A Capital Idea: The New Texas CAPCO Program

Paul Ballard and Byron Beasley discuss in-depth the Texas CAPCO Program and its benefits in Texas Business Review:

As the Texas economy continues its expansion from the 2001 recession, the need for seed and growth capital for young companies is intense. Unfortunately, venture capital funds and angel investors are often the only sources of funds for entrepreneurs. In the aftermath of the “dot-com” boom and bust, venture funds are much more risk-averse than they were a decade ago. The result is an enormous need for capital among startup companies in Texas that otherwise have few funding options.

A new funding program addresses this need, authorized by the Texas Legislature in 2001 and implemented in 2005. The Texas Certified Capital Company Program provides alternative sources of venture capital to Texas entrepreneurs. A Certified Capital Company (CAPCO) is a private government-sponsored venture capital company formed to stimulate job creation and to increase the availability of growth capital for small businesses located within a state or regional area.

Funds are provided by participating insurance companies who, in turn, receive premium tax credits equal to 100 percent of the amount of their investment, interest income, and in some cases an opportunity to participate in the profits of a CAPCO.

During 2005, ten new Texas CAPCOs raised $200 million of venture capital through certified capital notes or “qualified debt instruments” to insurance companies.

In Texas, the state Comptroller of Public Accounts implements and administers the CAPCO program through the Texas Treasury Safekeeping Trust Company.

CAPCOs Across the United States

To date, nine states and the District of Columbia have collectively authorized more than $2 billion in CAPCO funding legislation. When a state’s legislature passes a CAPCO Act, it also sets forth the operating guidelines for the program. A typical CAPCO Act may be summarized as follows:

1. Premium tax credits are defined and authorized.

2. A single insurance company may claim and invest a maximum of 15 percent of the total tax credit allocation amount.

3. Each CAPCO must have an initial capitalization of $500,000.

4. Each CAPCO must have two principals or employees with investment management experience in the venture capital industry.

5. CAPCO Certification requirements are established:

* Investments must be placed in “qualified businesses,” typically headquartered or having a principal office in the relevant state.

* Timing: 30 percent of certified capital must be placed in qualified businesses within 3 years; 50 percent within 5 years.

* Diversification of investments, with no more than 15 percent of certified capital in any single portfolio company.

* Compliance with various regulations and reporting requirements.

Most enabling statutes are substantially similar but show various provisions for the vesting of tax credits.

In Texas, only insurers who are required to pay a premium tax on insurance policies issued in Texas are eligible to invest in CAPCO-issued debt instruments. Insurers then use applicable tax credits to reduce future tax obligations on revenue from insurance premiums. When investing insurance companies file annual premium tax returns, they are allowed a dollar-for-dollar reduction of taxes on policy premiums. Texas collects almost $1 billion in premium taxes each year.

A unique feature of Texas’ CAPCO statute is the deferral of these tax credits. Although they were issued in 2005, the credits cannot be utilized until the filing of 2008 premium tax returns in March 2009. Also, the tax credits may not all be used in a single year. The law requires the credits to be taken at an annual rate that is no greater than 25 percent of the initial certified capital invested.

Competition & Safeguards for Funds

In Texas and elsewhere, CAPCOs must compete for available funds from a limited pool of insurance company investors. Investments in CAPCOs are facilitated by debt instruments in the form of notes or bonds that, in turn, are repaid via the tax credits earned by the CAPCOs. The insurance companies evaluate the offerings of the CAPCOs by comparing several factors including:

* the management team’s experience and record of success

* expected rates of return

* risk of decertification as CAPCO entity

Decertification insurance is a unique feature of almost all CAPCO debt instruments (essentially a performance bond), in order to guarantee that the investing insurance companies will receive all tax credits they are expecting as repayment under the terms of the CAPCO note, in the event that the CAPCO fails to perform or is decertified for violating the program rules.

CAPCOs market their notes/bonds by either directly contacting an insurance company, or by hiring a broker to make the initial sales pitch on their behalf. The document of approach is a sophisticated sales brochure commonly known as a private placement memorandum (PPM).

The PPM typically includes sections outlining the rate and repayment terms of the note, an executive summary of the CAPCO program, background information on the CAPCO’s management team, the rules of the CAPCO program, a business plan, and information about its decertification insurance.

A controlling document, the decertification policy often requires the CAPCO to set aside (generally with a trustee) a portion of the money they received from their investors. This restricted cash is earmarked to pay interest on the notes. In some cases, the trustee has a vote on, or a veto right over, a CAPCO’S investment decisions. They might also have the right to take control of the CAPCO if it is at risk of being decertified. The decertification policy allows the CAPCO to obtain a high credit rating (Aaa, Aa or A) from recognized debt rating agencies on the note/bond it issues, which provides a powerful tool to entice a conservative, risk-averse insurance company to make an investment in the CAPCO’s venture fund.

Maintaining Certification Is Vital

In order to remain certified, all CAPCOs file a prescribed annual report with the Comptroller by January 31 of each year with specific information about certain aspects of the firm’s activity during the previous year, including how the CAPCO distributed and invested its funds. There are several restrictions and limitations on CAPCO expenditures, and violations can result in assessment of penalties or, in severe cases, decertification of the CAPCO.

Regulations restrict monies spent each year for management fees, debt repayment, professional fees and distributions to the CAPCO’s partners or managers. For example:

* A CAPCO cannot repay the principal on its notes at a rate faster than five years.

