CAPCO Programs Offer Tax Credits to Attract Venture Capital for Small Business

The Journal of Multistate Taxation and Incentives discusses in-depth the importance of CAPCO programs and its success in economic development:

The “certified capital company” (CAPCO) program provides a framework for states to foster local entrepreneurship and lends itself to modifications in response to industry trends, thus giving states a new tool with which to address the priorities of the small-business sector and the states own economic development goals.

VELISLAVA GRUDKOVA is a Manager and MICHAEL L. BENTON is a Supervising Senior Consultant with the Strategic Relocation and Expansion Services practice (Mid-Atlantic region) of KPMG LLP, in the firms McLean, Virginia office. Both authors are actively involved with several professional economic development organizations. Ms. Grudkovas endeavors include the D.C. High-Tech Council, as a member of an incentives policy group; the International Economic Development Council, where she has had several speaking engagements; and the Maryland Industrial Developers Association (MIDAS). Mr. Bentons memberships include the International Economic Development Council and MIDAS. He also is an attorney and an active member of both the Maryland and District of Columbia Bar Associations. The authors thank Anna K. S. McKean, a Senior Manager with SRES, for her work in editing the article. Copyright © 2002 KPMG LLP, the U.S. member firm of KPMG International, a Swiss association. All rights reserved.

THE CERTIFIED CAPITAL COMPANY (CAPCO) PROGRAM is a state economic development tool designed to encourage the growth of local small businesses and the formation and support of a local venture capital infrastructure. Under a CAPCO program, insurance companies are encouraged to invest in certified capital companies; the state allows the insurance companies to claim tax credits for qualified investments in CAPCO funds. The tax credits, taken over time, generate large pools of private venture capital to be invested in the state. CAPCOs, typically venture capital groups with significant local knowledge and industry expertise, leverage the funds received from insurance companies to invest in qualified small businesses in the state.

Recognizing that small businesses are a significant driver of job creation in the economy, states create CAPCO programs to deal with the unique challenges small businesses face in raising capital. Unlike traditional government assistance programs, the CAPCO program relies primarily on the private sector to invest in the targeted industries or geographic areas. By providing access to capital for early-stage businesses, CAPCOs promote entrepreneurship and serve as a catalyst for small-business growth. While uniquely positioned to leverage private resources, CAPCOs are different from traditional venture capital firms and are best examined and evaluated as an economic development instrument. To compensate for the greater risks and internal rate of return compression associated with economic development mandates, the participation in returns to the CAPCO managers is greater than the participation ratio typically associated with a traditional venture capital structure. The anticipated effect of the CAPCO program is the creation of new jobs and an increase in state and local tax revenue, with minimal initial investment on the part of the state. A by-product is business expansion through follow-on investment and the development of a venture capital infrastructure.

Several states have established CAPCO programs. In 1983, Louisiana became the first state to adopt a CAPCO-type program to encourage venture capital funding of small businesses in the state.  Subsequently, Missouri, New York, Florida, Wisconsin, and, most recently, Colorado and Texas have added the CAPCO technique to their arsenals of economic development incentives.

Trends in Economic Development

Over the last 20 years, state economic development policies have undergone a fundamental shift. Traditionally economic development initiatives focused primarily on attracting large-scale manufacturing ventures. States and localities often engaged in a highly competitive bidding process for high-profile manufacturing projects, where direct project subsidies and tax abatements could significantly influence facility decisions. Typically, this process resulted in a sizeable front-end investment by the community. Notable examples include Alabamas $153 million package to attract a major automotive plant with its 1,500 jobs, at a cost of $161,000 per direct factory job, and Pennsylvanias $429 million package in support of a major shipbuilding project in South Philadelphia. While there is certainly a role for such assistance, it has been less effective in spurring sustained local growth for small and medium-size businesses.

As an alternative to direct subsidies, some states have attempted to spur investment activity by creating a business-friendly environment through the enactment of tax credit programs, reduced or eliminated taxes, and the introduction of direct business assistance initiatives. An example of that approach includes the property and sales tax exemptions for manufacturing-related property that are common in many states.

