David L. Barkley, Clemson U...
Rural Policy Research Institute’s (RUPRI)
                               Rural Equity Capital Initiative

       The RUPRI...
Establishing Nontraditional Venture Capital Institutions:
                                  The Decision Making Process

example, a bank Small Business                            development corporation (CDC).
Investment Company (SBIC). Ventur...
Figure 1.
Steps in the Decision Making Process for Creating a Nontraditional Venture Capital Institution

venture capital investments. Founders of        focused on creating economic
these institutions recognized a demand for   ...
Figure 2. Impetus for Starting a Nontraditional Venture Capital Institution

     For other funds, however, a market   ...
firms generally specialize in specific         knowledge important to identifying potential
industries like manufacturing ...
Figure 3. Market Analysis

                                      Assess Local Deal Flow
                             •   ...
Articulation of Institution’s Goals         process, although they are considered to be
     After the need for venture ca...
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 come
discernible economic benefits.2 ...
order to overcome limitations resulting              If public funding is available for
from public investment. In both ca...
competitive rates of return on the state’s     capital. Utilities, for example, may invest
investments. However, private m...
credits are applied to the taxes paid on          Legal and Organizational Structure
premiums earned by insurance companie...
LLPs are attractive if the institution is   its SBA interest costs. Since this
seeking significant private funding, for   ...
structured as LLCs. While three networks      The fund can operate at lower cost by
are currently operating, ten are plann...
Figure 6. Management of Investment Activity

                     Screening Prospective Investments

              • Re...
In some cases, due diligence                    One cautionary note on investment
performed on a prospective company      ...
intervene in the decision-making process.      manufacturing firms that dominate small
The nontraditional venture capital ...
geographic dispersion of portfolio             their costs and can capture the external
companies.                        ...
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 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 ( 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 of communities, and small geographically support to worthy area businesses. isolated metropolitan areas often are This decision-making process is based overlooked by traditional venture capital on on-site interviews with founders and funds because of the relatively high cost of managers of 23 venture capital institutions finding and managing investments in small across the country (Table 1). The decision market areas. Yet opportunities for quality making is presented as a sequential venture capital investments are present in process (Figure 1); however, clear smaller markets, and successful feedback loops exist among the various nontraditional venture capital institutions stages of the process. Decisions made have been established to promote early in the process constrain later choices. entrepreneurial and business development In addition, if constraints are subsequently in such areas. In some cases, venture identified in the process, such as in capital institutions focus on local small fundraising or deal flow, modifications business communities, such as Northeast and adaptations to earlier decisions or Ventures (NEV) in Minnesota, McAlester goals may be needed. Investment Group (MIG) in Oklahoma, Based on the site visits, no single best and Ames Seed Capital Fund (ASCF) in model for a nontraditional venture capital Iowa. In others, a broader concern about institution exists. The organizational form economic development prospects spurs chosen for an institution will depend on state governments to provide venture the economic structure of the targeted capital through groups like Kansas region; the capital needs of resident Venture Capital Inc. (KVCI), Northern businesses; the goals of the organizers, Rockies Venture Fund (NRVF) in managers, and investors; and for public Montana, and the Oklahoma Capital entities, the statutes regulating public Investment Board (OCIB). Whether institutions. However, despite the venture capital is provided by private or underlying variability in market areas and public institutions, organizers consider differences in goals, organizational similar questions or issues when structure, and investment portfolios, the developing and designing institutions. concepts outlined in the decision process This paper provides an overview of appear applicable to all the institutions the decision-making process followed in visited. Indeed, institutions that clearly establishing nontraditional venture capital articulated how they approached each institutions. An understanding of this decision element were more successful process will enable communities to learn than those with a less precise notion of from the experiences of others and to what they hoped to achieve and how they develop venture capital institutions planned to accomplish it. tailored to their goals, market conditions, The organizational frameworks of and institutional constraints. A well- nontraditional venture capital institutions organized decision-making process vary. The venture capital institution may increases the probability of establishing a be a freestanding, independent entity. In successful 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 organizational capital investing also occurs as an form a nontraditional venture capital extension of the core activities of an institution ultimately assumes, organizers organization such as a state agency, rural can gain by using the decision-making electric 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 with significant 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 communities throughout 