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NONTRADITIONAL VENTURE CAPITAL INSTITUTIONS: FILLING A ...

  1. 1. NONTRADITIONAL VENTURE CAPITAL INSTITUTIONS: FILLING A FINANCIAL MARKET GAP David Freshwater, University of Kentucky David L. Barkley, Clemson University Deborah M. Markley, Policy Research Group Julia Sass Rubin, Harvard University Ron Shaffer, University of Wisconsin P2001-11B Part 2 of 4 of the Final Report RUPRI Rural Equity Capital Initiative Study of Nontraditional Venture Capital Institutions Funding provided by USDA Fund for Rural America
  2. 2. Rural Policy Research Institute’s (RUPRI) Rural Equity Capital Initiative The RUPRI Rural Equity Capital Initiative was funded by a grant from the U.S. Department of Agriculture’s Fund for Rural America. The purpose of this project was to examine innovative institutions that are making venture capital investments in rural places across the country and develop lessons learned from these institutions that might be applied in other areas. The project research team included Deborah M. Markley (chair), principal of Policy Research Group, a consulting firm in Chapel Hill, NC; David L. Barkley, Professor and Co-Coordinator, Regional Economic Development Research Laboratory, Clemson University, Clemson, SC; David Freshwater, Professor, Department of Agricultural Economics, University of Kentucky, Lexington, KY; Ron Shaffer, Professor, Department of Agricultural and Applied Economics, University of Wisconsin, Madison, WI; and Julia Sass Rubin, Ph.D. candidate in Organizational Behavior, Harvard University. As part of this project, 23 case studies of nontraditional venture capital institutions or programs were completed during 1998, 1999 and 2000. The information from these visits forms the basis of a four-part series that describes the lessons learned from the experiences of these institutions, the rationale for nontraditional institutions, the process for establishing nontraditional venture funds, and detailed case studies of each institution. The specific publications are: • Establishing Nontraditional Venture Capital Institutions: Lessons Learned. This publication describes lessons learned from the case studies. Advantages and disadvantages of different organizational structures are discussed and characteristics of successful nontraditional venture funds are presented. • Nontraditional Venture Capital Institutions: Filling a Financial Market Gap. This publication provides an overview of the venture capital industry, discusses impediments to making venture capital investments in rural areas and non-high tech business enterprises, and suggests roles for nontraditional venture capital in small market areas. • Establishing Nontraditional Venture Capital Institutions: The Decision-Making Process. Based on information from the 23 case studies, the research team outlined a decision- making process for establishing nontraditional venture capital funds. This publication describes the sequential steps in this process and discusses the interrelated nature of the decisions made at each point in the process. Specific examples illustrate the process. • Case Studies of Nontraditional Venture Capital Institutions. This publication provides detailed case studies of the 23 institutions included in this project. The history of each institution is described, along with its organizational structure, investment experience, and future concerns or opportunities for the fund. The perspective of some portfolio companies is also included. This report, along with other publications produced for this project, are available from the RUPRI website (www.rupri.org/pubs/equitycap/index.html) or by contacting RUPRI at 573-882-0316.
