venture Capital & Private Equity Journal (IVCJ). IVC Research Center publishes the Israel Venture Capital & Private Equity Journal, a quarterly review of trends and developments in the Israeli-related venture capital industry. IVCJ, distributed worldwide, is dedicated to provide wide-range coverage of Israel's venture capital industry. For more information please visit www.ivc-online.com
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