By John Alexander
Minnesota is considering duplicating the mistakes made by other states with the $100M CAPCO bill.
CAPCO (which stands for “Certified Capital Companies”) is intended to bring new venture capital money into Minnesota. While I applaud and support the conceptual effort, this bill (HF 1823) is ripe with problems and would duplicate the poor results and waste experienced by other states.
According to the January 2012 report from the Georgia Public Policy Institute in consideration of CAPCO in Georgia, “… nine states currently have CAPCO programs, (but) the scheme has been rejected by at least a dozen other states in all parts of the country …. (Other) states with CAPCOs, such as Colorado, Florida and most recently Wisconsin, have changed course with bipartisan support to limit or eliminate the programs ... Many of the model’s toughest critics are from states that have experimented with it.”
Here are my main issues with CAPCO.
-- The tax credits are awarded to the CAPCO funds on a first-come, first-served basis. There is no merit-based evaluation. The best and the least get the same amount with a pro rata allocation to any applicant meeting the minimum requirements by the initial deadline.
-- There can be as few as one CAPCO awarded the entire $100M potentially concentrating Minnesota’s risk.
-- The value to insurance company investors in a CAPCO is based upon creating complex investment instruments securities and has nothing to do with the CAPCO’s ability to make good investments in high-growth, job-creating businesses.
-- The CAPCO model is not attractive to real/successful venture capital firms, which do not raise capital by selling tax credits to insurance companies, or accept penalties for not investing fast enough. Fast investing is rarely good investing.
-- The tax credit is for 85% of the investment! The investor takes only 15% of the risk – a further disincentive for wise investing.
-- Minnesota stands to only receive 10% of the profits with no return of seed capital. This is in stark contrast standard venture capital terms, which would return 80% of the profits after returning 100% of the initial capital.
It is not hard to understand why legislators are attracted to the aggressive marketing from CAPCO proponents: they tout job creation and helping small business.
Unfortunately, CAPCO is an example of “if it sounds too good to be true, it probably is.”
Dr. Julia Sass Rubin of Rutgers University testified to congress in 2009 about the poor experience of some of the 9 states which passed versions of CAPCO:
Louisiana, where the CAPCO program originated, commissioned a study conducted by its Department of Economic Development and a leading CPA firm. This study found that the CAPCO program “is expensive and inefficient to the State” and that “the greatest and most immediate beneficiaries of the CAPCO program are the CAPCO companies and their owners.” Louisiana Senate President John Hainkel Jr., who helped create the original 1983 CAPCO, legislation said: ‘It hadn't really helped us worth a damn, quite frankly."
CAPCO proponents say they boost a venture capital ecosystem, enabling the development of venture capital funds that no longer need government subsidies. This clearly hasn’t happened in Louisiana, where after more than $600 million of CAPCO subsidies, the average annual rate of venture capital investments over the past three years is less than $18 million, according to Rubin.
Additionally, Missouri’s $140 million CAPCO (began 1996) was panned in a 2004 report by Claire McCaskill, a current U.S. Senator and former Missouri State Auditor, as an “inefficient and ineffective tax credit program.” The report projected that the program would create only 293 jobs in 15 years and generate only $23.6 million in state revenue, a loss of more than $116 million to taxpayers over the life of the program.
CAPCO proponents say the incremental tax revenues from the companies in which they invest will more than cover the state’s lost revenues from committed tax credits. They have hired university economists to write economic impact reports that assume unaudited CAPCO job counts are not only accurate, but reflect jobs that would not exist but for the existence of the CAPCO program.
In fact, many CAPCO investments are loans to profitable companies, or co-investments alongside real venture capital funds that deserve more credit than the CAPCOs for leading the investment round.
Colorado passed CAPCO in 2001, allocating a total of $200 million. Legislators were so displeased that they withheld the second round of tax credits two years later. A legislative audit in Colorado noted that "CAPCO programs are a most inefficient means for the state to raise venture capital" and questioned whether any jobs created were attributable solely to the CAPCO program. The state’s treasurer said, “Colorado went down the wrong path when they adopted the CAPCO program. This is a textbook case on what not to do with economic development.”
Colorado’s state treasurer advocated a different model, where the state would sell the tax credits directly to insurance companies at a much lower financing cost, yielding more capital for investments in small businesses. Nearly a decade later, Maryland is doing this – allocating deferred insurance premium tax credits to the Maryland Venture Capital Authority, using an auction system to sell the tax credits, and then pledging the proceeds to long-term investments in venture capital funds on standard limited partner terms.
Plus, Texasallocated $400,000,000 to two CAPCO programs starting in 2005. In 2011, the state’s lieutenant governor effectively stalled a vote on an extension of the program. His communications director said, "The lieutenant governor believes that before the state spends another $200 million on a third program, we should extensively analyze whether the program has been effective, how we can make it more effective and what financial benefits the state of Texas has realized from its investment." Days before releasing this statement, the Texas Comptroller’s staff responded to information requests from the lieutenant governor’s staff, indicating that, among other issues, the CAPCO job counts were self-reported, unaudited, and frequently recounted the same jobs as retained by “follow-on” investments that were originally reported as retained with initial investments.
Wisconsin allocated $50 million beginning in 1999. A bipartisan group of state legislators blocked that program’s extension in 2004. A 2006 state audit found that only 316 jobs had been created through the $26 million invested by CAPCOs.
Curiously, Minnesota’s House Research Department commissioned a study (2/9/2010) that analyzed the Wisconsin program concluding that “the Wisconsin CAPCO credit had little or no effect, likely displacing venture capital financing that would have otherwise occurred.”
So, while CAPCO is arguably not the way, you ask, “How should Minnesota attract Venture Capital Investment”?
In a subsequent piece next week, I shall provide a better way to accomplish this. Stay tuned.
John Alexander is President of Business Development Advisors, Founder and Chair of the Twin Cities Angels, and business author of the Angel Investment Tax Credit.
Email him at: mailto:John@BusDevAdvisors.com