  3. 3. Nontraditional Venture Capital Institutions: Filling A Financial Market Gap In spite of the growth and success of The Traditional Venture the venture capital industry in the 1990s, Capital Industry many areas of the United States are not Traditional Venture Capital Institutions served by traditional venture capital Traditional venture capitalists act as institutions. Research conducted by conduits between investors and RUPRI’s Rural Equity Capital Initiative entrepreneurs seeking equity capital. In suggests, however, that viable alternative doing so, venture capitalists bring sources of equity capital exist and that investors and entrepreneurs together in a alternative institutions can play an more efficient manner, make better important role in providing firms with the investment decisions than investors may financial resources required for growth. be able to do on their own, and provide While these nontraditional venture capital nonfinancial assistance to entrepreneurs institutions rarely earn the same rate of that improves the risk-return relationship return as do traditional funds, they can be for both investors and entrepreneurs.1 profitable and can promote economic Venture capital institutions control development in urban and rural pools of money to be used for investments communities. in companies that show considerable This paper provides an overview of promise of high future profits. Venture why nontraditional venture capital capitalists provide cash to companies in institutions have evolved and summarizes return for a share of ownership and the role they may serve in local economic control. In addition to providing money, development. First, the traditional venture venture capitalists generally exercise capital industry is described, including considerable control over the management discussions of traditional venture capital of the companies.2 In principle, venture institutions and their investments. Next, capital funds attempt to invest in firms gaps in the supply of venture capital, that have the potential to generate annual impediments to closing these gaps, and returns on investment in excess of 30 implications of venture capital shortages percent, and that can be readily sold on the local economic development within three to seven years from the time process are examined. The final section of the original investment. Venture capital summarizes the role of nontraditional funds then seek other innovative ideas and venture capital institutions in filling begin the cycle again. Although financial market gaps and the challenges traditional venture capital funds demand a in developing and maintaining these high rate of return, they can rapidly institutions. Throughout this discussion, provide entrepreneurs with large amounts nontraditional venture capital institutions of money, offer critical advice in are defined as funds or programs management and marketing, and with established to address venture capital their investment, give the new firms needs and enhance economic development credibility in the marketplace. prospects in regions and industries Venture capitalists have four underserved by traditional venture capital principal tasks or responsibilities.3 They funds. assemble pools of money from investors, 1
  4. 4. identify companies in which to invest, and participation limits the venture fund monitor the management of those because fund managers can monitor only companies after the investments are made. a small number of portfolio companies Finally, they develop a strategy for exiting and because the fund must have expertise the investments, considered by some to be in the sectors in which it invests. While the most challenging task.4 The exit many venture funds assume such an active strategy returns cash to the venture funds role, venture funds based in financial allowing them to begin the cycle again. In centers like New York or Chicago are recent years the preferred exit strategy has more likely to be passive investors been an initial public offering (IPO) of because they are experts at assembling stock. Other exit strategies include a pools of money, not at operating private sale or the purchase of the firm by companies.6 Consequently, new venture a larger business, both of which return capital funds with expertise in a specific money to the funds. In those cases where industry or location may be able to partner firms are not successful, venture with passive venture funds in financial capitalists may exit by selling their shares centers looking for opportunities to place at a loss or by liquidating the companies. their money. High profit potential, a short time horizon, and a clear set of rules governing The Traditional Venture Capital Market exit decisions are central parts of the In the last decade, the power of venture capital process. From this venture capital to stimulate economic perspective, investing in a firm that makes growth has been clearly demonstrated only modest profits is only slightly better through the rapid growth of the computer, than investing in a firm that fails. In either telecommunications, and biotechnology case, exiting the deal to return money to industries.7 Venture capital funds have the investors is not easy. Unfortunately been able to identify promising new ideas the majority of investments fall into this in these industries and, by financing the category, thus venture capital funds have creation of new companies, to move their to achieve some large successes to offset ideas rapidly to implementation. inevitable losses.5 Despite the great interest in adopting An important distinction in the venture capital model across industries investment strategies among traditional and regions, the majority of venture venture funds