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 development institution? Some institutions visited were generally were established primarily to created in response to concerns about the make investments in firms that could grow level of state or local economic and remain in the region, increasing development activity (Figure 2). The regional income and employment. For founders believed that local business example, local business people created the development and job creation were MIG, an organization of angel investors, hampered by a lack of venture capital and to help stimulate business development in that successful venture capital investments the town of McAlester, Oklahoma. could be made in area businesses at rates Other institutions were established to of return less than those sought by meet the venture capital needs of area traditional venture capitalists. Investments businesses and, as a result, to demonstrate in venture capital funds were made to that the local economy could support 3
  6. 6. venture capital investments. Founders of focused on creating economic these institutions recognized a demand for opportunities within the distressed venture capital in the region and the failure Appalachian region by developing of national venture capital institutions to potential deals, investing in the region’s meet that demand. Kansas bankers, businesses and entrepreneurs, and bringing recognizing a need for venture capital, entrepreneurs into the region to create new established KVCI, an SBIC. KVCI enterprises. In these examples, creating focused on meeting the venture capital economic development and social benefits needs of existing Kansas businesses, for specific segments of the population although economic development concerns were important objectives. were a secondary issue. OCIB responded to the need for venture capital in Market Analysis and Estimation of Oklahoma by investing in partner funds Local Deal Flow that could, in turn, invest in Oklahoma Developing an appreciation for the businesses. OCIB wanted to stimulate the need for venture capital in the relevant Oklahoma venture capital market by local, state, or regional market area is a bringing Oklahoma deals to the attention critical second step in the creation of a of established regional and national nontraditional venture capital institution. venture capital funds. However, This understanding, in turn, helps investment in Oklahoma businesses is not determine whether an effective demand for specifically required. NRVF was created the venture capital institution exists, what to stimulate the private capital market in niche the institution might occupy, and Montana after attempts to attract private what would be an appropriate size for the investors to an earlier state program were fund. In addition to evaluating the need for unsuccessful. While the earlier state venture capital, it is important to identify program grew out of economic the climate for venture capital investing in development concerns, NRVF was created the region. Are potential entrepreneurs to address the inadequacies of the private familiar with venture capital investing venture capital market in Montana and to available, or will some educational effort earn good returns for the investors and be required to develop this familiarity? managers of the fund. For some institutions, particularly A third group of institutions was created to community development venture funds use venture capital investments to create (CDVCs), adequate deal flow was not jobs, entrepreneurial capacity and wealth central to their creation. Almost by to benefit primarily distressed definition, CDVCs targeted populations communities and low-wealth individuals. where deal flow was limited or The institutions considered both financial nonexistent and had to be developed. and social returns in making investments. KHIC had to create deals by attracting For example, NEV was established in entrepreneurs to the region and by response to the downturn in northeast providing extensive assistance to Minnesota’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 expansion of businesses in the region. Kentucky Highlands 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 the analysis can help to determine the focus of potential need for venture capital can be the venture capital institution and provide obtained by understanding the structure of the information needed to make decisions the local, state, or regional economy. It is on structure, size, and targeting of the important, however, to recognize that institution. The need for venture capital measuring the need for venture capital is varies with the stage, sector, and level of subjective. technology of resident industries, as well Analysis of a market area determines as with their potential for growth. whether potential deal flow is sufficient to Established firms, experiencing only justify creating a venture capital institution moderate growth, may have limited need (Figure 3). Because institutions tend to for venture capital and may be able to invest in a small percentage of deals meet capital needs from retained earnings reviewed, deal flow must be adequate. For or borrowing. New, rapidly growing example, KVCI reviews about 150 deals companies have more limited access to annually, yet it makes investments in only debt capital and are more likely to have three or four deals. Analysis of investment capital needs that outpace their ability to opportunities in specific industry sectors and generate retained earnings. Consequently, development stages is equally important to such businesses may have a greater need assessing overall deal flow. Venture capital 5
