Rural Policy Research Institute’s (RUPRI)                               Rural Equity Capital Initiative       The RUPRI Ru...
Establishing Nontraditional Venture Capital Institutions:                                  The Decision Making Process    ...
example, a bank Small Business                            development corporation (CDC).Investment Company (SBIC). Venture...
Figure 1.Steps in the Decision Making Process for Creating a Nontraditional Venture Capital Institution                   ...
venture capital investments. Founders of        focused on creating economicthese institutions recognized a demand for    ...
Figure 2. Impetus for Starting a Nontraditional Venture Capital Institution     For other funds, however, a market       f...
firms generally specialize in specific         knowledge important to identifying potentialindustries like manufacturing o...
Figure 3. Market Analysis                                      Assess Local Deal Flow                             •    Cap...
Articulation of Institution’s Goals         process, although they are considered to be     After the need for venture cap...
Figure 4. Goals of the Institution                                                 Deal flow adequate or                  ...
subsidy of operating expenses. A $10           subsidized by the parent organization,million fund with a 10-year planning ...
Figure 5. Fund Size and Management Alternatives                                                                           ...
in a program with high costs and no               benefits. Federal investment funds comediscernible economic benefits.2  ...
order to overcome limitations resulting              If public funding is available forfrom public investment. In both cas...
competitive rates of return on the state’s     capital. Utilities, for example, may investinvestments. However, private ma...
credits are applied to the taxes paid on          Legal and Organizational Structurepremiums earned by insurance companies...
LLPs are attractive if the institution is   its SBA interest costs. Since thisseeking significant private funding, for    ...
structured as LLCs. While three networks      The fund can operate at lower cost byare currently operating, ten are planne...
Figure 6. Management of Investment Activity                     Screening Prospective Investments              • Responsib...
In some cases, due diligence                    One cautionary note on investmentperformed on a prospective company       ...
intervene in the decision-making process.      manufacturing firms that dominate smallThe nontraditional venture capital  ...
geographic dispersion of portfolio             their costs and can capture the externalcompanies.                         ...
Endnotes                             Julia Sass Rubin, 2001. “Certified                                                   ...
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  1. 1. ESTABLISHING NONTRADITIONAL VENTURE CAPITAL INSTITUTIONS: THE DECISION MAKING PROCESS David L. Barkley, Clemson University Deborah M. Markley, Policy Research Group David Freshwater, University of Kentucky Julia Sass Rubin, Harvard University Ron Shaffer, University of Wisconsin P2001-11C Part 3 of 4 of the Final Report RUPRI Rural Equity Capital InitiativeStudy of Nontraditional Venture Capital InstitutionsFunding 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 examineinnovative institutions that are making venture capital investments in rural places across thecountry 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 ResearchGroup, a consulting firm in Chapel Hill, NC; David L. Barkley, Professor and Co-Coordinator,Regional Economic Development Research Laboratory, Clemson University, Clemson, SC; DavidFreshwater, 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 OrganizationalBehavior, Harvard University. As part of this project, 23 case studies of nontraditional venture capital institutions orprograms were completed during 1998, 1999 and 2000. The information from these visits formsthe basis of a four-part series that describes the lessons learned from the experiences of theseinstitutions, the rationale for nontraditional institutions, the process for establishing nontraditionalventure 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 RUPRIwebsite ( or by contacting RUPRI at 573-882-0316.
  3. 3. Establishing Nontraditional Venture Capital Institutions: The Decision Making Process Rural areas, nonmetropolitan institution and increases the availability ofcommunities, and small geographically support to worthy area businesses.isolated metropolitan areas often are This decision-making process is basedoverlooked by traditional venture capital on on-site interviews with founders andfunds because of the relatively high cost of managers of 23 venture capital institutionsfinding and managing investments in small across the country (Table 1). The decisionmarket areas. Yet opportunities for quality making is presented as a sequentialventure capital investments are present in process (Figure 1); however, clearsmaller markets, and successful feedback loops exist among the variousnontraditional venture capital institutions stages of the process. Decisions madehave been established to promote early in the process constrain later choices.entrepreneurial and business development In addition, if constraints are subsequentlyin such areas. In some cases, venture identified in the process, such as incapital institutions focus on local small fundraising or deal flow, modificationsbusiness communities, such as Northeast and adaptations to earlier decisions orVentures (NEV) in Minnesota, McAlester goals may be needed.Investment Group (MIG) in Oklahoma, Based on the site visits, no single bestand Ames Seed Capital Fund (ASCF) in model for a nontraditional venture capitalIowa. In others, a broader concern about institution exists. The organizational formeconomic development prospects spurs chosen for an institution will depend onstate governments to provide venture the economic structure of the targetedcapital through groups like Kansas region; the capital needs of residentVenture Capital Inc. (KVCI), Northern businesses; the goals of the organizers,Rockies Venture Fund (NRVF) in managers, and investors; and for publicMontana, and the Oklahoma Capital entities, the statutes regulating publicInvestment Board (OCIB). Whether institutions. However, despite theventure capital is provided by private or underlying variability in market areas andpublic institutions, organizers consider differences in goals, organizationalsimilar questions or issues when structure, and investment portfolios, thedeveloping and designing institutions. concepts outlined in the decision process This paper provides an overview of appear applicable to all the institutionsthe decision-making process followed in visited. Indeed, institutions that clearlyestablishing nontraditional venture capital articulated how they approached eachinstitutions. An understanding of this decision element were more successfulprocess will enable communities to learn than those with a less precise notion offrom the experiences of others and to what they hoped to achieve and how theydevelop venture capital institutions planned to accomplish it.tailored to their goals, market conditions, The organizational frameworks ofand institutional constraints. A well- nontraditional venture capital institutionsorganized decision-making process vary. The venture capital institution mayincreases the probability of establishing a be a freestanding, independent entity. Insuccessful nontraditional venture capital other cases, the institution may be a subsidiary of another organization, for 1