With the growth and promise of the technology and small-business sectors, states are shifting resources to attract high-growth service and technology-based industries. Not surprisingly, recent industry fluctuations have stressed the need for a diversified economy. Business retention has once again become a top economic development priority, with incentive programs expanded to reward growth by existing businesses. Economic development policy increasingly recognizes the value of creating long-term, quality jobs in a community, regardless of the source. Increased emphasis has also been placed on sustainable development programs that support economic viability over the long run.

Despite its vital role in economic development, the small-business community historically has not benefited from meaningful state incentive programs. Small businesses typically do not satisfy incentive program eligibility criteria, which usually require the business to meet a minimum investment or job-creation threshold. For those small businesses that may qualify for incentives, the transaction costs often negate any potential benefits. As an alternative, small-business growth can be targeted through initiatives designed to increase the availability of venture capital.

What Is Venture Capital?

The venture capital industry provides money for start-up, early-stage, or expansion-stage companies and small businesses with significant growth potential. Using investors money, venture capitalists create pools of capital (similar to mutual funds) that invest in promising companies in exchange for a desired return. Venture capital firms reduce their overall risk by creating a portfolio of investments in several companies. For this reason, the businesses receiving venture funding are called “portfolio companies.” The portfolio companies will vary in stage, industry, and geographic location. Venture capital is not a passive investment, however. In addition to financial assistance, venture funds provide ongoing technical assistance in the development and management of the portfolio companies. Creating a fund.

The first step in the venture capital process is the creation of the venture capital fund. To create a fund, venture capital firms seek to gather pools of capital from diverse sources. A venture fund typically is structured as a limited partnership, with a general partner and several limited partners. In contrast to the numerous responsibilities of the general partner, the limited partners usually just contribute capital to the fund. Typical limited partners include institutional investors, pension plans, banks, foundations, and wealthy individuals, with the number of limited partners dependent on the target size of the venture fund. Each limited partner has the right to receive disbursements in proportion to its capital contribution. After the venture firm raises sufficient capital for its fund, the venture fund is closed to additional investment.

Once the venture fund is formed, the general partner then coordinates the selection of the portfolio companies. The selection may depend on the objectives of the venture fund or the competencies of the fund managers. For example, a venture fund may select portfolio companies within a particular industry, based on the expertise of the venture fund partners. In addition, some venture funds may favor investing in companies during a particular stage of development. A fund may provide “seed capital” to a company that has yet to begin operations, or may invest in companies in the initial stages of product development. A developing business may seek expansion or “mezzanine” financing from venture funds to assist with market delivery or deployment. Later-stage financing may assist a mature company prior to its initial public offering (IPO). These stages of development are subjective criteria with no set investment thresholds. In practice, the stage and pace of growth may vary for portfolio companies within the same fund. Selecting from a pool of applicants, each venture fund invests in a limited number of portfolio companies, which then use the investments to fund the growth and development of their businesses (see Exhibit 1 to the print version of this article, Journal of Multistate Taxation and Incentives, June 2002, p. 15).

Managing the investments

Unlike bank and “angel” assistance, venture funding requires hands-on involvement from its general partners, and thus adds another layer of value. The venture fund general partner assumes liability and management responsibility over the portfolio companies selected. To cover the related costs, the general partner imposes a management fee on the funds limited partners. The typical fee ranges from 2% to 2.5%.  In return for accepting increased risk, the general partner in a venture capital fund receives shares of the investment in each portfolio company, referred to as “carried interest.” Through the management and technical expertise of the general partner, the venture capital fund attempts to increase the value of its investment.

The venture fund receives a return on its investment through a “liquidity event” such as an IPO, merger, or acquisition. The proceeds from a liquidity event can be reinvested or distributed. Investing in a venture fund is a long-term endeavor—the time from the funds initial investment to the eventual disbursement of proceeds may be as long as seven-to-ten years. Venture capital investment requires a liquidity event before the process can begin again. Because of this, the general partners dedicate considerable resources to the evaluation of portfolio companies.

Although venture capital funds may invest in portfolio companies in several industries, many funds specialize in certain industry sectors. To reduce their risk, venture capital firms often focus on geographic markets with a critical mass of potential recipients. Consequently, venture capital investment has often been concentrated in certain regions with industry clusters. For instance, venture capital funds focusing on technology are most prevalent in the San Francisco Bay Area.