  8. 8. firms generally specialize in specific knowledge important to identifying potential industries like manufacturing or computer deal flow. software or in specific stages of If overall deal flow in the institution’s development like start-ups, expansions, or proposed service area is considered transfers of ownership. The targeting of inadequate to support a successful fund, investments occurs because different types organizers can choose to cease the decision of investments require different types of making process or investigate alternatives expertise for the fund manager. for increasing deal flow (Figure 3). How can a community assess Broadening the geographic region served or potential deal flow? When the impetus for industry sector targeted can increase deal creating a rural venture capital institution flow. Colorado Venture Management’s comes 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 limited institution. NEV’s founder’s years of economy, was not successful. However, experience working with small businesses NRVF, CVM’s recent initiative, fosters in the region provided the baseline greater deal flow by operating statewide in information that defined the need in Montana. northeast Minnesota. Pacesetter, a venture The industry focus of an institution can capital fund based in Dallas, Texas, was be expanded rather than limiting established by its parent, MESBIC investments to a small number of specific Ventures, because of an identified need for sectors. The Iowa Capital Corporation later stage venture capital for minority (ICC), for example, focuses on industries businesses in which MESBIC had strategic to the electric power industry, but originally invested. However, in spite of ICC will consider firms in most their assessment of deal flow, venture manufacturing sectors. capital institutions may be faced with a Small community-based funds and very different pool of potential deals than CDVCs may have difficulty broadening anticipated. This situation affects their geographic region or industry focus. investment strategies and the time frame They often are already generalists and for exiting investments. For example, the cannot spread their staff and resources over early market research undertaken by NEV a broader geographic region without did not reveal that most of their deals compromising their potential impact. They would be in early stage businesses. can, however, develop deal flow by When nontraditional venture capital providing support services for entrepreneurs institutions are created because of lack of and new businesses through incubators, capital availability, however, assessing technology transfers, and assistance in deal flow is more problematic. developing business plans. Institutions with Networking with organizations that know a strong developmental orientation, like the needs of small businesses and KHIC, have created deals by coupling entrepreneurs takes on added significance. technical assistance with venture capital. In Networking with banks, Small Business regions where role models for entrepreneurs Development Centers, chambers of are limited, entrepreneurial development commerce, and local economic must precede the development of sound development 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 capital identified, the institution’s goals must be institution may be able to capture benefits more specifically articulated (Figure 4). from other externalities, such as increased Some nontraditional funds want to property values in the community or maximize financial returns. Their improved general quality of life. managers believe that investment Some institutions seek to maximize opportunities in the area offer the potential social benefits or returns while earning an for earning an overall annual rate of return IRR that is sufficient to ensure the of 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, Coastal traditional venture institutions. These Ventures Limited Partners (CVLP), and investments are not currently undertaken MIN-Corp, consider potential financial by traditional institutions because of an and social returns in the decision making imperfect flow of information, but the process. While both IRR and social returns deals are available to regional investors can be considered, managers and investors who recognize the investment opportunity. must determine how these two variables Profit maximizing institutions face the are balanced, based on their mutual goals. challenge of making sound investments For example, managers may choose to while attempting to overcome the factors invest to achieve the highest possible IRR, of distance, high transaction costs, and subject to achieving certain minimum lack of information that discourage the social benefits. Alternatively, social extension of traditional venture funds into benefits could be maximized subject to more geographically isolated markets. achieving a minimum rate of IRR. NRVF and OCIB are organized around Achieving consensus on these tradeoffs is this principle. Finding a source of capital critical to the decision-making process. to fund the demonstration effort constrains the development of these types of Selection of Institutional Size and institutions. In some cases, public Management Alternatives investment can play an important role in Institution Size this demonstration phase. The optimal capitalization of a Other institutions also seek to nontraditional venture capital institution maximize financial returns, but recognize depends upon the institution’s goals, that investment opportunities in small organizational structure, and sources of market areas offer potential IRRs that are funding. In addition, capital available lower than those expected by traditional should be closely related to investment venture funds. They work to maximize opportunities or deal flow. If capitalization IRR, given that the expected rate of return is large relative to deal flow, the institution will be lower than those accepted by may be encouraged to make questionable traditional venture funds. Social returns investments. If capitalization is low from investments such as jobs, income, compared to estimated deal flow, then retail sales, and housing starts are not investment opportunities may go valued 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 of return (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 fund horizon would have $7 to $8 million to be viable. Alternatively, the Small available to invest in portfolio companies