  4. 4. example, a bank Small Business development corporation (CDC).Investment Company (SBIC). Venture However, regardless of the organizationalcapital investing also occurs as an form a nontraditional venture capitalextension of the core activities of an institution ultimately assumes, organizersorganization such as a state agency, rural can gain by using the decision-makingelectric cooperative or community process outlined here. 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 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)a, b C. Community-Level Equity Programs Ames Seed Capital Fund, Inc. (Ames, IA) Siouxland Ventures, Inc. (Sioux City, IA) McAlester Investment Group (McAlester, OK) Montana Rural Electric Utility Cooperativesc 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) Cascadia (Seattle, WA) Northeast Ventures (Duluth, MN) Appalachian Ohio Development Fund (Athens, OH) F. Small Business Investment Companies (SBICs) First United Ventures (Durant, OK) North Dakota SBIC (Fargo, ND) North Carolina Economic Opportunities Fund (Raleigh, NC)a MIN-Corp and Kansas Venture Capital, Inc. recently became private venture capital institutions and MIN-Corp is also considered a community development venture fund. However, both institutions were started withsignificant public support (funding and/or management).b Kansas Venture Capital, Inc. is also an SBIC.c The Montana Rural Electric Utility Cooperatives’ investment activity occurred in a number of communitiesthroughout the state: Medicine Lake, Great Falls, Sun River, Opheim, and Culbertson. 2
  5. 5. Figure 1.Steps in the Decision Making Process for Creating a Nontraditional Venture Capital Institution 1.Recognize impetus for creating a nontraditional venture institution 2. Conduct market 7. Manage analysis; estimate investment activity local deal flow/how to create deal flow 6. Select legal and 3. Articulate organizational institution’s goals structure and objectives 5. Identify sources of funds to 4. Select capitalize institution’s size institution and management Impetus for Starting a Nontraditional indirectly stimulate income and Venture Capital Institution employment. Institutions created to Why create a venture capital stimulate regional economic developmentinstitution? Some institutions visited were generally were established primarily tocreated in response to concerns about the make investments in firms that could growlevel of state or local economic and remain in the region, increasingdevelopment activity (Figure 2). The regional income and employment. Forfounders believed that local business example, local business people created thedevelopment and job creation were MIG, an organization of angel investors,hampered by a lack of venture capital and to help stimulate business development inthat successful venture capital investments the town of McAlester, Oklahoma.could be made in area businesses at rates Other institutions were established toof return less than those sought by meet the venture capital needs of areatraditional venture capitalists. Investments businesses and, as a result, to demonstratein venture capital funds were made to that the local economy could support 3
  6. 6. venture capital investments. Founders of focused on creating economicthese institutions recognized a demand for opportunities within the distressedventure capital in the region and the failure Appalachian region by developingof national venture capital institutions to potential deals, investing in the region’smeet that demand. Kansas bankers, businesses and entrepreneurs, and bringingrecognizing a need for venture capital, entrepreneurs into the region to create newestablished KVCI, an SBIC. KVCI enterprises. In these examples, creatingfocused on meeting the venture capital economic development and social benefitsneeds of existing Kansas businesses, for specific segments of the populationalthough economic development concerns were important objectives.were a secondary issue. OCIB respondedto the need for venture capital in Market Analysis and Estimation ofOklahoma by investing in partner funds Local Deal Flowthat could, in turn, invest in Oklahoma Developing an appreciation for thebusinesses. OCIB wanted to stimulate the need for venture capital in the relevantOklahoma venture capital market by local, state, or regional market area is abringing Oklahoma deals to the attention critical second step in the creation of aof established regional and national nontraditional venture capital institution.venture capital funds. However, This understanding, in turn, helpsinvestment in Oklahoma businesses is not determine whether an effective demand forspecifically required. NRVF was created the venture capital institution exists, whatto stimulate the private capital market in niche the institution might occupy, andMontana after attempts to attract private what would be an appropriate size for theinvestors to an earlier state program were fund. In addition to evaluating the need forunsuccessful. While the earlier state venture capital, it is important to identifyprogram grew out of economic the climate for venture capital investing indevelopment concerns, NRVF was created the region. Are potential entrepreneursto address the inadequacies of the private familiar with venture capital investingventure capital market in Montana and to available, or will some educational effortearn good returns for the investors and be required to develop this familiarity?managers of the fund. For some institutions, particularlyA third group of institutions was created to community development venture fundsuse venture capital investments to create (CDVCs), adequate deal flow was notjobs, entrepreneurial capacity and wealth central to their creation. Almost byto benefit primarily distressed definition, CDVCs targeted populationscommunities and low-wealth individuals. where deal flow was limited orThe institutions considered both financial nonexistent and had to be developed.and social returns in making investments. KHIC had to create deals by attractingFor example, NEV was established in entrepreneurs to the region and byresponse to the downturn in northeast providing extensive assistance toMinnesota’s mining industry. The need for promising local entrepreneurs during start-venture capital was identified as an up of new businesses.impediment to the creation and expansionof businesses in the region. KentuckyHighlands Investment Corporation (KHIC) 4
  7. 7. Figure 2. Impetus for Starting a Nontraditional Venture Capital Institution For other funds, however, a market for venture capital. An estimate of theanalysis can help to determine the focus of potential need for venture capital can bethe venture capital institution and provide obtained by understanding the structure ofthe information needed to make decisions the local, state, or regional economy. It ison structure, size, and targeting of the important, however, to recognize thatinstitution. The need for venture capital measuring the need for venture capital isvaries with the stage, sector, and level of of resident industries, as well Analysis of a market area determinesas with their potential for growth. whether potential deal flow is sufficient toEstablished firms, experiencing only justify creating a venture capital institutionmoderate growth, may have limited need (Figure 3). Because institutions tend tofor venture capital and may be able to invest in a small percentage of dealsmeet capital needs from retained earnings reviewed, deal flow must be adequate. Foror borrowing. New, rapidly growing example, KVCI reviews about 150 dealscompanies have more limited access to annually, yet it makes investments in onlydebt capital and are more likely to have three or four deals. Analysis of investmentcapital needs that outpace their ability to opportunities in specific industry sectors andgenerate retained earnings. Consequently, development stages is equally important tosuch businesses may have a greater need assessing overall deal flow. Venture capital 5