is willingness to be the lead capital investments continue to be in investor. The lead investor has the businesses in early stages and expansion primary responsibility for day-to-day phases in the advanced electronics and management of the relationship with the biotechnology sectors and in California portfolio company. Consequently, the lead and the Northeast. In 1999, for example, investor of the fund must have 90 percent of venture capital investments considerable expertise in the firm’s were in technology-based companies, particular business and should be able to including Internet-related businesses.8 either assist or replace the management of Almost 40 percent of the investments the firm to protect the interest of the fund. made by venture capital firms responding During the investment period, the venture to a PriceWaterhouseCoopers survey were capitalists in the lead fund are very in computer-related fields (software, involved in the management of their hardware, new media, or networking). portfolio companies. This high degree of The next largest sector was 2
  5. 5. telecommunications and electronics New England (11.6 percent), New York (telecommunications, semiconductors, metropolitan area (7.1 percent), and Los and instruments) with 16 percent of all Angeles metropolitan area (7.0 percent). investments, followed by business Alternatively, both the North Central and services with 13 percent and health- South Central regions of the nation had related sectors (medical devices, less than 2 percent of reported 1999 biotechnology, and health services) with venture capital investments, and some 11 percent. states reported no venture capital Some industrial sectors do not, investments. The geographic however, seem well suited to the venture concentration of venture capital funds capital model. For example, despite the parallels the concentration of investment growing demand for new drugs and the activity. Proximity to portfolio companies vast profits associated with successful is important to venture capital institutions drugs, few venture capitalists invest in because they need to closely monitor pharmaceuticals. The cost and time investments and, at times, to participate required to move an idea to market are so directly in the management of client firms. great that a more appropriate development Thus, more remote rural areas and states model, the large integrated drug company, outside the existing venture capital has evolved. In addition, only four percent corridors, for example, Boston to New of the reported venture capital investments York, have few funds and limited venture went into manufacturing activity and only capital investments one percent into publishing and broadcasting, sectors that generally lack Gaps in the Supply of Venture Capital rapid growth rates and high probabilities Given the clear, persistent geographic for a quick and lucrative exit. and sectoral concentration of venture Another important factor in venture capital investments, the traditional venture fund investments is the stage of capital model is not likely to be development of the firm that receives appropriate for areas of the United States financing. Thirty-seven percent of not already participating in the venture investments for the third quarter of 2000 capital investment process. If the went to expanding firms with a business traditional venture capital model were track record.9 Financing for early stage directly appropriate to all regions and firms, with limited operating histories, sectors in the United States, by now accounted for another 34 percent of funds. venture capitalists would be active Only 12 percent of the $17.6 billion nationwide. Many states have less than a invested by venture funds during this handful of venture capital funds, and period went for start-up financing. states with many funds have regions Admittedly, firms in later stage lacking access to capital. Rural areas and development typically require larger smaller cities far from larger metropolitan amounts of capital than firms just starting centers seldom have venture capital operations. institutions and investments. Almost 40 percent of 1999 venture capital investments, according to Impediments to the Venture Capital PriceWaterhouseCoopers, were in the Investment Process Silicon Valley. The next largest Traditional venture capital funds concentrations of investments were in choose not to operate in rural places and 3
  6. 6. in many smaller metropolitan areas viable exit strategy for many because of: traditional manufacturing enterprises and businesses found there. • Investment opportunities with profit potential below that sought by • Limited interest by many small traditional venture capital funds. business owners in accepting the Small market areas do not provide the conditions set by the venture fund in investment environment venture order to get its money. To many rural capitalists prefer: a large number of business owners, particularly in firms with high projected growth rates family-owned businesses, giving up and the likelihood of lucrative exits. any ownership stake in exchange for capital is unacceptable. Concerns • Too few investments to provide about the intergenerational transfer of adequate deal flow. In sparsely the firm may make a business owner populated areas, few firms need and unwilling to accept the terms of a qualify for venture capital venture investment. investments. As a result, the cost of searching out promising entrepreneurs • Difficulty in attracting venture capital and identifying prospective deals is staff to the region. A venture capital higher. institution is only as good as its management team. In more isolated • Too great a physical distance between regions, venture institutions