The likelihood of obtaining venture capital funding rests on building relationships between prospective funding recipients and the venture firms. In general, venture capital firms employ local experts with knowledge of the regional market. Accordingly, a local presence in venture funds often is essential. Start-up businesses are discouraged from locating in areas outside of industry clusters because of their need for access to the venture capital market. Existing early-stage companies often reach a critical point in their development process where venture capital can promote continued growth. Without access to necessary financing, however, small businesses are more likely to relocate or stop growing. Thus, financing becomes critical for survival and sustained business growth. Greater availability of financing may facilitate such growth and economic development.

Relationship Between Venture Capital and Economic Development

The economic impact of 24 million small businesses on the U.S. economy underscores that small businesses are the backbone of that economy. Small businesses employ 69% percent of the countrys workers and create over 60% of the new jobs in the U.S. Moreover, small firms produce twice as many innovations per employee as their large-firm counterparts. In addition, small businesses offer increased opportunities for women and minorities.  Yet, despite the economic benefits that flow from the success of small businesses, they rarely have access to sufficient capital.

Thus, venture capital is essential to avoid stagnation of the small-business community. In return for assuming the risk of investment, general partners of venture funds typically serve on the board of the portfolio company and become involved in the compans day-to-day operations. General partners leverage their significant expertise and relationships to provide valuable management assistance to guide the development of their portfolio companies. Historically, venture capital has served a vital role in accelerating the growth process of various high-profile companies. Notable examples include such household names as Cisco Systems and Amazon.com. In Inc. magazines annual list of 500 fastest-growing companies, 25% began with an investment of less than $5,000. Most of these companies leverage the venture capital investment to build thriving businesses that contribute significantly to regional economic development. Throughout their expansion, portfolio companies create increasing employment opportunities, as well as tax revenues. With the current uncertainty in the U.S. economy, the availability of venture capital funding has become increasingly scarce and competitive.

Government acknowledges the relationship. Recognizing the important role of venture capital in economic development, many states have undertaken targeted development efforts to encourage such investment.  As a method of encouraging private-sector investment in a targeted activity, tax credits may be desirable because they do not require direct governmental investment to induce the desired result. Furthermore, unlike negotiated incentives, tax credits provide similarly situated taxpayers with comparable benefits. This transparency and predictability allow taxpayers to rely on the credits to reduce their costs.

One example of a successful investment tax credit is the federal low-income housing credit (LIHC).  Offering tax credits to low-income housing developers, the LIHC has grown to become the largest federal program for affordable housing. The LIHC has made steps towards alleviating the low-income housing shortage that prompted the inauguration of the credit in 1986.  One particularly attractive feature of the LIHC is the deferred impact on the U.S. Treasury, because of the ten-year period over which the credit is claimed. As a 90% credit taken at the rate of one-tenth per year, the federal LIHC is similar in cost and structure to the CAPCO program. The economic relationships between the developer and the manager are negotiated privately.

As evidence of the success of these programs, similar state tax credits have been adopted using the federal credits as a model. Several states have enacted income tax credits for taxpayers making direct investments in venture capital.  By encouraging investments in venture capital, the tax credit programs aim to increase the level of venture funding available to small businesses. A precondition of private-sector investment in venture capital is the existence of adequate venture funds or qualified individuals interested in fund organization. As noted above, venture funds typically invest in several portfolio companies. The formation of a venture fund requires a significant up-front expenditure that would not be made without a sufficient supply of eligible portfolio investments. Without a critical mass of potential portfolio companies to justify the formation of venture funds, investment in such funds may remain low. Programs that encourage the formation of venture funds attempt to break the vicious cycle.

The Role of CAPCOs in Economic Development

By encouraging the creation of CAPCOs, states directly address the barriers to venture capital investment. CAPCOs generally are required to invest in non-bank, small businesses located in the state, with limits on the businesss revenue and number of employees. Unlike other venture capital arrangements, the CAPCO program is structured so as to encourage in-state capital formation and foster local business growth. CAPCOs face multiple restrictions on their activities and are required to balance strictly market-based investment decisions with the equity and growth objectives set by states.