  8. 8. firms generally specialize in specific knowledge important to identifying potentialindustries like manufacturing or computer deal or in specific stages of If overall deal flow in the institution’sdevelopment like start-ups, expansions, or proposed service area is consideredtransfers of ownership. The targeting of inadequate to support a successful fund,investments occurs because different types organizers can choose to cease the decisionof investments require different types of making process or investigate alternativesexpertise for the fund manager. for increasing deal flow (Figure 3). How can a community assess Broadening the geographic region served orpotential deal flow? When the impetus for industry sector targeted can increase dealcreating a rural venture capital institution flow. Colorado Venture Management’scomes from within a region, such as with (CVM) Colorado Rural Seed Fund (CRSF)NEV, knowledge of potential deals is focused on the western slope of the Rockies,typically part of the rationale for the an area with a small population and a limitedinstitution. NEV’s founder’s years of economy, was not successful. However,experience working with small businesses NRVF, CVM’s recent initiative, fostersin the region provided the baseline greater deal flow by operating statewide ininformation that defined the need in Montana.northeast Minnesota. Pacesetter, a venture The industry focus of an institution cancapital fund based in Dallas, Texas, was be expanded rather than limitingestablished by its parent, MESBIC investments to a small number of specificVentures, because of an identified need for sectors. The Iowa Capital Corporationlater stage venture capital for minority (ICC), for example, focuses on industriesbusinesses in which MESBIC had strategic to the electric power industry, butoriginally invested. However, in spite of ICC will consider firms in mosttheir assessment of deal flow, venture manufacturing institutions may be faced with a Small community-based funds andvery different pool of potential deals than CDVCs may have difficulty broadeninganticipated. This situation affects their geographic region or industry focus.investment strategies and the time frame They often are already generalists andfor exiting investments. For example, the cannot spread their staff and resources overearly market research undertaken by NEV a broader geographic region withoutdid not reveal that most of their deals compromising their potential impact. Theywould be in early stage businesses. can, however, develop deal flow by When nontraditional venture capital providing support services for entrepreneursinstitutions are created because of lack of and new businesses through incubators,capital availability, however, assessing technology transfers, and assistance indeal flow is more problematic. developing business plans. Institutions withNetworking with organizations that know a strong developmental orientation, likethe needs of small businesses and KHIC, have created deals by couplingentrepreneurs takes on added significance. technical assistance with venture capital. InNetworking with banks, Small Business regions where role models for entrepreneursDevelopment Centers, chambers of are limited, entrepreneurial developmentcommerce, and local economic must precede the development of sounddevelopment offices can provide the local business deals. 6
  9. 9. Figure 3. Market Analysis Assess Local Deal Flow • Capital needs of industry • Industry prospects for growth • Prospects for return on investments • Alternatives for exiting deals • Good ideas/managers that could be developed Overall deal flow Overall deal flow adequate inadequate Is deal flow (industry sector, stage and location) Cease decision consistent with impetus making process for institution? • Increase deal flow by broadening geographic or industry focus Yes, proceed to No, re-evaluate • Create deals through institutional goals reason for technical assistance, deal and organization institution, and/or development, import cease process entrepreneurs Re-assess local deal flow 7
  10. 10. Articulation of Institution’s Goals process, although they are considered to be After the need for venture capital has positive results of the investment process.been demonstrated and potential deal flow However, investors in the venture capitalidentified, the institution’s goals must be institution may be able to capture benefitsmore specifically articulated (Figure 4). from other externalities, such as increasedSome nontraditional funds want to property values in the community ormaximize financial returns. Their improved general quality of life.managers believe that investment Some institutions seek to maximizeopportunities in the area offer the potential social benefits or returns while earning anfor earning an overall annual rate of return IRR that is sufficient to ensure theof 30 percent or more, an internal rate of institution’s long-term sustainability.return (IRR) on a par with that earned by Institutions such as ASCF, Coastaltraditional venture institutions. These Ventures Limited Partners (CVLP), andinvestments are not currently undertaken MIN-Corp, consider potential financialby traditional institutions because of an and social returns in the decision makingimperfect flow of information, but the process. While both IRR and social returnsdeals are available to regional investors can be considered, managers and investorswho recognize the investment opportunity. must determine how these two variablesProfit maximizing institutions face the are balanced, based on their mutual goals.challenge of making sound investments For example, managers may choose towhile attempting to overcome the factors invest to achieve the highest possible IRR,of distance, high transaction costs, and subject to achieving certain minimumlack of information that discourage the social benefits. Alternatively, socialextension of traditional venture funds into benefits could be maximized subject tomore geographically isolated markets. achieving a minimum rate of IRR.NRVF and OCIB are organized around Achieving consensus on these tradeoffs isthis principle. Finding a source of capital critical to the decision-making fund the demonstration effort constrainsthe development of these types of Selection of Institutional Size andinstitutions. In some cases, public Management Alternativesinvestment can play an important role in Institution Sizethis demonstration phase. The optimal capitalization of a Other institutions also seek to nontraditional venture capital institutionmaximize financial returns, but recognize depends upon the institution’s goals,that investment opportunities in small organizational structure, and sources ofmarket areas offer potential IRRs that are funding. In addition, capital availablelower than those expected by traditional should be closely related to investmentventure funds. They work to maximize opportunities or deal flow. If capitalizationIRR, given that the expected rate of return is large relative to deal flow, the institutionwill be lower than those accepted by may be encouraged to make questionabletraditional venture funds. Social returns investments. If capitalization is lowfrom investments such as jobs, income, compared to estimated deal flow, thenretail sales, and housing starts are not investment opportunities may govalued explicitly in the decision-making unfunded. 8