may have investment opportunities. Venture difficulty attracting and keeping the capital investing is a hands-on process qualified staff needed to invest that often requires frequent contact successfully. Recruiting management with portfolio companies. If a for portfolio companies when an traditional venture capital investor injection of new leadership is required cannot travel easily and quickly to may also be more difficult. visit a firm, the investment is not likely to be made. If venture capital is to become a significant source of funding for rural and • Inadequate infrastructure to support small city businesses, the impediments venture capital investment. Attorneys, must be addressed.10 One way of dealing accountants, bankers, and business with a portfolio of lower profit consultants are often needed to help opportunities is presented as an example. put a deal together and ensure the Traditional venture capitalists focus success of the investment. Such a strictly on the financial rate of return on business service infrastructure is their investment, thus only benefits that limited outside larger urban places. can be captured in the net worth of the portfolio firm are important. However, from a larger social context, some benefits • Difficulty in defining a viable exit of an investment are not reflected on a strategy. Most businesses located in firm’s balance sheet. Property values may rural or small market areas are rise in a community, as a result of new unlikely to provide rapid, lucrative business activity. Individuals with real exits. For example, IPOs are not a estate investments may accept a lower rate 4
  7. 7. of return on an equity investment in a the global economy. But, creating this local business if its presence leads to new economic base requires the support increased rates of return on their property of entrepreneurs and their firms, a key holdings. McAlester Investment Group of component of which is access to equity McAlester, Oklahoma was started by finance. If potential entrepreneurs do not individuals who have significant local believe funds are available to bring their property holdings, which allows them to ideas to reality, they will not act upon benefit both from their venture them. Thus, while a supply of venture investments and any increase in local capital may not create a demand for these property values that those investments funds if the entrepreneurs are not present, produce. the recognized absence of a supply may convince a potential entrepreneur not to The Role of Finance in Local Economic try to start a business. Without this Development venture capital infrastructure, potential In general, rural America consistently entrepreneurs cannot be identified and lags behind urban America in terms of their ideas will not make it to the income levels, employment growth rates, marketplace.11 and various other measures of economic Surveys of small- and medium-size well-being. Some rural places enjoy levels business owners and some academic of prosperity that equal or exceed those of studies, consistently argue that more all but the wealthiest urban places; businesses would be in place and existing however, most rural areas fall well below businesses would grow faster if more national standards in terms of income and money were available. The underserved employment levels. Similarly some cities businesses generally are involved in and parts of most metropolitan areas also introducing new production practices or have persistently slow rates of economic new goods and services to a region. growth. Government programs can Lenders unfamiliar with those innovations provide temporary support for the most do not have the expertise to assess the disadvantaged urban and rural areas, but underlying risks and returns, and the only way to ensure long-term consequently, are reluctant to expose development of lagging parts of America themselves to losses. Such problems are is to enhance levels of private enterprise. typical for all forms of small businesses Thus, those interested in enhancing and for both debt and equity capital (see economic activity in these places ask: Figure 1). Almost by definition, what barriers exist to increasing the innovative enterprises are not well number and success rate of local understood, and lenders are businesses, and what policies or programs understandably reluctant to take on risks can be put in place to remove these whose magnitudes they cannot assess. barriers? However, this problem is more critical in Many have argued that future rural areas and in smaller communities prosperity for small towns and rural areas because a local financial institution may will require a new economic base of be the primary or only source of capital small- and medium-sized firms. With for area businesses. With fewer roots in their communities, these firms alternatives, businesses in these would use local resources to produce communities are more likely to lack goods and services in growing demand in access to both debt and equity capital. 5