Enterprise Growth Fund (SEGF) in Maine after allocations for management fees. uses a volunteer board for due diligence Such a fund could make seven to eight and investment decisions to reduce investments averaging $1 million per management costs. Small, local funds such investment. Generally, the initial as ASCF and Siouxland Ventures Fund investment in a portfolio company would (SVF) rely on the local chamber of be less than the $1 million average since commerce for administrative support. part of the fund’s investment capital will Management Alternatives be set aside for additional investments. With the goals and size of the institution More than seven to eight investments established, a professional management could be made if initial deals are exited team must be secured to run the venture profitably and earnings are reinvested in capital institution. Most institutions noted the fund. that professional management was critical For small community-based to the success of the fund. In small market institutions and CDVCs, operating budgets areas, organizers must consider whether may be covered by grant money, monetary experienced professional investors can be and in-kind contributions from partner hired from within the local labor pool or organizations and retained earnings. As a whether professionals can be attracted to result, institution size may have less the local area. In addition, the institution’s influence on the ability of these goals will play a role in determining the institutions to hire experienced, committed characteristics of the management team. If managers. the goal of the institution is to maximize If prospects for raising a $10 million IRR, the fund must be large enough to fund are limited given the goals and focus support an experienced management team, of the institution, then the organizers have relying primarily on an average other alternatives (Figure 5). One, the management fee of 2½ percent. In organizers can cease planning for a addition, the potential to earn significant venture capital institution and investigate returns on the investments must be other means of assisting new area sufficient. For institutions with dual goals, businesses. Two, the organizers can management must be motivated by reevaluate the proposed goals, area, and concern with the social benefits of industry focus of the institution to investments and be comfortable with the determine whether the institution can tradeoff between financial and social become more attractive to potential returns. Since the community development investors. Three, alternatives to a venture capital industry is relatively young freestanding venture capital fund such as compared with traditional venture capital, partnerships with public or private the pool of professional, socially organizations, could be investigated as a motivated investors is more limited. means to subsidize management of the Consequently, institutions with dual goals fund. 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 venture community 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 reward management, attention must be given to good investment decisions, the institution establishing an incentive structure for may not achieve either its financial or management that is consistent with the social goals. The Magnolia Venture goals of the institution. Most traditional Capital Corporation (MVCC) in and profit maximizing nontraditional Mississippi provides the classic example funds are structured so that the of potential problems with an institution management team shares in any profits when oversight is inadequate (in this case, earned when investments are exited. Even public oversight) and the incentive system smaller community-based and community fails to reward sound investments and fund development venture funds provide some growth. Lax oversight of Magnolia’s way for fund managers and staff to share management and board and questionable in 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 come discernible 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 Financial considered throughout the decision- Institutions (CDFI) fund. NEV, CVLP, making process. When organizers begin to and KHIC received CDFI funding, and discuss the creation of a nontraditional North Dakota SBIC and First United venture capital institution, it is important Ventures (FUV) in Oklahoma tapped the that they have a realistic view of leveraging available through SBA. Title alternative sources of funding for VII (no longer available) program funds capitalizing the institution and the for community development corporations implications of these sources for provided capital to KHIC. management structure. In addition, The experience of site visit organizers need to understand any institutions suggests several caveats to the restrictions or covenants that are placed on use of public funds, particularly state funds invested in the institution. For funds. Funding for a venture capital example, if foundations are identified as institution should be provided in one lump lead investors, their goals will be sum as opposed to annual appropriations instrumental in setting the goals of the over a period of time. Annual institution. If the state is the lead investor, appropriations of state funding tend to be restrictions on investments to in-state subject to the vagaries of the political firms will be likely. These constraints will process. This uncertainty with respect to influence the decision-making options future funding availability may encourage available to institution organizers.3 suboptimal investment decisions on the Funding for the capitalization and part of the venture capital institution; for management of the site-visit institutions example, the institution may feel pressure came 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 the public incentives (tax credits), and institution’s portfolio companies are likely nongovernmental organizations (nonprofit to occur before successes, cooling foundations). Each funding source has its legislative support for future own advantages and