* CAPCO management fees may not exceed 2.5 percent of committed capital annually.

* Distributions of certified capital or profits earned on investments are restricted until the CAPCO has invested an amount equal to 100 percent of its original capital allocation (unless a partner’s personal tax liability is increased in any year as a result of the CAPCO generating undistributed profits, in which case, the amount of the tax increase may be distributed to the partner).

Investments in qualified businesses must be reported along with certain key employment metrics of particular interest to the state. CAPCOs are required to provide details about the dollar amount of investments in their portfolio companies. They must report the North American Industry Classification System (NAICS) number of the businesses and employment levels at the time of investment and at the end of the year. Very specific employment data must be disclosed.

The data includes their portfolio businesses’ employee head counts, average wages, and the number of jobs created or retained as a result of the investment. The CAPCO must also file a financial report audited by a Texas licensed certified public accountant.

Once the CAPCO has complied with its annual reporting requirements, the Comptroller’s office conducts a thorough review of the information to verify its accuracy and confirm whether the CAPCO is in compliance with the statute and regulations. The annual review may include site visits to portfolio companies and an examination of accounting records and state and federal employment reports filed by the CAPCO’s portfolio companies.

In turn, the Comptroller reports all CAPCO investment and employment information to the Governor, Lt. Governor, and the Speaker of the House of Representatives by December 15 of each even-numbered year.

CAPCO Investments

Unlike typical venture capital funds, the rules governing the types of businesses and the structures of CAPCO investments are targeted and restrictive. The CAPCO legislation was designed to support strategically located and early-stage businesses, businesses that have at least 80 percent of their employees (either head count or payroll amount) located in Texas, and entrepreneurs who are developing new products or services and are in need of seed or expansion capital.

If investments fall to meet prescribed tests, they may be disallowed as qualified CAPCO investments. To safeguard against having specific investments disqualfied because of company status, CAPCOs may request the Comptroller to determine a business as pre-qualified before investments are placed.

In June 2005, the Comptroller began receiving requests for qualified business determinations. By the end of January 2006, 28 of 33 proposed investments had been pre-qualified. The qualified investments ranged in size from as little as $10,000 to just over $3.5 million. The targeted companies represent both technical and basic industries and are located throughout Texas. Prequalification activity for all the CAPCOs from late June 2005 through January 2006 is shown on the previous page in Figure 1.

Deploying Investments

Once the CAPCO managers have access to investor cash, they must start a fairly aggressive effort to deploy the money by investing in qualified Texas businesses. By statute, the CAPCO must invest 30 percent of its certified capital within three years of funding and 50 percent by the end of the fifth year. It must invest 50 percent of its capital in operations defined as early-stage businesses and 30 percent into businesses with principal business operations in strategic investment areas.

Early-stage businesses are defined under the rules as those that meet at least one of three criteria. Revenues of the early-stage business must be under $2 million during the previous fiscal year or, the business must not be more than two years old or, the business must be involved in the development of a new product or service.

Strategic investments have their principal business operations located in an area of the state that is classified as a strategic investment area (SIA). The State Comptroller makes an annual determination of what constitutes an SIA, based on unemployment and per-capita income and also including locations identified as federal urban empowerment zones. The SIA designation is a state economic development tool that permits companies located in these areas to take credits against state franchise taxes for research activities, job creation, and investment in machinery and equipment.

For the calendar year 2006, State Comptroller Carol Keeton Strayhorn has determined that of the state’s 254 counties, 216 fall wholly or partially in strategic investment areas.

What Constitutes a Qualified Business?

A qualified business is one that, at the time of a CAPCO’s first investment in the business:

* Is headquartered in Texas or intends to locate in the state within 90 days of a CAPCO’s investment.

* Has no more than 100 employees and pays at least 80 percent of its payroll to employees residing in Texas, and is primarily engaged in

–Manufacturing, processing, or assembling products

–Conducting research & development

–Providing Services

* Is not primarily engaged in any of the following:

–Retail sales

–Real estate development

–Business of insurance, banking, or lending

–Professional services

Insurance Companies Invest Readily

Texas insurers show robust interest in the new CAPCO program. A total of 110 eligible insurance companies submitted subscriptions (requests for allocation) for a share of the $200 million in available tax credits. The total amount of credit requested by insurance company investors was almost $1.8 billion, or nine times the total of tax credits available through the program.

Tax credits were allocated on a pro rata basis to the requesting insurance company investors, and each insurance company was required to designate a CAPCO in which they would invest. Once notified of the amount of their allotted tax credits, the investing insurance companies released a total of $200 million in cash to the ten CAPCOs. Seven CAPCOs raised funds of $23.4 million, one received $22.5 million, one raised $8.6 million and the smallest CAPCO received just under $5 million.

Conclusion

The need for accessible growth capital in Texas is undeniable. There are positive signs that the Texas’ CAPCO program partially addresses this pressing need: the most compelling indicator is that in the first few months of the program, the Comptroller was requested to qualify over $33 million for investments of new venture capital in Texas small businesses.

It will be several years before the full impact of the CAPCO program on the Texas economy is known. However, it is encouraging that at this early stage, participation among insurance company investors has been deep and wide. Additionally, several venture capital companies either have returned to the state or established new operations here, with the hope that VC activity in general will pick up across the state. Concurrently, demand from young businesses for the growth capital exceeds the supply, which means that CAPCO investment managers have a plethora of of investment options from which to choose.

 

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