  11. 11. Figure 4. Goals of the Institution Deal flow adequate or investment opportunities can be developed to support venture capital institution Maximize financial returns Goal A: Maximize rate of Goal B: Maximize rate ofreturn (assume rates will be return (assume rate of competitive with those return will be less than sought by traditional market rate) venture capital funds) Investors may capture external benefits from investments Goal C: Maximize economic development and social impacts while earning rate of return sufficient for long-run sustainability The institution should also be institutions have a requirement that no financially able to support a professional investment account for more than 10 to 15 management team. While it is difficult to percent of total capital in the institution. set an absolute minimum size for a venture And fourth, a management fee of 2 to 3 capital institution, an estimate can be made percent of total capital is charged annually for funds driven by rate of return based on to cover operating expenses. Therefore, a observations from site visits. First, each fund with a 10-year life allocates partner or manager in an institution approximately 20 to 30 percent of the generally can manage six to eight deals or initial value of the fund to management investments. Second, investments must be fees.1 large enough to justify a seat on the board Based on observations from the site of a portfolio company, if that is a visits, a minimum of $10 million enables a requirement of the institution. Third, most freestanding institution to operate without 9
  12. 12. subsidy of operating expenses. A $10 subsidized by the parent organization,million fund with a 10-year planning enabling the smaller venture capital fundhorizon would have $7 to $8 million to be viable. Alternatively, the Smallavailable to invest in portfolio companies Enterprise Growth Fund (SEGF) in Maineafter allocations for management fees. uses a volunteer board for due diligenceSuch a fund could make seven to eight and investment decisions to reduceinvestments averaging $1 million per management costs. Small, local funds suchinvestment. Generally, the initial as ASCF and Siouxland Ventures Fundinvestment in a portfolio company would (SVF) rely on the local chamber ofbe less than the $1 million average since commerce for administrative support.part of the fund’s investment capital will Management Alternativesbe set aside for additional investments. With the goals and size of the institutionMore than seven to eight investments established, a professional managementcould be made if initial deals are exited team must be secured to run the ventureprofitably and earnings are reinvested in capital institution. Most institutions notedthe fund. that professional management was critical For small community-based to the success of the fund. In small marketinstitutions and CDVCs, operating budgets areas, organizers must consider whethermay be covered by grant money, monetary experienced professional investors can beand in-kind contributions from partner hired from within the local labor pool ororganizations and retained earnings. As a whether professionals can be attracted toresult, institution size may have less the local area. In addition, the institution’sinfluence on the ability of these goals will play a role in determining theinstitutions to hire experienced, committed characteristics of the management team. Ifmanagers. the goal of the institution is to maximize If prospects for raising a $10 million IRR, the fund must be large enough tofund are limited given the goals and focus support an experienced management team,of the institution, then the organizers have relying primarily on an averageother alternatives (Figure 5). One, the management fee of 2½ percent. Inorganizers can cease planning for a addition, the potential to earn significantventure capital institution and investigate returns on the investments must beother means of assisting new area sufficient. For institutions with dual goals,businesses. Two, the organizers can management must be motivated byreevaluate the proposed goals, area, and concern with the social benefits ofindustry focus of the institution to investments and be comfortable with thedetermine whether the institution can tradeoff between financial and socialbecome more attractive to potential returns. Since the community developmentinvestors. Three, alternatives to a venture capital industry is relatively youngfreestanding venture capital fund such as compared with traditional venture capital,partnerships with public or private the pool of professional, sociallyorganizations, could be investigated as a motivated investors is more limited.means to subsidize management of the Consequently, institutions with dual goalsfund. For example, CVLP, a $5.5 million may have to rely more heavily on hands-fund, is part of Coastal Enterprises, a on training than more traditional venturecommunity development corporation in capital funds.Maine. Operating costs for CVLP are 10
  13. 13. Figure 5. Fund Size and Management Alternatives Prospective fund size significantly Prospective fund less than $10 m size approximately $10 m or more Cease planning process Establish self-standing Re-evaluate goals, Develop partnerships fund with professional target industries, with other organizations management team and service areas such as state or development organizations to subsidize management costs Seek additional capitalization of fund In addition to finding professional If the incentive system does not rewardmanagement, attention must be given to good investment decisions, the institutionestablishing an incentive structure for may not achieve either its financial ormanagement that is consistent with the social goals. The Magnolia Venturegoals of the institution. Most traditional Capital Corporation (MVCC) inand profit maximizing nontraditional Mississippi provides the classic examplefunds are structured so that the of potential problems with an institutionmanagement team shares in any profits when oversight is inadequate (in this case,earned when investments are exited. Even public oversight) and the incentive systemsmaller community-based and community fails to reward sound investments and funddevelopment venture funds provide some growth. Lax oversight of Magnolia’sway for fund managers and staff to share management and board and questionablein the returns from profitable investments. business practices by employees resulted 11