constraints. appropriations for the institution. In some cases public funds come with Public Funds restrictions, such as limiting investments A number of institutions were to in-state firms or firms in a particular capitalized either completely or in part by industry sector or region. While such public funds, both state and federal. KVCI, restrictions may meet certain economic MIN-Corp, NRVF, Iowa Seed Capital development objectives, they create Corporation (ISCC), CRSF, and SEGF obstacles that limit the institution’s ability received substantial state investments. to develop sufficient deal flow or to Public capital may be compatible with partner with venture capital investors goals of maximizing IRR in the low to outside the state or region. The ICC has moderate range or meeting the dual reimbursed Iowa and KVCI has refunded objectives 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 for from public investment. In both cases, capitalization of the venture capital however, the repayment plans were institution, considerations must be given to beneficial to both the state and the venture the tradeoffs between public and private capital institution since state resources management of the funds. For example, were made available for other uses. A state public funds can be invested directly into constitution may limit the type of portfolio companies through a public or investments an institution can undertake quasi-public institution like SEGF or with public funds. SEGF was prohibited ISCC. SEGF is administered through the from making pure venture capital Finance Authority of Maine, using staff investments and, as a result, used a resources and an advisory board to make complicated debt with warrants investment investment decisions. The state is engaged structure that initially limited the number in direct investing in this institutional of 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 targeting restrictions on venture capital investments, investments and of subsidizing deal flow increased. management costs. The principal A venture capital institution with disadvantages are the potential for political significant public funding may have interference in fund management and the difficulty raising capital from private difficulty in attracting experienced venture sources or finding private venture capital capitalists to run the public program. firms willing to coinvest in potential deals. As an alternative to public MIN-Corp, for example, found that private management, public capital can be sources of capital were reluctant to invest managed by private venture funds like in the fund because they presumed the NRVF, OCIB, and KVCI. In the OCIB fund could continue to draw on public model, capital comes from institutional resources. In addition, federal programs lenders and investors through the such as the CDFI fund will not invest in Oklahoma Capital Formation Corporation institutions with state control. More (OCFC). Principal and interest, if seriously, private venture capital firms are necessary, are guaranteed by $50 million reluctant to coinvest with public funds in state tax credits with limits of $10 because they perceive public funds may be million per year. The funds are used to subject to political interference. They fear form partnerships with private venture political pressure to invest in specific funds that have successful records of firms, industries, or geographic areas at venture capital investing. These the expense of the fund’s return on partnerships, in turn, focus their efforts on investment. According to the site visits, identifying and making investments in the potential for and impacts of political Oklahoma businesses, although they are interference are perceived to be serious not restricted to in-state investing. This enough that public funds must be model is particularly relevant when organized in a way that insulates them prospective deals in the region are from external pressures. Potential expected to achieve relatively high IRR. investors must see clearly that this Private management of public funds political 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 invest investments. However, private managers in venture capital institutions that operate generally are less interested in the in their region. The principal sources of economic development impacts of funding for ICC were two regional electric investments. Thus, some targeting of cooperatives, and NEV received an privately managed funds might be needed investment from a state utility. to make this strategy relevant to the Alternatively, in Montana, utility creation of nontraditional venture capital cooperatives made direct venture capital funds.4 investments in existing and start-up businesses in their service areas. Utility Private Funds cooperatives are in a unique position to For nontraditional venture capital provide venture capital to business institutions that expect to achieve only enterprises because they may be willing to moderate IRR or to focus on achieving accept a moderate rate of return on their social benefits as well as moderate IRR, funds in order to maintain businesses private funds have certain limitations. within their service area as customers. Private investors interested solely in Most utility cooperatives also are in a earning high IRR are unlikely to invest in position to take a long-term view of venture capital institutions with dual investments, given their commitment to objectives or in institutions where the region and their members’ strong roots expected returns are below traditional in the community. However, state venture capital market targets. However, regulatory constraints may limit the ability the focus on social benefits and economic of a utility cooperative to make venture development goals may enable an capital investments.5 Moreover, with institution to attract investments from industry deregulation, electric power banks seeking to meet Community cooperatives will have less incentive to Reinvestment Act (CRA) requirements. participate in venture capital programs Although the CRA has been