The insurance connection

For various legal and practical reasons, the benefits of investing in CAPCO programs have generally been restricted to insurance companies. As noted above, insurance companies are a significant source of investment funds and, in every state, are subject to premium tax (a levy imposed on the premiums insurers receive). Because the insurance companies typically pay premium taxes in lieu of income taxes, they generally do not benefit from income tax credits.  Thus, to encourage insurance companies to invest their considerable cash reserves in state-restricted venture capital funds, states include the premium tax credits as a key component of their CAPCO programs.

A premium tax credit is unique because of the consistent nature of premium taxes, which are less prone to year-to-year fluctuation than income tax credits. While predicting taxable income in future years can be difficult, insurance companies may easily estimate the future receipts on which their premium tax will be based. As a result, states can predict with increased accuracy the fiscal impact of a credit against premium tax. Because of the greater certainty of the premium tax credit, an insurance company is more likely to factor the value of the credit into its investment calculations. Because insurance companies generally are sophisticated, long-term investors in fixed-income instruments, the premium tax credit enhances the expected return and encourages participation in the CAPCO program. For these reasons, states may derive more predictable economic development benefits from a premium tax credit for investments in CAPCOs than from a credit claimed against income taxes. The premium tax credit for CAPCO investments attracts funding that otherwise would not have been invested in the newly formed venture funds.

Helping in-state, start-up small businesses.

CAPCOs differ from some other state venture fund programs in that capital is not allocated through a government agency, although it is specifically limited to investments in the state. The state does not direct any of the CAPCOs investment decisions but, instead, requires that they be based strictly on each managers investment judgment. The states active role in the process generally is limited to rule-setting and monitoring.

CAPCOs operate as a competitive, private-sector mechanism to channel capital from insurance companies to growing, early-stage companies in need of assistance. By relying on private-sector financing, the CAPCO program provides venture capital through several CAPCOs working independently. In an attempt to maximize profits, CAPCOs compete with one another to raise funds and support the most promising companies in need of financial assistance. The process is competitive, and potential recipients apply for funding through one of several CAPCOs that have been established in a state. By providing funds to only the most promising applicants, the CAPCO program validates the return potential of the portfolio companies. This facilitates the ability of portfolio companies to leverage their funds to obtain subsequent rounds of financing. Once a CAPCO investment is made, the information necessary to obtain supplemental venture capital is more readily available and follow-on funding is likely.

The benefits are varied. Ultimately, the economic development effects of a successful CAPCO program are threefold:
1) CAPCO increases direct venture investment in a region;
2) CAPCO investments have a multiplier effect on additional venture capital investments; and
3) the prospects for growth of the portfolio companies are enhanced.
The state may profit directly from the CAPCO program as well. In Florida and Colorado, for example, the state can receive a percentage of the CAPCOs profits.  Most significantly, the state benefits through new jobs and higher tax revenue.

Thus, the overriding objective of the CAPCO program is economic development. This objective affects how CAPCOs are evaluated and how the programs overall success is measured by the state. The ultimate purpose of a CAPCO investment is not simply to generate profits for the state, although some states do take advantage of this aspect. By instituting a CAPCO program, states seek benefits much broader than venture capital profit. As those familiar with economic development know, these broader benefits are both more meaningful for a states long-term economic well-being and extremely difficult to quantify or attribute to one specific program.

CAPCOs are not merely a source of cash infusions for early-stage companies. They allow states to support business growth in a hands-off manner, by bringing management skills and expertise to each CAPCO-supported company, and by exercising investment and administrative oversight. Thus, while the state does have a significant financial stake in the process through the premium tax credit, the CAPCO program allows the state to avoid day-to-day management and oversight resources, and to support high-risk investment activities while being protected from the traditional downsides associated with venture capital investment.

CAPCOs act as funders of last resort in that they typically support companies that would not be immediate funding targets for traditional venture capital firms. CAPCOs face various restrictions and requirements with respect to eligible portfolio companies, in part to ensure that the CAPCO resources are spread equitably among as many potentially viable recipients as possible and that the CAPCO investment efforts reach areas targeted for economic development by the state. Understandably, therefore, the risk-return profile for a CAPCO is different from that for a traditional venture capital firm.