  14. 14. in a program with high costs and no benefits. Federal investment funds comediscernible economic benefits.2 from the Small Business Administration (SBA) for Small Business Investment Sources of Funds Companies (SBICs) and investments made Potential sources of funds must be by the Community Development Financialconsidered throughout the decision- Institutions (CDFI) fund. NEV, CVLP,making process. When organizers begin to and KHIC received CDFI funding, anddiscuss the creation of a nontraditional North Dakota SBIC and First Unitedventure capital institution, it is important Ventures (FUV) in Oklahoma tapped thethat they have a realistic view of leveraging available through SBA. Titlealternative sources of funding for VII (no longer available) program fundscapitalizing the institution and the for community development corporationsimplications of these sources for provided capital to structure. In addition, The experience of site visitorganizers need to understand any institutions suggests several caveats to therestrictions or covenants that are placed on use of public funds, particularly statefunds invested in the institution. For funds. Funding for a venture capitalexample, if foundations are identified as institution should be provided in one lumplead investors, their goals will be sum as opposed to annual appropriationsinstrumental in setting the goals of the over a period of time. Annualinstitution. If the state is the lead investor, appropriations of state funding tend to berestrictions on investments to in-state subject to the vagaries of the politicalfirms will be likely. These constraints will process. This uncertainty with respect toinfluence the decision-making options future funding availability may encourageavailable to institution organizers.3 suboptimal investment decisions on the Funding for the capitalization and part of the venture capital institution; formanagement of the site-visit institutions example, the institution may feel pressurecame from public funds, private funds to invest the year’s appropriations(individuals, commercial banks, public regardless of the availability of good deals.utilities), quasi-private funds backed by In addition, failures among thepublic incentives (tax credits), and institution’s portfolio companies are likelynongovernmental organizations (nonprofit to occur before successes, coolingfoundations). Each funding source has its legislative support for futureown advantages and constraints. appropriations for the institution. In some cases public funds come withPublic Funds restrictions, such as limiting investments A number of institutions were to in-state firms or firms in a particularcapitalized either completely or in part by industry sector or region. While suchpublic funds, both state and federal. KVCI, restrictions may meet certain economicMIN-Corp, NRVF, Iowa Seed Capital development objectives, they createCorporation (ISCC), CRSF, and SEGF obstacles that limit the institution’s abilityreceived substantial state investments. to develop sufficient deal flow or toPublic capital may be compatible with partner with venture capital investorsgoals of maximizing IRR in the low to outside the state or region. The ICC hasmoderate range or meeting the dual reimbursed Iowa and KVCI has refundedobjectives of moderate IRR and social the state’s investment in the institution in 12
  15. 15. order to overcome limitations resulting If public funding is available forfrom public investment. In both cases, capitalization of the venture capitalhowever, the repayment plans were institution, considerations must be given tobeneficial to both the state and the venture the tradeoffs between public and privatecapital institution since state resources management of the funds. For example,were made available for other uses. A state public funds can be invested directly intoconstitution may limit the type of portfolio companies through a public orinvestments an institution can undertake quasi-public institution like SEGF orwith public funds. SEGF was prohibited ISCC. SEGF is administered through thefrom making pure venture capital Finance Authority of Maine, using staffinvestments and, as a result, used a resources and an advisory board to makecomplicated debt with warrants investment investment decisions. The state is engagedstructure that initially limited the number in direct investing in this institutionalof deals. After changes to SEGF’s structure.investment structure were made within the The publicly managed approach, then,confines of the state’s constitutional has the advantages of better targetingrestrictions on venture capital investments, investments and of subsidizingdeal flow increased. management costs. The principal A venture capital institution with disadvantages are the potential for politicalsignificant public funding may have interference in fund management and thedifficulty raising capital from private difficulty in attracting experienced venturesources or finding private venture capital capitalists to run the public program.firms willing to coinvest in potential deals. As an alternative to publicMIN-Corp, for example, found that private management, public capital can besources of capital were reluctant to invest managed by private venture funds likein the fund because they presumed the NRVF, OCIB, and KVCI. In the OCIBfund could continue to draw on public model, capital comes from institutionalresources. In addition, federal programs lenders and investors through thesuch as the CDFI fund will not invest in Oklahoma Capital Formation Corporationinstitutions with state control. More (OCFC). Principal and interest, ifseriously, private venture capital firms are necessary, are guaranteed by $50 millionreluctant to coinvest with public funds in state tax credits with limits of $10because they perceive public funds may be million per year. The funds are used tosubject to political interference. They fear form partnerships with private venturepolitical pressure to invest in specific funds that have successful records offirms, industries, or geographic areas at venture capital investing. Thesethe expense of the fund’s return on partnerships, in turn, focus their efforts oninvestment. According to the site visits, identifying and making investments inthe potential for and impacts of political Oklahoma businesses, although they areinterference are perceived to be serious not restricted to in-state investing. Thisenough that public funds must be model is particularly relevant whenorganized in a way that insulates them prospective deals in the region arefrom external pressures. Potential expected to achieve relatively high IRR.investors must see clearly that this Private management of public fundspolitical interference is eliminated. provides greater insulation from political pressure and higher potential for 13
  16. 16. competitive rates of return on the state’s capital. Utilities, for example, may investinvestments. However, private managers in venture capital institutions that operategenerally are less interested in the in their region. The principal sources ofeconomic development impacts of funding for ICC were two regional electricinvestments. Thus, some targeting of cooperatives, and NEV received anprivately managed funds might be needed investment from a state make this strategy relevant to the Alternatively, in Montana, utilitycreation of nontraditional venture capital cooperatives made direct venture capitalfunds.4 investments in existing and start-up businesses in their service areas. UtilityPrivate Funds cooperatives are in a unique position to For nontraditional venture capital provide venture capital to businessinstitutions that expect to achieve only enterprises because they may be willing tomoderate IRR or to focus on achieving accept a moderate rate of return on theirsocial benefits as well as moderate IRR, funds in order to maintain businessesprivate funds have certain limitations. within their service area as customers.Private investors interested solely in Most utility cooperatives also are in aearning high IRR are unlikely to invest in position to take a long-term view ofventure capital institutions with dual investments, given their commitment toobjectives or in institutions where the region and their members’ strong rootsexpected returns are below traditional in the community. However, stateventure capital market targets. However, regulatory constraints may limit the abilitythe focus on social benefits and economic