Navigating an SBIC Term Sheet

Why Term Sheets Matter More Than You Think

An SBIC term sheet isn't just a preliminary agreement – it's a detailed roadmap of your relationship with the investment firm for years to come. While not typically legally binding in their entirety, certain provisions (like expense reimbursement and termination fees) often are binding immediately upon signing.

Let's examine the critical elements you'll encounter in SBIC term sheets and what they mean for your business operations and financial future.

Investment Structure: The Foundation of the Deal

The Hybrid Approach

SBICs typically structure investments using a combination of:

1. Subordinated Debt - Usually comprising 60-80% of the total investment

2. Equity Participation - Typically 20-40% of the total package

This structure allows the SBIC to generate ongoing interest income while maintaining upside potential through equity ownership.

What You'll See in the Term Sheet:

Example: On a recent deal Lender X offered $6.5 million in subordinated debt with a 11% interest rate (10% current + 1% PIK) and $3.5 million in equity, while Lender Y proposed $7.5 million in subordinated debt with a 14% interest rate (12% current + 2% PIK) and $2 million in equity.

Why It Matters: The debt-to-equity ratio affects both your repayment obligations and the amount of control you're ceding to investors. Higher equity components generally mean more investor involvement in business decisions.

Debt Terms: Devil in the Details

Interest Rate Structure

Most SBIC subordinated debt includes:

• Current Pay Interest - Cash payments typically made monthly

• PIK (Payment-in-Kind) Interest - Accrues and adds to principal balance

Maturity and Repayment

SBIC loans generally feature:

• Bullet Maturity - Most principal due at the end of the term (typically 5 years)

• Limited or No Amortization - Unlike bank loans, little or no regular principal reduction

• Prepayment Penalties - Substantial fees for early repayment, especially in early years

Example: Lender X’s term sheet included no amortization and a "yield maintenance" provision requiring 0.48x return on prepaid amounts. Lender Y’s included no amortization with prepayment penalties of 3%/2%/1% in years 1/2/3.

Why It Matters: These structures conserve cash flow in the near term but create large balloon payments. The prepayment penalties mean you're effectively locked into the relationship even if better financing becomes available.

Equity Terms: Ownership and Control Implications

Ownership Percentages

SBICs typically require:

• Minority but Significant Stakes - Usually 10-40% of total equity

• Preferred Terms - Often better than common shareholders

Control Provisions

Look for these key provisions:

• Board Seats - Usually 1-5 board positions

• Veto Rights - Approval requirements for major business decisions

• Put Options - Rights to force the company to repurchase their equity

Example: Lender X’s term sheet specified equity divided among Class A (81.3% ownership), Class B (12.5%), and Class C (6.3%), with Lender X holding five board seats. Lender Y’s term sheet included a put option exercisable after 60 months at fair market value.

Why It Matters: These provisions often grant the SBIC significant influence over your company's strategic direction, well beyond what their equity percentage might suggest.

Covenants: The Operating Boundaries

Financial Covenants

Common requirements include:

• Leverage Ratios - Typically maximum debt-to-EBITDA ratios

• Fixed Charge Coverage - Ensuring sufficient cash flow for debt service

• Minimum EBITDA - Floor for operational performance

Operational Restrictions

Be prepared for limitations on:

• Capital Expenditures - Approval requirements above thresholds

• Acquisitions/Divestitures - SBIC approval for significant transactions

• Management Changes - Approval rights for executive hiring/firing

• Distributions to Owners - Strict limitations on dividends and distributions

Example: Lender Y’s term sheet specified maximum total net debt to LTM EBITDA (likely 3.5x), minimum fixed charge coverage ratio (likely 1.2x), and minimum EBITDA, with approval requirements for capital expenditures, new debt, acquisitions, and limitations on distributions.

Why It Matters: These covenants can significantly limit your operational flexibility and ability to respond quickly to market opportunities or challenges.

Reporting Requirements: The Transparency Mandate

Financial Reporting

Expect to provide:

• Monthly Financials - Typically within 30 days of month-end

• Quarterly Reports - More detailed financial and operational data

• Annual Audited Statements - Formal third-party verification

• Annual Budgets - Forward-looking financial plans

Example: Lender Y’s term sheet required monthly company-prepared financial statements within 30 days, annual audited financials within 120 days, and a monthly budget for the upcoming fiscal year within 30 days of year-end.

Why It Matters: These requirements create additional administrative burden and costs, while also increasing transparency into your operations.

Fees and Expenses: The Hidden Costs

Upfront Fees

Common charges include:

• Origination Points - Typically 1-3% of total investment

• Due Diligence Expenses - Pass-through of third-party costs

• Transaction Fees - Legal and documentation expenses

Ongoing Expenses

Be aware of:

• Monitoring Fees - Annual charges for oversight

• Board Meeting Expenses - Reimbursement for SBIC representative travel

• Amendment Fees - Charges for adjusting terms post-closing

Example: Lender X’s term sheet included 1.5% origination points at closing. Lender Y’s included a 2.00% closing fee and provisions for board expense reimbursement and monitoring fees.

Why It Matters: These costs can significantly increase the effective cost of capital beyond the stated interest rate and reduce the net proceeds available for your business needs.

Termination Provisions: The Exit Penalties

Breakup Fees

Watch for:

• Termination Fees - Penalties if you pursue alternate financing

• Expense Reimbursement - Payment of all SBIC due diligence costs regardless of closing

Example: Lender X’s term sheet specified that if the company pursued a transaction with another party after accepting the proposal letter, Lender X would be entitled to a fee equal to 2% of the investment amount plus all out-of-pocket expenses.

Why It Matters: These provisions can make it costly to walk away from the deal, even if you discover better options during the due diligence period.

Strategic Negotiation Points: Where to Focus Your Efforts

Not all term sheet provisions are equally negotiable. Here's where to concentrate:

1. Interest Rate Structure - Push for less current pay vs. PIK based on cash flow

2. Covenant Levels - Seek headroom above current performance

3. Board Representation - Maintain control of the board when possible

4. Prepayment Flexibility - Negotiate reduced penalties in later years

5. Reporting Timelines - Ensure requirements align with your capabilities

The Bottom Line: Balancing Growth and Control

SBIC financing can provide crucial growth capital when traditional bank financing isn't available, but it comes with significant costs beyond the interest rate. Before signing a term sheet:

1. Model the Full Impact - Analyze how all provisions affect your cash flow and operations

2. Consult Advisors - Get experienced legal and financial guidance

3. Consider Alternatives - Evaluate all capital sources before committing

4. Negotiate Strategically - Focus on provisions that most impact your business model

By understanding the complete picture of what an SBIC term sheet entails, you'll be better positioned to negotiate favorable terms and maintain the right balance between accessing growth capital and preserving operational control. That's the kind of financing that both investors and owners can build upon.

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