All CAPCO programs seek to directly benefit the enacting state. Much like other economic development programs, CAPCO programs require that funding recipients have a significant percentage of their employees working in the state.  To further implement their economic development mandate, states may require that portfolio companies be members of a certain industry or be located in a particular region. Texas, for example, requires that at least 50% of the CAPCO investment be allocated to early-stage companies and at least 30% be placed with companies in certain geographic locations, termed “strategic investment areas.”  Through these requirements, states ensure that the economic development benefits are targeted to priority businesses. (See Exhibit 2 to the print version of this article, Journal of Multistate Taxation and Incentives, June 2002, p. 17.)

CAPCO Structure and Return Profile

A CAPCO is generally made up of a venture capital firm as the general partner or controlling shareholder, with insurance companies as limited partners or minority shareholders. The insurance companies usually are limited with regard to their percentage ownership interest in the CAPCO, and they may not be a general partner, manager, or affiliate of, or otherwise control the investment decisions of, the CAPCO.

Some general requirements

An entity seeking CAPCO status typically must file an application with the administrating agency. Barriers to entry in the CAPCO program include the experience requirements, the high costs associated with participation, and the complex structure of a CAPCO. To participate, a potential CAPCO must demonstrate that it possesses the necessary resources to effectively provide venture capital assistance. The CAPCO must have significant experience with venture capital investments and have access to sufficient financial resources.

To serve its portfolio companies, the CAPCO must maintain a local office in the state.  Although, as noted above, CAPCOs receive a small annual management fee, typically the fee is allocated to expenditures for salaries and overhead related to establishing an office staffed with quality investment professionals. For example, the new CAPCO must acquire office space, purchase office furniture and equipment, and hire investment professionals and administrative staff. These costs often exceed the income collected as management fees.

In instituting a CAPCO program, the state does not bear any risk for the quality of the subsequent investment activity.  CAPCOs are required to include a disclaimer in their investment prospectuses explaining that CAPCO investments are not government obligations.  The success of the CAPCO program depends on the attractiveness of the investments and the stability of the participating CAPCOs.

To provide for adequate capitalization of CAPCO investments, states have established requirements to limit distributions. In general, disbursements of gains are permitted only to the extent that sufficient capital investments have been made by the fund over and above the level of authorized tax credits.  Disbursements of capital may not otherwise be made until at least 100% of the CAPCOs certified capital (capital on which tax credits may be claimed) has been invested in qualified portfolio companies.  Once a CAPCO has fulfilled its investment requirements, the CAPCO may voluntarily decertify and distribute funds to its owners without triggering credit recapture provisions.

To encourage participation by the regulated insurance companies, the structure of a CAPCO works to minimize the limited partners exposure to risk. Of the funds invested in a CAPCO, a certain portion is available for financing of qualified portfolio companies and a portion is invested in low-risk securities, such as U.S. Treasury notes. In addition, rather than offering only equity investments that may represent an inappropriate level of risk for regulated insurance companies, CAPCOs often agree to provide a note with a fixed rate of return to the limited partners, in addition to an equity component. Also, a CAPCO frequently is structured to offer credit enhancement insurance to enable it to repay the insurance companies if it fails to qualify for the tax credit benefit. By providing an insured rate of return, CAPCOs demonstrate the security of the investment to both the insurance companies and their regulators.

CAPCOs typically do not profit from the program until their investments or portfolio companies mature and undergo a liquidity event. Proceeds from a liquidity event in the CAPCOs early investments generally are put back into the venture fund and recycled to fulfill the 100%-investment requirement. Therefore, to reap any profits or benefits from the program, CAPCOs must make prudent investments within well-defined limitations set forth by state regulations, seeking to ensure the success of the program through a liquidity event. Only the proceeds of the portfolio company investments are reinvested in additional portfolio companies. As noted above, the typical time horizon for distributions is three-to-seven years from program inception.

Practice Note: The Other CAPCO Benefit—Who Receives Funding?

While the tax credits offered under a CAPCO program generally go to insurance companies that invest in the CAPCO, the range of businesses that can benefit from the programs venture capital financing is broader. Colorados CAPCO program statutes, for example, contain a basic definition of the typical business that can qualify as a portfolio company recipient of funds. Under Colo. Rev. Stat. § 10-3.5-103(11), a “qualified business” is “a business that meets all of the following conditions as of the time of a certified capital companys first investment in the business:
(a) It is headquartered in this state, and its principal business operations are located in this state;
(b) It is a small business concern as described in the small business size regulations of the United States Small Business Administration, 13 CFR 121.201; and
(c) It is not a business predominantly engaged in professional services provided by accountants or lawyers.”

