Bringing Venture Capital to Minnesota, but not with CAPCO

We need more venture capital in Minnesota. But, a proposal at the legislature this year doesn't cut it. Here are some fresh ideas...

By John Alexander

In my previous opinion piece, I presented the poor experiences other states have had with CAPCOs, their fundamental and structural flaws, and suggested that there were better alternatives to the CAPCO legislation currently making its way through the Minnesota House and Senate. Here you will see several better alternatives to CAPCO.

First of all, the premise behind this concept is that attracting new Venture Capital investment to Minnesota is a good idea. I agree and here’s why:

-- Venture capital finances high-potential entrepreneurs, innovative technologies, and high-growth small businesses that create jobs and wealth that benefit society;

-- Companies financed by venture capital are more likely to be involved in disruptive innovation that creates new markets and competitive advantage; companies financed by venture capital are more likely to scale into large enterprises that anchor regional economies (e.g.,Starbucks, Apple, FedEx, Amgen, Google), employ and develop people with skill sets which create sustainable and competitive advantage;

-- VCs supply managerial expertise that is often deficient in start-ups, increasing the success-ratio of entrepreneurs.

-- Venture capital fills a vital gap between funding provided by friends, family and angel capital at the earliest stage, and public equity and commercial lending at more mature stages of a company development.

But what we need to accomplish is more than just getting VCs to invest here to fill a funding gap. Any program should:

-- Bring experienced and talented investors into the state to provide expertise as well as capital (sometimes called smart money) which benefits the companies in which they invest;

-- Increase the leverage of any state investment with a majority of private capital and avoid gifts or grants;

-- Assure that any process or incentive using state funds should be competitive to get the
most from state resources;

-- Assure that any incentive not change the nature of venture investing that makes it successful or fundamentally changing the VC investment process jeopardizing what we are hoping to attract;

-- Not put the state in a position to pick winners and losers among companies or
industries, leaving this responsibility to professional VCs who succeed by picking winners;

-- Result in sustainable, high-wage jobs in Minnesota.

There are 2 very different approaches which have the potential to create real value, satisfy our criteria and achieve our objectives. Both of these are superior to CAPCO in that they more effectively leverage state resources and emphasize the use of VC expertise to successfully grow entrepreneurs in Minnesota.

The first is a Venture Capital Investor Tax Credit (VCITC): a tax credit similar to the Angel Investor Tax Credit (AITC) with the credit flowing through to the investors in venture funds (the Limited Partners or LPs) for those investments made in qualified Minnesota companies.

In the second, the state of Minnesota would make Investments in Venture Funds directly or through a Fund of Funds.

Here, the state of Minnesota invests a very small (financially prudent) portion of state assets in venture funds with successful track records and with a preference towards high-quality investments in Minnesota companies.

Like the AITC, the VCITC would leverage taxpayer dollars to stimulate investment in local companies. This would be at a later stage in the company’s life than the AITC and like the AITC the credit would pass through to the LP investor. The credit needs to be a large enough percent of the investment to induce the results we seek but not so large as to fundamentally change investor behavior – I like 25%.

So for example, when any VC firm invests a minimum amount (say $5M) in a qualified Minnesota, it’s LPs would get a maximum credit of ¼ the investment back in the form of a tax credit. As a result and like the AITC, LPs world-wide are encouraged to invest in VCs which invest in Minnesota companies. The result is increased attraction to invest in Minnesota companies over companies with comparable reward/risk in other geographies.

Since, these LPs are typically insurance companies, pension funds or very wealthy individuals, I would test this with LPs directly to determine whether this credit could be spread over a 2 or 3 year period beginning a few years out. All the other AITC-like restrictions requiring the receiving company to stay in the state would apply.

The VCITC avoids many flaws in CAPCO:

-- No winning VC firms are chosen up front locking up credits well before any investment is made.

-- There no mandates to invest by a specific date and penalties for missing such dates [which promote bad investment decisions],

-- There should be no gaming by creating securities to churn the allocation as is the case with CAPCO because of how it is designed.

-- VCITC is simpler and cleaner.

In the case of a direct investment in a VC fund, the state acts just like a typical limited partner [LP] investor in a venture fund. VC funds serve the financial interests of their investors. Minnesota can get excellent performance from VC funds by structuring its interests as does any other LP investor: align its interests for returns with the strength of VCs.

Choosing a well-qualified and successful VC company is much of the battle. When a VCFund makes money, the LPs get 80% of the return on the funds investments after all of the investors capital is returned. A portion of the states pension or other capital could be used to achieve these objectives but with the overriding criteria being that these funds should be invested with a successful VC of national reputation. The process for selecting a VC must be competitive and based upon their performance, vetted by thorough due
diligence of the candidates and should prioritize financial returns on the state’s assets.

A variation on the 2nd program is the InvestMaryland funding model. Rather than use a small percentage of state pension money, the state of Minnesota would directly sell tax credits to insurance companies at a discount of 20% to 30%. The sales provide the funds for the investments. Several years out beyond the current budget period, say four years in the future, the insurance companies could take those tax credits against tax payments due the state, effectively shifting a percentage of future tax revenue forward. The state then allocates this money to venture funds as stated above.

Each of these approaches can have the desired effect with less risk than CAPCO and deserve thoughtful consideration before CAPCO gets voted upon in the legislature.

John Alexander is President of Business Development Advisors, Founder and Chair ofthe Twin Cities Angels, and business author of the Angel Investment Tax Credit.Email him at: John@BusDevAdvisors.com

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