Governing Magazine, April 2004
Private investors are pushing a complex venture-capital scheme that
involves big risks and uncertain rewards for states.
There is a phrase that venture capitalists, the investors who bet on
small start-up companies, use to describe business locations that
aren't worth their time: "flyover states." For any place in America
that is watching jobs move to China or India, to be labeled a flyover
state is an ominous sign. Information technology, biotechnology and
nanotechnology are the future, and growing these industries without
venture capital is like growing a rose without water.
The distressing truth, however, is that venture investors and the
money they manage are concentrated in frustratingly few places.
Silicon Valley accounts for one-third of all venture capital in the
country, followed by a handful of smaller hubs such as Boston, Austin,
San Diego, New York and Seattle. The lack of venture capital almost
everywhere else makes it likely that any inventor with an idea, any
professor with a patent or any entrepreneur with a business plan who
aspires to launch a start-up company will move to where the money is.
States are understandably desperate to hold on to their entrepreneurs.
So it is easy to see why governors and legislators are increasingly
willing to use public funds to jump-start a local venture-capital
What is harder to understand is why so many of them have latched onto
one controversial strategy, lobbied for by a small cadre of private
investors, that critics call a rip-off for taxpayers and a sweetheart
deal for both its promoters and insurance companies. Nine states have
earmarked nearly $2 billion to "certified capital companies" or
CAPCOs. Yet many state economic development officials contend that
CAPCOs don't much resemble typical venture-capital deals in which
investors pouring large sums of money into risky start-up companies
expect to be highly rewarded. With CAPCOs, the state is taking on
nearly all of the risk in exchange for little, if any, of the
financial rewards. In fact, states are not really "investing" their
money at all. They are essentially handing it over to the CAPCOs,
which, after fulfilling their obligations, are free to keep the
Ever since a Louisiana law gave birth to the CAPCO program in the
1980s, three CAPCOs in particular have been quietly but aggressively
pushing this venture-capital model around the country. They make big
campaign contributions and use well-paid lobbyists to win over
lawmakers. And in states where they have secured funding once, they
have nearly always come back and pressed for more.
The CAPCO trend hasn't attracted much public interest, however,
because the funding structure is so complex. Last year in Alabama,
while voters were souring on new taxes for education, state officials
were quietly implementing a 2002 law that gave CAPCOs $100 million in
tax credits. In November, Washington, D.C.'s city council passed a $50
million CAPCO bill without triggering a single mention in the
Washington Post. Texas and Georgia are preparing to fund CAPCO
programs worth $200 million and $75 million, respectively. "These
CAPCO guys are good at lobbying," says George Lipper, who tracks
CAPCOs for the National Association of Seed and Venture Funds, a group
that monitors economic development efforts in the states. "They show
up at the table with a solution to the state's lack of venture
capital. Most state legislators don't have any knowledge of venture
capital at all, and what they have in front of them is a promise to
answer that problem. So they're very vulnerable to it."
The beginnings of a backlash are visible, however. The Wisconsin
Assembly last month beat back the CAPCOs' push for a second round of
funding. Florida is refusing to fund a 2002 law giving the CAPCOs a
second $300 million. The situation is even more heated in Colorado.
When the legislature passed a CAPCO law in 2001, funding was split
into two $100 million installments, the first of which was disbursed
two years ago. Policy makers in Colorado are so angry with how the
first $100 million is being used that they raced to divert the second
$100 million before the CAPCOs got it this April. Even the former
House speaker who originally sponsored the CAPCO measure is having
second thoughts. "As a legislator, I passed 80 good bills," says Doug
Dean, who is now Colorado's insurance commissioner. "And one bad one."
BUY NOW, PAY LATER
To understand the CAPCO controversy, it is helpful to look at how
venture capital traditionally works. After pooling together money from
pension funds, foundations and wealthy individuals who become limited
partners in a fund, venture capitalists invest in start-up companies
in exchange for an equity stake in the business. This kind of early-
stage investing carries big risks--more than half of those start-ups
typically won't survive. But occasionally one hits it big, earning
limited partners large returns on their investments. If all goes well,
an investor who gives $100 million to a venture capitalist would
expect to get his $100 million back, and in addition a share of 80
percent of the fund's profits. The venture capitalist takes 20 percent
of the profits, plus an annual management fee of about 2.5 percent, or
roughly $2.5 million a year.
CAPCOs work quite differently. In order to raise a $100 million
venture pool, states turn to insurance companies. (Ed: as it turns out the insurance companies
were only loaning the money and the states were on the hook for the loans, if the business investments
aren't successful enough to repay the loans) Insurers give $100
million upfront to the CAPCOs, in exchange for the same amount in tax
credits to be taken over 10 years. The CAPCOs then begin investing the
money in local start-up companies. It is a buy-now, pay-later formula
that elected officials find hard to resist. The state, however, is the
only party in the deal who bears much risk. The CAPCOs have none of
the fiduciary responsibilities to the state that a venture capitalist
owes to his limited partners. In fact, much of the "investment" here--
the state's $100 million in forgone tax revenues--actually lands on
the CAPCOs' books as income.