of a utility cooperative to make venturedevelopment goals may enable an capital investments.5 Moreover, withinstitution to attract investments from industry deregulation, electric powerbanks seeking to meet Community cooperatives will have less incentive toReinvestment Act (CRA) requirements. participate in venture capital programsAlthough the CRA has been used most since the new businesses will noteffectively in urban markets, the necessarily be power customers of the areaincreasing presence of national banks may cooperative.increase CRA’s usefulness in small townsand rural areas. The Appalachian Ohio Public Incentives for Private InvestmentsDevelopment Fund (AODF) was State tax credits to encourage privatesuccessful in using CRA requirements to investments in private venture capitalattract bank financing for capitalization of funds are a hybrid of the public fundingits fund. and private funding alternatives. The Angel investors can be an important certified capital companies (CAPCO)source of private capital for a venture programs of Louisiana, Missouri, andcapital institution. In addition, angels can other states are one example of thisbe coinvestors in deals made by venture funding process. Under CAPCO programs,capital institutions. Angel investors also the state provides tax credits to insuranceare an important source of matching companies that invest in certified venturecapital for public funds that have private capital companies. In general, thematching capital requirements like SEGF. insurance companies receive one dollar of Some regions or states use tax credit spread out over 10 years forunconventional sources of private venture each dollar invested in a CAPCO. The tax 14
  17. 17. credits are applied to the taxes paid on Legal and Organizational Structurepremiums earned by insurance companies In choosing an appropriate legal andon insurance policies written in that state. organizational structure, organizers shouldThe CAPCOs, in turn, must invest in consider the goals and constraints underspecific types of state businesses which they will operate. In some cases,according to a specified time schedule. institutions can operate independently, CAPCO programs have been without affiliation or subsidy from asuccessful in attracting private funds for parent organization. However, particularlyventure capital investments and in for the smaller funds created by someencouraging the expansion of the venture nonmetropolitan communities, ancapital infrastructure in the states adopting independent structure may not be viable.the program. However, under CAPCOs, As a result, affiliation with an existingunlike the public funds alternative, the organization may be crucial for success.public bears significant costs for taxcredits with all or most of the fund’s For-Profit vs. Nonprofit Organizationreturns on investments going to the Venture capital institutions typicallyCAPCOs and insurance companies.6 are for-profit enterprises. However, particularly for institutions balancing IRRFunding from Nongovernmental with economic development goals, aOrganizations nonprofit subsidiary or partner provides Nongovernmental organizations, such institutional flexibility. The nonprofit canas foundations, are more likely to be receive grants for technical assistance tofocused on economic development help offset the venture capital fund’sobjectives and to accept lower returns on operating costs. NEV’s institutionaltheir investments than private sources of structure features both nonprofit and for-funding. National foundations provided an profit entities. KHIC features a parentimportant impetus to the creation of some institution organized as a nonprofitof the first venture capital funds focused community development corporation andon rural or developmental markets. For several for-profit subsidiaries, including anexample, primarily national and regional SBIC.foundations initially capitalized NEV. This Limited Liability Partnerships andfoundation support, in turn, helped Corporationsdetermine the institutional structure of the Most private venture capital funds arefund. As more venture capital funds are organized as limited liability corporationscreated, foundation support will likely (LLC) or partnerships (LLP), where thechange. Foundations may look to some general partners manage the investmentsintermediary that can conduct due and the limited partners provide thediligence on funds and reduce the burden majority of capital for the fund.7 Theseof dealing with individual funds. For funds typically have a limited life of tennontraditional venture capital institutions, years. Investments are made during thesupport from regional foundations may first three to five years and then exitedbecome increasingly important in the during the later stages of the fund. Returnsfuture. to investment are distributed to partners, not retained in the fund to support future investments. 15
  18. 18. LLPs are attractive if the institution is its SBA interest costs. Since thisseeking significant private funding, for instrument is not well suited toexample, NRVF. Private investors prefer investments in start-up enterprises, SBICsLLPs because of the limited financial generally focus on later stage enterprisesliability, absence of managerial and expansion capital.responsibilities, and fixed investment time In 1992, the SBIC program changedperiod. Alternatively, LLCs provide more to facilitate more venture capital investing.flexibility than LLPs and do not have a Participating securities SBICs can deferlimited life. LLCs provide a more interest payments until the SBIC realizespermanent presence with more favorable gains through the sale of the investments,tax treatment of gains than corporations so obstacles to making pure equityhave. investments are fewer. In addition to interest payments, SBA receives a 10Corporations percent participation in the SBIC’s profits. Some institutions are organized as This new institutional structure is bettercorporations. NEV, established to serve suited to making investments in promisingthe northeast Minnesota region, used a early stage companies. North Carolina iscorporate structure because the investors, in the early stages of capitalizing a rural-primarily foundations, wanted to create a focused state venture capital fund, usingpermanent presence in the region. The the participating securities SBIC model.corporate structure was in line with the The fund has received an initial $30economic development goals established million commitment from large banks infor the fund. However, when a corporation the state, with more fundraising plannedrealizes a gain from the exit of a from smaller state banking institutions.successful investment, corporate taxliabilities place a significant burden on the Angel Networksinstitution. The tax treatment for LLPs and An angel capital network is a lessLLCs is more favorable since gains are institutionalized form of venture capitaltaxed at individual, not corporate levels.8 institution. Angel investors have high net worth and are successful entrepreneurs,Small Business Investment Companies providing capital and management(SBIC) expertise to a limited number of start-up Although not a separate legal form, companies. As part of the informal capitalthe SBIC is a popular way to establish market, they are estimated to be the largestventure capital funds. SBICs are private source of capital to new firms.9 Whileventure capital institutions, licensed by the angels typically operate independently,SBA. The license allows an institution to networks are formed to share informationleverage private capital with SBA- and pool capital resources. The MIG andguaranteed funds, where SBA funds are ASCF, angel networks serving a veryoffered at a fixed interest rate payable specific geographic region, pool thesemiannually. Until recently, most SBICs resources of successful business people toborrowed money from the SBA. SBICs make investments in their communities.typically provided subordinated debt with MIN-Corp, a nonprofit institutionthe option to acquire equity in their operating in Minnesota, represents a moreportfolio companies, an investment institutional approach to angel networks. Itinstrument that enabled the SBIC to cover is organizing angel investment networks, 16