used most since the new businesses will not effectively in urban markets, the necessarily be power customers of the area increasing presence of national banks may cooperative. increase CRA’s usefulness in small towns and rural areas. The Appalachian Ohio Public Incentives for Private Investments Development Fund (AODF) was State tax credits to encourage private successful in using CRA requirements to investments in private venture capital attract bank financing for capitalization of funds are a hybrid of the public funding its 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, and capital institution. In addition, angels can other states are one example of this be coinvestors in deals made by venture funding process. Under CAPCO programs, capital institutions. Angel investors also the state provides tax credits to insurance are an important source of matching companies that invest in certified venture capital for public funds that have private capital companies. In general, the matching capital requirements like SEGF. insurance companies receive one dollar of Some regions or states use tax credit spread out over 10 years for unconventional 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 Structure premiums earned by insurance companies In choosing an appropriate legal and on insurance policies written in that state. organizational structure, organizers should The CAPCOs, in turn, must invest in consider the goals and constraints under specific 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 a successful in attracting private funds for parent organization. However, particularly venture capital investments and in for the smaller funds created by some encouraging the expansion of the venture nonmetropolitan communities, an capital infrastructure in the states adopting independent structure may not be viable. the program. However, under CAPCOs, As a result, affiliation with an existing unlike the public funds alternative, the organization may be crucial for success. public bears significant costs for tax credits with all or most of the fund’s For-Profit vs. Nonprofit Organization returns on investments going to the Venture capital institutions typically CAPCOs and insurance companies.6 are for-profit enterprises. However, particularly for institutions balancing IRR Funding from Nongovernmental with economic development goals, a Organizations nonprofit subsidiary or partner provides Nongovernmental organizations, such institutional flexibility. The nonprofit can as foundations, are more likely to be receive grants for technical assistance to focused on economic development help offset the venture capital fund’s objectives and to accept lower returns on operating costs. NEV’s institutional their investments than private sources of structure features both nonprofit and for- funding. National foundations provided an profit entities. KHIC features a parent important impetus to the creation of some institution organized as a nonprofit of the first venture capital funds focused community development corporation and on rural or developmental markets. For several for-profit subsidiaries, including an example, primarily national and regional SBIC. foundations initially capitalized NEV. This Limited Liability Partnerships and foundation support, in turn, helped Corporations determine the institutional structure of the Most private venture capital funds are fund. As more venture capital funds are organized as limited liability corporations created, foundation support will likely (LLC) or partnerships (LLP), where the change. Foundations may look to some general partners manage the investments intermediary that can conduct due and the limited partners provide the diligence on funds and reduce the burden majority of capital for the fund.7 These of dealing with individual funds. For funds typically have a limited life of ten nontraditional venture capital institutions, years. Investments are made during the support from regional foundations may first three to five years and then exited become increasingly important in the during the later stages of the fund. Returns future. 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 this seeking significant private funding, for instrument is not well suited to example, NRVF. Private investors prefer investments in start-up enterprises, SBICs LLPs because of the limited financial generally focus on later stage enterprises liability, absence of managerial and expansion capital. responsibilities, and fixed investment time In 1992, the SBIC program changed period. Alternatively, LLCs provide more to facilitate more venture capital investing. flexibility than LLPs and do not have a Participating securities SBICs can defer limited life. LLCs provide a more interest payments until the SBIC realizes permanent presence with more favorable gains through the sale of the investments, tax treatment of gains than corporations so obstacles to making pure equity have. investments are fewer. In addition to interest payments, SBA receives a 10 Corporations percent participation in the SBIC’s profits. Some institutions are organized as This new institutional structure is better corporations. NEV, established to serve suited to making investments in promising the northeast Minnesota region, used a early stage companies. North Carolina is corporate structure because the investors, in the early stages of capitalizing a rural- primarily foundations, wanted to create a focused state venture capital fund, using permanent presence in the region. The the participating securities SBIC model. corporate structure was in line with the The fund has received an initial $30 economic development goals established million commitment from large banks in for the fund. However, when a corporation the state, with more fundraising planned realizes a gain from the exit of a from smaller state banking institutions. successful investment, corporate tax liabilities place a significant burden on the Angel Networks institution. The tax treatment for LLPs and An angel capital network is a less LLCs is more favorable since