Other states may set their own standards for what is a “small business,” and may target other industries for specific inclusion or exclusion as a qualifying business.

New Yorks CAPCO program provides some typical investment milestones

Within two years of the CAPCOs certification, it is required to invest at least 25% of its certified capital in qualified companies. The investment requirement increases to 40% within three years and 50% within four years from certification. The CAPCO must invest 100% of its certified capital before any profits can be realized.  By establishing phased-in investment thresholds, the CAPCO program balances the need for expedited investments of venture capital with the realities of the portfolio selection process. Reinvestment of the proceeds from qualified investments may count towards the threshold investment requirements, effectively rewarding CAPCOs for realizing early profits.

Additional safeguards exist to minimize the risk to the investor insurance companies and maximize the economic development benefits. CAPCOs must abide by a diversification requirement, which generally limits investments in any one portfolio company to no more than 15% of the total certified capital under management.  Furthermore, CAPCOs often obtain reinsurance by hiring an independent insurance company to guarantee a certain return to investors.

State oversight

To further reduce the risk of participation, each state provides oversight of its CAPCO program. In Florida, for example, the Department of Banking and Finance, along with the Office of Tourism, Trade, and Economic Development, are charged with administering the CAPCO program. Shortly after the programs inception there, comprehensive regulations were established to govern the application and compliance process.  In addition to undergoing a strict financial review, the applicants are required to have at least one in-state, full-time manager with venture capital experience.  Florida CAPCOs are also required to comply with various disbursement standards.

The state conducts an annual review of each CAPCO to determine whether it has adhered to the program requirements.  To offset a portion of the administrative costs, Florida charges CAPCOs for the costs of the annual reviews, and also levies an initial application fee and annual renewal certification fees.  Failure to comply with the program standards may result in a forfeiture of future premium tax credits as well as recapture of all credits previously claimed.  These state oversight measures have resulted in compliance by each of Floridas approved CAPCOs.  These protections also reduce the risks for the insurance companies participating in the CAPCO program.

Program Duration

The duration of a typical CAPCO fund varies based on the time needed for completion of the certification, portfolio company selection, and disbursement processes. On satisfying the investment thresholds, the CAPCOs proceeds from subsequent liquidity events may be either reinvested in portfolio companies or distributed to its investors.

Other constraints relate to the annual and total limits on the tax credits a state may allocate to its CAPCO program.  The level of interest expressed by the venture capital and entrepreneurial community, however, has outpaced the allocation of CAPCO credits. To meet the demand, states have renewed their CAPCO programs through additional allocations of CAPCO credits. For instance, Missouris CAPCO program went into effect in 1997 with an initial allocation of $50 million in tax credits. In 1998, the state expanded the program with another $50 million in allocated credits. A third round of Missouri CAPCO credits was authorized in 2000.  Other states have renewed their programs as well.

To minimize the fiscal impact of premium tax credits, states generally require CAPCO credits to be taken over several years. Typically, as noted briefly above, states allow CAPCO investors to claim their premium tax credits ratably over ten years, beginning in the year of the investment.  Also, a one-to-two-year lag exists between the insurers collection of premiums and their payment of tax on those premiums. Based on the time-value of money, the value of each dollar of tax credit in 12 years may be approximately 55% to 65% of a dollar of credit claimed currently. The delayed fiscal impact of the CAPCO program allows states to defer the programs expenses, with the goal that increased tax revenues through added jobs and business expansion as a result of the CAPCO program may offset its costs.

CAPCOs Focus on Small Business

As noted above, small business is the primary driver of our nations economy. With that in mind, every state CAPCO program has adopted restrictions on portfolio company size. By focusing on small companies, CAPCO programs contribute to a favorable business environment for such enterprises.

The federal Small Business Administration (SBA) has adopted size standards for qualified businesses under its programs.  Rather than devise their own, potentially cumbersome requirements, some states, such as Colorado and Florida, have explicitly incorporated the SBA standards in their CAPCO programs.  Some other states set their own guidelines. Wisconsin, for example, restricts CAPCO investments to companies with no more than 100 employees, up to $2 million in net income after federal taxes, and a net worth of no more than $5 million.  Portfolio companies also must be independently owned and operated.  Regardless of the particular requirements, all CAPCO programs generally are geared towards investments in small businesses only. The specific type and range of investments may vary by state.