  8. 8. Figure 1 Debt Versus Equity Capital Financial capital is not homogenous. There are major variations among different types of financial capital, the most important being the distinction between debt and equity finance (Brealey and Myers). Debt Finance: Debt finance creates specific obligations for the borrower to repay the loan on a predetermined schedule. Failure by the borrower to meet the repayment terms typically allows the lender to attempt to recover the outstanding debt, even if the borrower is forced into bankruptcy. Equity Capital: Equity capital conveys a share of ownership in the firm to the individual or institution that provides the funds. The equity investor gives up the right to a predetermined repayment schedule and a preferential claim on the assets of the firm in exchange for a share of future profits (or losses). This longstanding concern has led to exist even where ample debt capital is many initiatives at the federal and state available.12 Thus a core issue facing those levels to increase the availability of funds seeking to implement a locally based to small businesses. In addition, private economic development strategy is organizations, including foundations and whether they can develop programs to community groups, have tried to develop provide better access to equity capital.13 programs to expand the supply of business An alternative perspective of regional capital. However, most new programs economic development argues that local provide loans, rather than equity. Because development is not constrained by a both debt and equity capital are usually shortage of capital, but by inadequate necessary for start-up and expanding investment opportunities. Proponents of firms, a critical financing gap may still this view argue that capital markets are 6
  9. 9. indeed efficient and seek out During this research, no ideal opportunities, and that the reason many nontraditional venture capital institution small businesses cannot attract funding is was found among the broad spectrum of because they fail to offer the risk adjusted organizational types currently being used rate of return that can be earned on across the nation. However, many varied investments elsewhere. programs can be drawn upon for The two perspectives lead to different guidance. To help determine the right conclusions about local development model for a given situation, the research opportunities, needs, and appropriate team identified some common issues: policy interventions. This research found anecdotal evidence to support both • New or add-on enterprise. Will the perspectives. On the one hand, venture capital institution be nontraditional venture capital institutions structured as part of a larger entity, and their portfolio companies are such as a community development operating successfully in locations organization, or will it be free unserved by traditional venture capital standing? funds. On the other hand, in some locations nontraditional funds and their • Privately capitalized and managed or portfolio companies were short lived. publicly assisted institution. Will Thus, the focus of the RUPRI research capital be raised from the public project was to provide insights into the sector, from private investors, or from characteristics of small market locations some combination of public and where a nontraditional institution might private investors? succeed and to ascertain what kinds of institutions were most likely to prosper in • Fund Size. How much money will be these locations. sought from investors to capitalize the fund? Role of Nontraditional Venture Capital Models to Consider • Rate of return driven or The 23 nontraditional venture capital developmental. Will the institution try institutions and programs selected for this to maximize financial return to research were designed to increase the investors, or will it try to achieve supply of venture capital in specific small some other goal, such as job creation, market areas (Table 1). They represent a subject to meeting a target rate of wide range of institutional types, return? operating in diverse economic and political situations. Most programs are not • Investment focus. Will investments be easy to implement, nor are they practical made across all industrial sectors or in for all places. In almost every case, the specific sectors? Will investments be nontraditional institutions accept a lower targeted to firms in a particular rate of financial return than the traditional business stage, such as start-ups, or venture capital model. But, the will firms in all business stages be nontraditional approaches also focus on eligible? goals other than maximizing the financial rate of return on investments. 7
  10. 10. Table 1. Site Visit Venture Capital Institutions by Category A. Publicly Funded, Publicly Managed Institutions Small Enterprise Growth Fund (Augusta, ME) Minnesota Technology Corporation Investment Fund/MIN-Corp (Minneapolis, MN)a, b Iowa Product Development Corporation/Iowa Seed Capital Corporation (Des Moines, IA) B. Privately Managed Funds with Public Funding or Incentives Iowa Capital Corporation (Des Moines, IA) Colorado Rural Seed Fund (Boulder, CO) Northern Rockies Venture Fund (Butte, MT) Oklahoma Capital Investment Board (Oklahoma City, OK) Partner Funds: Pacesetter and MESBIC Venture Funds (Dallas, TX) Magnolia Venture Capital Fund (Jackson, MS) Kansas Venture Capital, Inc. (Overland Park, KS)c C. Community-Level Venture Capital Programs Montana Rural Electric Utility Cooperativesd Ames Seed Capital Fund, Inc.(Ames, IA) McAlester Investment Group (McAlester, OK) Siouxland Ventures, Inc. (Sioux City, IA) D. Certified Capital Companies (CAPCOs) Louisiana CAPCO Program (Baton Rouge, LA) Missouri CAPCO Program (Jefferson City, MO) E. Community Development Venture Funds Coastal Ventures Limited Partnership (Portland, ME) Kentucky Highlands Investment Corporation (London, KY) Northeast Ventures (Duluth, MN) Cascadia (Seattle, WA) Appalachian Ohio Development Fund (Athens, OH) F. Small Business Investment Companies (SBICs) North Dakota SBIC (Fargo, ND) First United Ventures (Durant, OK) North Carolina Economic Opportunities Fund (Raleigh, NC) a MIN-Corp received state support during earlier years of operation. b MIN-Corp is also a Community Development Venture Capital Fund. c Kansas Venture Capital, Inc. is structured as a SBIC, but had not used SBA leverage at the time of the case study. It was capitalized with state funds but is in the process of becoming strictly private. d The Montana Rural Electric Utility Cooperatives’ investment activity occurred in a number of communities throughout the state: Medicine Lake, Great Falls, Sun River, Opheim, and Culbertson. 8