  19. 19. structured as LLCs. While three networks The fund can operate at lower cost byare currently operating, ten are planned.10 using the volunteer advisory board, butAs with most nontraditional venture this system limits the number of deals thatcapital institutions visited, the level of can be considered. In addition, it iscoordination, the quality of due diligence, difficult to coordinate this type ofand success of investments of angel organization, and the costs of coordinationnetworks can vary significantly. More may become burdensome to theanalysis of these networks and their institution. Under the SEGF modelapplicability to rural markets is needed. volunteer members of the board are not considered part of the management team, a Management of Investment Activity significant limitation. While they are given Finally, decision makers must responsibility for conducting duedetermine how to conduct the institution’s diligence, they are not accountable forinvestment activities (Figure 6). their investment or strategic decisions.Specifically, how will the institution Their lack of accountability could affectscreen prospects, select investment the quality of investment decisions made.instruments, and exit deals? To a large Due diligence on prospectiveextent earlier decisions will dictate investments for the small, local fundchoices. For example, a decision to use a ASCF is provided by several resources.volunteer board will affect how due Businesses seeking funding from ASCFdiligence for prospective investments is agree to counseling with the Smallconducted. A decision to focus on very Business Development Center or Iowaearly stage investments will dictate an State University Innovations System. Afterinvestment instrument structured more like prescreening, applicants are reviewed bypure equity than debt. the executive director of the Ames Economic Development Committee, aScreening Prospective Investments division of the Ames Chamber of Establishing a thorough system for Commerce, the fund investment reviewconducting due diligence on prospective committee, and a private venture capitalistinvestments is a key component to under contract with ASCF.building a sustainable venture capital Venture capital institutions can alsoinstitution. In many institutions, spread the risk or burden of due diligenceprofessional managers conduct due by partnering with other institutions, suchdiligence with very limited input from as larger venture capital funds, oninvestors. KVCI uses this approach. The investments or by requiring a matchinggeneral partners make all the investment investment from another source. Thedecisions for the investors, over 300 managers or advisors for each institutionKansas banks. In other cases, an advisory conduct their own due diligence, reducingboard provides the technical expertise to the risk that a critical flaw in the businessconduct due diligence, aided by fund staff. plan, for example, might be overlooked.SEGF operates in this manner since the This strategy is particularly important forfund does not have a full-time professional smaller venture capital institutions,manager. Members of the advisory board because larger deals can be put togetherreview business plans, visit entrepreneurs, through partnering and the burden of dueand do the market analysis required to diligence can be shared.identify viable investment opportunities. 17
  20. 20. Figure 6. Management of Investment Activity Screening Prospective Investments • Responsibility for due diligence (fund managers, volunteer advisory board, partner venture capital funds) • Identify management expertise Select Appropriate Investment Instrument • Subordinated debt • Debt with warrants • Convertible debentures • Convertible preferred stock • Preferred stock • Participation agreements • Royalties Select Exit Strategies • Initial Public Offering (IPO) • Acquisition or merger • Employee or owner buyout 18
  21. 21. In some cases, due diligence One cautionary note on investmentperformed on a prospective company instruments is drawn from SEGF. Theconcludes that the company has a good fund originally used a complicatedproposal, but the venture capital institution subordinated debt instrument with putsis not confident that current company and calls. Portfolio companies had to incurmanagement can achieve what is the expense of hiring legal expertise toproposed. Therefore, a second part of the interpret the instrument in order to makescreening process determines if the needed an investment decision. As a result, somemanagement expertise is available locally firms simply did not pursue the potentialor can be attracted to the area. If the local investment. The complicated structure waseconomy provides infrastructure and due, in part, to state constitutionalsupport services, entrepreneurial restrictions on the fund taking a puredevelopment and small business growth equity position in the firm. However, thewill be more successful. CRSF noted fund recently restructured the investmentdifficulty in finding people willing to instrument as a convertible debenture andrelocate to rural Colorado to manage and has had more success in attracting newgrow their portfolio companies. As a potential deals and meeting the needs ofresult, portfolio companies did not develop their existing portfolio anticipated. Alternatively, KHIC and Structuring venture capital deals canNEV brought entrepreneurs into the region also be difficult in markets where theand built deals around them. The provision entrepreneurs are unfamiliar with equityof venture capital alone may not be capital. An equity investment requiressufficient to build successful businesses giving up some ownership stake in thethat can contribute to the overall economic business, at least in the short term. Fordevelopment process. family-owned businesses, the owner’s goals of passing the business to the nextSelecting Investment Instruments generation may be threatened by an equity Investment instruments used by a investment in contrast to an investmentventure capital institution include pure instrument structured as debt with equityequity such as stock and quasi-equity features.instruments such as debt with warrants,debt with equity kickers, royalties, Involvement in Portfolio Companyparticipation agreements, and convertible Managementdebt. Most institutions have a preferred The level of involvement withinvestment instrument, and the choice of portfolio company management is ainstrument will depend, to some extent, on function of the expertise of the venturethe source of funds and the institution’s capital institution’s staff. Many traditionalpreferred exit strategy. For example, venture capital funds require a seat on theSBICs traditionally used subordinated debt portfolio company’s board as a conditionor debt with warrants to generate a stream of investment. The managing partnersof current income that could be used to have technical expertise that they cancover interest costs on SBA leveraged contribute to the company’s board. Thisfunds. board presence allows investors to follow management decisions and, if necessary, 19