Industries included/excluded

To direct CAPCO funding to small businesses in need, states have enacted certain eligibility restrictions. For example, portfolio companies typically may not be predominantly engaged in professional services such as accounting, law, or medicine.  Also, real estate development firms may not receive CAPCO funding in many states, and CAPCOs may not invest in retail establishments.  In addition to the above exclusions, Florida also explicitly prohibits CAPCO funding for businesses engaged in oil and gas exploration.  Generally, the excluded industries already are motivated to serve customers in local markets. Because market-driven expansions likely will occur there without incentives, the CAPCO programs goal is to focus on industries for which venture capital can positively affect retention and growth. The CAPCO program seeks to foster the transformation of local businesses from small to regional and, ultimately, national in scope.

States also may enact eligibility requirements to target CAPCO funding to key industries. For instance, Floridas CAPCO program is restricted to companies engaged in manufacturing, processing, or assembling products; conducting research and development; or providing services not specifically excluded.  Florida also requires CAPCOs to invest 25% of their funds in “early stage technology businesses,” which are businesses that are less than two years old and have less than $3 million in annual revenues, and that are involved in “activities related to developing initial product or service offerings, such as prototype development or the establishment of initial production or service processes.”  Similarly, Colorados new program calls for at least 25% of CAPCO investments to be dedicated to qualified businesses in certain rural areas.  With these types of requirements, states can direct additional resources towards specific economic development priorities. Targeted regions or industries may benefit from receiving a relatively greater share of venture capital funding.

The CAPCO investments have a leverage effect on venture capital for portfolio companies. CAPCO funding often is a last resort for early-stage companies, and CAPCO programs may require that a portfolio company demonstrate its inability to secure financing from traditional sources.  Thus, any growth by CAPCO portfolio companies likely would not have otherwise occurred. Also, a portfolio companys access to supplemental capital may improve because its selection into the CAPCO program provides an added level of comfort for sources of conventional financing. In essence, CAPCO compounds the quantity of venture capital that may be available in a given area. By doing so, CAPCO helps a state produce a critical mass of venture capital funding for assisting other early-stage companies.

The Future of CAPCO

New York originally enacted its CAPCO program with the purpose of encouraging “the investment of private financial resources into the States venture capital markets, emphasizing viable smaller business enterprises which traditionally have had difficulty in attracting institutional venture capital.”  Since it initiated the program with authorized tax credits for up to $100 million in certified capital, New York has approved two subsequent funding rounds of $30 million and $150 million in additional authorized certified capital.  Missouri (noted above) and Louisiana have conducted multiple rounds of CAPCO certifications as well. In its less-than-ten-years of existence and active use, the CAPCO program has gained momentum across the country. Colorado and Texas enacted their CAPCO legislation in 2001, and similar legislation is under consideration in several other states for the upcoming year.

Now more than ever, small businesses need venture capital assistance to continue their growth. In general, venture capital transactions have undergone a precipitous slowdown and, with the decline in IPOs attributable to current market conditions, the liquidity events necessary for the venture capital cycle to renew itself have been delayed. In the absence of an influx of capital that normally would be available through an IPO, later-stage companies need supplemental infusions of venture capital. Thus, venture funding has been diverted from early-stage companies to sustain the continued growth of pre-IPO enterprises. In negotiating the remaining deals, venture capital firms have curtailed their outreach efforts and retreated geographically to the industry hotbeds. Just as a community experiences exponential growth with an increase in venture capital, the effect of the declining availability of venture capital is compounded as well. The CAPCO program may provide a mechanism to stem that outward flow.

The CAPCO program is an economic development tool that enables states to encourage private-sector investment activity in target industries and geographic areas. In light of the role venture capital plays in the formation of developing industries and businesses, CAPCO programs may be used as a mechanism to cultivate small businesses in high-growth industries. The CAPCO program lends itself to modifications in response to industry trends, and it provides a framework for states to foster local entrepreneurship. Thus, states have a new tool with which to address the priorities of the small-business sector and the states economic development goals.

 

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