gains are institutionalized form of venture capital taxed 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 capital the SBIC is a popular way to establish market, they are estimated to be the largest venture capital funds. SBICs are private source of capital to new firms.9 While venture capital institutions, licensed by the angels typically operate independently, SBA. The license allows an institution to networks are formed to share information leverage private capital with SBA- and pool capital resources. The MIG and guaranteed funds, where SBA funds are ASCF, angel networks serving a very offered at a fixed interest rate payable specific geographic region, pool the semiannually. Until recently, most SBICs resources of successful business people to borrowed money from the SBA. SBICs make investments in their communities. typically provided subordinated debt with MIN-Corp, a nonprofit institution the option to acquire equity in their operating in Minnesota, represents a more portfolio companies, an investment institutional approach to angel networks. It instrument 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 by are currently operating, ten are planned.10 using the volunteer advisory board, but As with most nontraditional venture this system limits the number of deals that capital institutions visited, the level of can be considered. In addition, it is coordination, the quality of due diligence, difficult to coordinate this type of and success of investments of angel organization, and the costs of coordination networks can vary significantly. More may become burdensome to the analysis of these networks and their institution. Under the SEGF model applicability 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 due determine how to conduct the institution’s diligence, they are not accountable for investment activities (Figure 6). their investment or strategic decisions. Specifically, how will the institution Their lack of accountability could affect screen prospects, select investment the quality of investment decisions made. instruments, and exit deals? To a large Due diligence on prospective extent earlier decisions will dictate investments for the small, local fund choices. For example, a decision to use a ASCF is provided by several resources. volunteer board will affect how due Businesses seeking funding from ASCF diligence for prospective investments is agree to counseling with the Small conducted. A decision to focus on very Business Development Center or Iowa early stage investments will dictate an State University Innovations System. After investment instrument structured more like prescreening, applicants are reviewed by pure equity than debt. the executive director of the Ames Economic Development Committee, a Screening Prospective Investments division of the Ames Chamber of Establishing a thorough system for Commerce, the fund investment review conducting due diligence on prospective committee, and a private venture capitalist investments is a key component to under contract with ASCF. building a sustainable venture capital Venture capital institutions can also institution. In many institutions, spread the risk or burden of due diligence professional managers conduct due by partnering with other institutions, such diligence with very limited input from as larger venture capital funds, on investors. KVCI uses this approach. The investments or by requiring a matching general partners make all the investment investment from another source. The decisions for the investors, over 300 managers or advisors for each institution Kansas banks. In other cases, an advisory conduct their own due diligence, reducing board provides the technical expertise to the risk that a critical flaw in the business conduct due diligence, aided by fund staff. plan, for example, might be overlooked. SEGF operates in this manner since the This strategy is particularly important for fund does not have a full-time professional smaller venture capital institutions, manager. Members of the advisory board because larger deals can be put together review business plans, visit entrepreneurs, through partnering and the burden of due and 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 investment performed on a prospective company instruments is drawn from SEGF. The concludes that the company has a good fund originally used a complicated proposal, but the venture capital institution subordinated debt instrument with puts is not confident that current company and calls. Portfolio companies had to incur management can achieve what is the expense of hiring legal expertise to proposed. Therefore, a second part of the interpret the instrument in order to make screening process determines if the needed an investment decision. As a result, some management expertise is available locally firms simply did not pursue the potential or can be attracted to the area. If the local investment. The complicated structure was economy provides infrastructure and due, in part, to state constitutional support services, entrepreneurial restrictions on the fund taking a pure development and small business growth equity position in the firm. However, the will be more successful. CRSF noted fund recently restructured the investment difficulty in finding people willing to instrument as a convertible debenture and relocate to rural Colorado to manage and has had more success in attracting new grow their portfolio companies. As a potential deals and meeting the needs of result, portfolio companies did not develop their existing portfolio companies. as anticipated. Alternatively, KHIC and Structuring venture capital deals can NEV brought entrepreneurs into the region also be difficult in markets where the and built deals around them. The provision entrepreneurs are unfamiliar with equity of venture capital alone may not be capital. An equity investment requires sufficient to build successful businesses giving up some ownership stake in the that can contribute to the overall economic business, at least in the short term. For development process. family-owned