  22. 22. intervene in the decision-making process. manufacturing firms that dominate smallThe nontraditional venture capital towns and rural areas, IPOs are less likelyinstitutions visited are involved in the to be successful, particularly in the currentmanagement of their portfolio companies volatile market. While acquisition is aat different levels. Some institutions viable strategy in small market areas, thisrequire a board seat and maintain active strategy may not work for institutions thatinvolvement in company management. In have the dual objectives of competitivesome cases, new management, such as a IRR and economic development benefits.chief financial officer, is brought into the The sale of a company to an outside partycompany as a condition of investment. may provide positive financial returns toOther institutions, such as SEGF, do not the venture capital institution, but if thealways take a seat on a company’s board plant relocates, economic developmentsince oversight of investments is the impacts may be negative. For institutionsresponsibility of a volunteer board. with an interest in economic development, The level of involvement with an employee or owner buyout providesportfolio companies also varies over the liquidity to the venture capital institutionlife of the investment. If a company is and retains economic benefits in the localdoing well, the venture capital institution area. However, unless the owner oris unlikely to intervene in management employees borrow funds to financedecisions. If the company encounters purchase of the business, payments areproblems, the managing partners may usually structured to fit within the cashprovide assistance themselves or through flow limitations of the business and areoutside consultants, they may make an typically made over a relatively longadditional investment to strengthen the period of time. As a result, the financialcompany, or they may be involved in return on the investment is likely to bereplacing an existing company smaller for the venture capital team with a new team. Thelevel of involvement depends on the Summary and Conclusionsexpertise and resources of the venture The establishment of a venture capitalcapital institution’s managers. institution is complicated, time- consuming, and expensive. It is even moreExiting the Deal difficult in small market areas than urban Exit strategies present important centers. Nonmetropolitan communitieschallenges to venture capital investors. In and rural areas have a relatively smalla recent study of Canadian markets, survey number of firms that are familiar with andresults show the importance of exit receptive to the concept of venturepotential to venture capital investment investments. These areas often lack thedecisions. According to the study, venture management expertise, support services,capitalists consider the prospects for a and infrastructure beneficial forprofitable exit when deciding whether to entrepreneurial and small businessinvest and what the terms of investment development. Businesses have relativelywill be.11 Most venture capital institutions few options for exiting deals with ventureexit successful investments through an capitalists. The costs of managing ainitial public offering (IPO) of stock, venture capital institution with a smallacquisition by another firm, or employee market focus also can be high due to theor owner buyout. For traditional 20
  23. 23. geographic dispersion of portfolio their costs and can capture the externalcompanies. benefits. The relatively unfavorable Despite the success of a number ofenvironment for venture capital nontraditional venture capital institutions,investments in small market areas partly all institutions interviewed for this studyexplains why venture capital investments said that they would do things differentlyare highly concentrated in metropolitan if they had the opportunity to start anew.areas. Yet this study finds examples of That is, earlier decisions regarding goals,successful venture capital institutions that funding, management and investmentsare located in nonmetropolitan would have been made differently had thecommunities and rural areas. In general, institution known the implications of theirthese nontraditional venture capital decisions. They would have benefitedinstitutions can function in the limited from a formalized decision-makinginvestment environment because (1) they process demonstrating the linkageshave a patient source of investment funds, between early decisions and those that(2) they are willing to accept less than the followed. The decision-making processmarket rate of return in exchange for described here can be used as a guide toexternal or social benefits, or (3) they are creating nontraditional venture capitalaffiliated with organizations that subsidize institutions in small urban centers and rural communities across the U.S. 21
  24. 24. Endnotes Julia Sass Rubin, 2001. “Certified Capital Companies (CAPCOs): The1. An option for smaller funds may be to Latest Wave in State-Assisted have a staggered fee schedule. Fees Venture Capital Programs,” Economic can be higher in the initial years and Development Quarterly, forthcoming. then be reduced over time so that the average is 2 to 3 percent. 7. For a discussion of LLPs and LLCs, see Sahlman, W. A., 1990, “Structure2. Barkley, David L., Deborah M. of Venture-Capital Organizations,” Markley, and Julia Sass Rubin, 1999, Journal of Financial Economics, “Public Involvement in Venture 27:473-521. Capital Funds: Lessons from Three Program Alternatives,” Columbia, 8. Executives with Iowa Capital MO: Rural Policy Research Institute, Corporation noted that they would not University of Missouri, P99-9. have selected the corporate structure had they known how successful the3. Organizers also must consider who fund would be. ICC is investigating will be responsible for the costs of alternative structures such as LLC or creating the venture capital institution. LLP to reduce the fund’s tax Both time and money are required to liabilities. Northeast Ventures is in the create an organization and raise the process of converting from a C funds to capitalize it. According to corporation to a nonprofit corporation Pete Bloomer of Colorado Venture largely because of the tax Management (Boulder, Colorado), it consequences associated with the takes approximately one year and corporate structure. $300,000 to create a venture capital fund. 9. Gaston, Robert J., 1990, “Financing Entrepreneurs: The Anatomy of a4. Interested readers may refer to Hidden Market,” chapter in Financing Barkley, Markley, and Rubin (1999) Economic Development: An for a more thorough discussion of the Institutional Response, edited by advantages and disadvantages of Richard D. Bingham, Edward W. Hill, alternative publicly-assisted venture and Sammis B. White, Sage capital programs. Publications.5. For more information on the Montana 10. For more information, see Jossi, cooperatives, see Freshwater, David, Frank and Paul Duncan, 1998, 1998, “Utility Cooperatives as a “Angels take Wing,” Ventures, Source of Equity Finance: Montana (October): 34-36. Examples,” Department of Agricultural Economics, University of 11. MacIntosh, Jeffrey G., 1997, “Venture Kentucky, Staff Paper No. 386, Capital Exits in Canada and the (November). United States,” Financing Growth in Canada, edited by Paul Halpern,6. For a more in-depth discussion of University of Calgary Press. CAPCO programs, refer to Barkley, David L., Deborah M. Markley, and 22