  11. 11. • to find people with the skill to assess a • Degree of involvement with portfolio business plan. companies. How involved will the institution be in the day-to-day • to get enough business volume to operations of the firms in which it allow the venture capital institution to invests? cover its costs. In general, there is a relationship • to find competent managers to take among these factors and the region that over the operation of businesses that will be served by the nontraditional get into trouble. venture institution. Remote rural communities seeking to establish a • to get any sort of value for the assets venture capital institution will usually be of failed businesses. restricted to start-up stage investments. Rural institutions probably will have to • to find buyers for businesses that are accept relatively low rates of return nominally successful when it is time because of the type of firms in which they to exit. invest, their smaller fund sizes and higher administrative costs per dollar of Each case study institution provides investment, and the necessity of providing guidance on how these problems can be high levels of assistance to their portfolio addressed, but clearly no institution has companies. In addition, rural funds are been able to completely resolve all likely to require some form of public or problems. Trying to solve one part of the nonprofit investment for capitalization. puzzle, such as focusing on a narrow In contrast, nontraditional funds that range of industries to ensure competence, operate in metropolitan areas across a creates other management problems such state have more flexibility. These as maintaining adequate deal flow. institutions generally will be larger and, as Ultimately the challenge for any a result, may choose to focus on start-ups, institution interested in making venture but they also may be able to focus on later capital investments is to identify the most stage investments. In addition, because the important risks and opportunities in its market is larger, they may have the investing environment and then to design opportunity to concentrate on specific an organization that is compatible with its industries. Thus, the choices facing assessment. This research project has venture capital institutions operating in identified a number of key issues that larger places are less limited. existing nontraditional venture capital institutions addressed during their The Nontraditional Venture Capital development. The decision making Dilemma process identified from the experiences of Many rural and urban places face real these institutions provides important challenges in resolving venture capital insights for those considering the creation shortfalls.14 Success in establishing a and support of nontraditional venture venture capital institution lies in finding programs in other communities and ways to resolve the impediments. Where regions. local markets are small, it is harder: 9
  12. 12. Endnotes of how specific organizations approached these problems. This 1. A. K. Gupta and H. J. Sapienza. publication is available on the RUPRI “Determinants of Venture Capital web site (www.rupri.org/ Firms’ Preferences Regarding the pubs/equitycap/index.html). Industry Diversity and Geographic Scope of Their Investments.” Journal of 11. R. Gaston. “Financing Entrepreneurs: Business Ventures 7 (1992):347-362. The Anatomy of a Hidden Market.” in R. D. Bingham, E. W. Hill, and S. B. 2. W. Sahlman. “The Structure and White (editors), Financing Economic Governance of Venture Capital Development: An Institutional Organizations.” Journal of Financial Response. Thousand Oaks, California: Economics 27 (1990): 473-521. Sage Publication, 1990. 3. B. Elango, V. Fried, R. Hirsrich, and A. 12. R. Brealey and S. Myers. Principles of Polonchek. “How Venture Firms Corporate Finance, 3rd Edition. New Differ.” Journal of Business Venturing York, New York: McGraw-Hill, 1988. 10 (1995): 157-179. 13. While the supply of investment funds in 4. J. Macintosh. “Venture Capital Exists in an area is critical, the ability of potential Canada and the United States.” in P. investors to assess the wisdom of an Halpern (ed.), Financing Growth in investment is equally important. In the Canada. Ottawa; Ontario: Ministry of jargon of venture capital, the notion of Supply and Services, 1997. due diligence is a vital concept. Due diligence refers to the investor’s ability 5. See Sahlman (1990). to look into the plans of the entrepreneur to determine if a viable 6. R. Florida and M. Kennedy. “Venture business can be developed. Without this Capital, High Technology, and ability, more money will not ensure a Regional Development.” Regional significant increase in economic Studies 22 (1998):34-48. development, because too much money 7. “Venture Capital: Money to Burn.” The will go to projects with little future. Economist. May 27, 2000, 71-73. Thus the two important requirements for addressing the financial needs of 8. PriceWaterhouseCoopers, National small market areas are money and Venture Capital Survey, 1999 expertise in investing that money. (www.pwcglobal.com). 14. S. J.Waddell. “Emerging Socio- 9. PriceWaterhouseCoopers. Economic Institutions in the Venture Capital Industry: An Appraisal.” 10. The fourth report in this series, “Case American Journal of Economics and Studies of Nontraditional Venture Sociology 54(1995):332-338. Capital Institutions,” provides examples 10

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