businesses, the owner’s goals of passing the business to the next Selecting Investment Instruments generation may be threatened by an equity Investment instruments used by a investment in contrast to an investment venture capital institution include pure instrument structured as debt with equity equity such as stock and quasi-equity features. instruments such as debt with warrants, debt with equity kickers, royalties, Involvement in Portfolio Company participation agreements, and convertible Management debt. Most institutions have a preferred The level of involvement with investment instrument, and the choice of portfolio company management is a instrument will depend, to some extent, on function of the expertise of the venture the source of funds and the institution’s capital institution’s staff. Many traditional preferred exit strategy. For example, venture capital funds require a seat on the SBICs traditionally used subordinated debt portfolio company’s board as a condition or debt with warrants to generate a stream of investment. The managing partners of current income that could be used to have technical expertise that they can cover interest costs on SBA leveraged contribute to the company’s board. This funds. board presence allows investors to follow management decisions and, if necessary, 19
  22. 22. intervene in the decision-making process. manufacturing firms that dominate small The nontraditional venture capital towns and rural areas, IPOs are less likely institutions visited are involved in the to be successful, particularly in the current management of their portfolio companies volatile market. While acquisition is a at different levels. Some institutions viable strategy in small market areas, this require a board seat and maintain active strategy may not work for institutions that involvement in company management. In have the dual objectives of competitive some 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 party company as a condition of investment. may provide positive financial returns to Other institutions, such as SEGF, do not the venture capital institution, but if the always take a seat on a company’s board plant relocates, economic development since oversight of investments is the impacts may be negative. For institutions responsibility of a volunteer board. with an interest in economic development, The level of involvement with an employee or owner buyout provides portfolio companies also varies over the liquidity to the venture capital institution life of the investment. If a company is and retains economic benefits in the local doing well, the venture capital institution area. However, unless the owner or is unlikely to intervene in management employees borrow funds to finance decisions. If the company encounters purchase of the business, payments are problems, the managing partners may usually structured to fit within the cash provide assistance themselves or through flow limitations of the business and are outside consultants, they may make an typically made over a relatively long additional investment to strengthen the period of time. As a result, the financial company, or they may be involved in return on the investment is likely to be replacing an existing company smaller for the venture capital institution. management team with a new team. The level of involvement depends on the Summary and Conclusions expertise and resources of the venture The establishment of a venture capital capital institution’s managers. institution is complicated, time- consuming, and expensive. It is even more Exiting the Deal difficult in small market areas than urban Exit strategies present important centers. Nonmetropolitan communities challenges to venture capital investors. In and rural areas have a relatively small a recent study of Canadian markets, survey number of firms that are familiar with and results show the importance of exit receptive to the concept of venture potential to venture capital investment investments. These areas often lack the decisions. According to the study, venture management expertise, support services, capitalists consider the prospects for a and infrastructure beneficial for profitable exit when deciding whether to entrepreneurial and small business invest and what the terms of investment development. Businesses have relatively will be.11 Most venture capital institutions few options for exiting deals with venture exit successful investments through an capitalists. The costs of managing a initial public offering (IPO) of stock, venture capital institution with a small acquisition by another firm, or employee market focus also can be high due to the or owner buyout. For traditional 20
  23. 23. geographic dispersion of portfolio their costs and can capture the external companies. benefits. The relatively unfavorable Despite the success of a number of environment for venture capital nontraditional venture capital institutions, investments in small market areas partly all institutions interviewed for this study explains why venture capital investments said that they would do things differently are 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 investments are located in nonmetropolitan would have been made differently had the communities and rural areas. In general, institution known the implications of their these nontraditional venture capital decisions. They would have benefited institutions can function in the limited from a formalized decision-making investment environment because (1) they process demonstrating the linkages have 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 process market rate of return in exchange for described here can be used as a guide to external or social benefits, or (3) they are creating nontraditional venture capital affiliated 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): The 1. 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, “Structure 2. 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 the 3. 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 a 4. 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