Almost any group of investors may form a CAPCO, as long as they have
a couple of years of venture-capital experience, $500,000 in the bank
and agree to set up an in-state office. But the states' boilerplate
laws, crafted by CAPCO lobbyists, subtly favor a few established
national players who have been around since the early days in
Louisiana. Not coincidentally, they are the same players who are
lobbying legislatures the hardest. Of the $1.5 billion that seven
states have so far funneled to CAPCOs via the insurance tax-credit
mechanism, only $1 billion is traceable through public records. Those
records clearly show who the Big Three nationally are:
Advantage Capital Partners in St. Louis has received at least $261
The Wilshire Group, a subsidiary of Newtek Business Services in New
York City, has received at least $140 million.
- Stonehenge Capital Corp., based in Columbus, Ohio, and affiliated
with Bank One, has received at least $226 million.
The insurance companies, in addition to receiving the tax credits,
negotiate with the CAPCOs for a guaranteed rate of return. Exactly how
much insurance companies make off the deal is not public record,
although Colorado regulators believe the insurers' overall return is
as high as 10 percent a year. According to state records in Florida,
New York and Colorado, insurers Metropolitan Life, Travelers, John
Hancock and Northwestern Mutual, among others, have taken CAPCO tax
credits in each of those states.
To be sure, states do attach a few strings to CAPCO money. The CAPCOs
must invest in start-ups located in the state. Start-ups typically
must begin with a small number of employees, and firms practicing law,
accounting, medicine or real estate often don't qualify. Otherwise,
state laws are generally silent about how to measure outcomes. It is
hoped that the CAPCOs will create jobs and taxable income, but they
are not required to show any economic benefits. Instead, the laws
gauge success by how quickly the CAPCOs pump out dollars. They
typically must have 30 percent of their funds invested within three
years and 50 percent invested within five years.
These laws leave much open to the CAPCOs' interpretation. The
Wilshire Group, for example, uses the states' CAPCO programs primarily
as an income stream for Newtek, its parent company. Newtek is a
publicly traded company that performs credit card processing and
financial services for small businesses. Its corporate strategy, laid
out in filings with the Securities and Exchange Commission, is to
channel the states' money into Newtek's own subsidiaries. In 2002,
state CAPCO programs accounted for 88 percent of Newtek's gross
Newtek calls its tactic a "hands-on approach" to investing and says
in its latest annual report that "the states' objectives of job
creation and economic development are unquestionably met." Indeed, all
of Newtek's "partner companies" are based in CAPCO states. But Alice
Kotrlik, who oversees the CAPCOs for Colorado's economic development
office, says, "Legislators never intended this to be free capital for
a company to expand its own product line. That's not anybody's
perception of venture capital."
When the CAPCOs came calling in Colorado three years ago, the state
was already in an enviable position--ranking among the top 10 for
venture-capital investment. Nevertheless, high-tech industries were
complaining that early-stage seed funding was still hard to come by,
particularly in biotechnology. The CAPCOs finally won over lawmakers
by agreeing to spread the venture-capital wealth beyond Denver and
Boulder and make one-quarter of their investments in rural counties.
It didn't take long for policy makers to realize that the CAPCO
approach wasn't quite what they expected. Their first shock was
learning that $100 million worth of tax credits yielded a pool of only
about $40 million for the CAPCOs to invest. That's because the CAPCOs
placed nearly half of the $100 million in safe havens such as treasury
bonds in order to pay the insurance companies back. This would not
have come as a surprise to anyone who had looked at other states'
CAPCO programs. Still, even legislators who originally supported the
CAPCOs didn't understand how this so-called "defeasance" worked. Nor
did they seem to grasp the fees CAPCOs were allowed to charge: $11
million to set up their offices, plus an additional $4 million in
management fees the first year.
This is not to say that the CAPCOs won't make $100 million worth of
investments. In fact, the law encourages them to do so--and quickly.
The CAPCOs are deregulated once they have put 100 percent of the
insurance companies' money to work. What that means though, is that in
order to turn a $40 million pool into $100 million worth of
investments, the CAPCOs must roll over some of the money a few times.
That prompts them to make safe bets, which is at odds with the very
goals of a venture-capital program. Indeed, more than half of the
CAPCOs' investments to date have been in the form of loans, some of
The last straw for Colorado officials, however, was the revelations
in a state auditor's report last October: Not only had the CAPCOs
spent $472,000 on lobbying in four years, but $85,000 of that was
financed with state-backed money from the venture-capital program. And
the CAPCOs were meeting only the letter, not the spirit, of the rural
investment requirement. Three portfolio companies landed in an office
park in "rural" Clear Creek County, 600 yards from the border of
Denver's western suburbs.
BANG FOR THE BUCK
The question, however, is not whether the CAPCOs might produce some
positive results. The
issue is cost-efficiency. Are there ways to accomplish the same goals
that give states more bang for the buck?
Note: The report has been abbreviated to shorten the Internet download time.