Attracting Venture Capital for Business Start-ups

By Catherine M. Gillman & Anne E. Ross

n April 28, 1998, Wisconsin added a new tool to its economic development program when it enacted legislation authorizing tax incentives for investments in Certified Capital Companies (CAPCOs). CAPCOs, organizations whose primary business activity is investing in "qualified businesses," have been used in a handful of other states as a method of promoting venture capital investment within the state. With the enactment of 1997 Wisconsin Act 215 (the Act),¹ Wisconsin joined Louisiana, Missouri, and New York in offering premium tax credits to insurance companies that make a certified capital investment in a CAPCO. Florida joined the group shortly after Wisconsin by passing its own CAPCO legislation on May 28, 1998, and CAPCO legislation has been introduced in both houses of the Illinois Legislature.

This article reviews the development and operation of these CAPCO programs and the enabling legislation in Wisconsin, exploring the roles of the CAPCO investment vehicles, the qualified businesses that will receive the venture capital funds, and the insurance company investors. The article also focuses on how attorneys can help their clients in any of these three categories take advantage of Wisconsin's new CAPCO program.

History of CAPCOs

CAPCOs began in 1983 when Louisiana enacted legislation allowing their creation. The initial legislation sought to encourage residents to invest in small Louisiana businesses by offering Louisiana income tax credits, in amounts of up to 35 percent of the cash invested, to both individual and corporate taxpayers for qualified investments in a certified Louisiana capital company.² This focus on relatively small investors proved unsuccessful, however, and CAPCOs did not emerge as a viable means of raising venture capital for early-stage companies until 1990. In 1990 Louisiana amended its CAPCO statute to provide for premium tax credits to insurers investing in Louisiana CAPCOs at the rate of 120 percent of the dollars invested. That year, a Louisiana venture capital firm began its first CAPCO.³ Since then, more than $200 million reportedly has been invested in Louisiana CAPCOs.⁴

Because of the apparent success of CAPCOs in Louisiana, Missouri became the second state to authorize CAPCOs in February 1997, with New York joining the group in August. Although hard evidence is not readily available, anecdotal evidence suggests that CAPCOs have been successful in attracting venture capital investment from insurance companies that had not previously invested in venture capital funds on a regular basis.⁵

Overview of the CAPCO program

The goal of the CAPCO legislation is straightforward: increase the pool of private venture capital available for investment in early-stage small businesses in the state. The CAPCO program seeks to achieve this goal by providing tax incentives totaling $50 million, initially, to insurance companies to increase their level of participation in early-stage investments. Insurance companies, which often have significant amounts of cash to invest, are subject to regulatory and market constraints on their ability to increase their premiums written as a percentage of their total "surplus" (that is, funds held to satisfy policyholder claims). Funds invested in relatively high risk, illiquid investment vehicles are not fully credited to an insurer's surplus by regulators and financial rating agencies. Therefore, many insurers are not active in financing early-stage companies. The CAPCO legislation constitutes a "credit enhancement" tool that opens the door for certain insurance companies to invest in early-stage Wisconsin companies, without incurring an unacceptable risk of reduction of their policyholders' surplus.

In Wisconsin, the CAPCO legislation will work essentially as follows. An insurance company will make a certified investment in a business licensed by the state as a CAPCO. The insurance company will receive a dollar of premium tax credits for each dollar of certified investment in the CAPCO. Premium taxes (technically, "license fees") against which the credit will be allowed are assessed against gross premiums collected in Wisconsin by out-of-state fire and marine, casualty, and life insurance companies and by Wisconsin domestic life insurance companies. An insurer may take credit for its certified capital investments in CAPCOs (to the extent that such investments represent an actual increase in the insurer's aggregate investments in early-stage Wisconsin businesses) at the rate of 10 percent per year for 10 years. Unused credits may be carried forward to future tax years. Insurers also may sell the CAPCO tax credits to other insurers that are subject to premium taxes in Wisconsin, upon proper notice to the Commissioner of Insurance.⁶

 The premium tax credits are "earned" in the year that the insurance company makes the certified investment in a CAPCO. The credits are subject to recapture, however, if the CAPCO fails to comply with certain requirements of the Act, causing either decertification of the CAPCO or disqualification of the investment pool. The portion of the credits subject to recapture depends upon the extent to which the CAPCO placed its certified capital in "qualified investments" in "qualified businesses" before the event giving rise to decertification or disqualification.⁷

Certification and operation of CAPCOs

The Wisconsin Department of Commerce (WDOC) is responsible for certifying CAPCOs and investments in them. To be certified as a CAPCO, an organization must be primarily involved in the investment of cash in qualified businesses, and must have a minimum of $500,000 in both net worth and liquid assets. In addition, at least two responsible officers of the CAPCO must each have a minimum of two years of experience in the venture capital industry.⁸ An organization seeking certification must pay a nonrefundable application fee of $7,500,⁹ and an annual certification fee of $5,000 thereafter.¹⁰ The WDOC will conduct an annual compliance review of each CAPCO to ensure compliance with applicable statutory and regulatory requirements.

To maintain its certification, and the premium tax credits claimed by investors, the CAPCO must make "qualified investments" in "qualified businesses" in accordance with a specified investment schedule. Qualified investments consist of cash investments for the purchase of: 1) an equity security; or 2) a debt security having a maturity of at least five years and that is either unsecured or is convertible into equity securities or other equity participation instruments (for example, options or warrants). Straight debt is not a qualified investment.

A qualified business must meet certain statutory tests of its worthiness to receive economic assistance, including, among others:

• location (that is, the business must be headquartered, and have its principal business operations, in Wisconsin);
• need (that is, the business must be in need of venture capital and be unable to obtain it by conventional financing);
• size and profitability (that is, the business may not have more than 100 employees [at least 75 percent of whom are employed in Wisconsin], may not have had an average after-tax consolidated net income in excess of $2 million in the two previous fiscal years, and may not have a consolidated net worth in excess of $5 million); and
• nature of business (that is, the business must not be predominantly engaged in professional services rendered by accountants, lawyers, or physicians; the development of real estate for resale; or banking or lending).

In addition, the qualified business must enter into four covenants, which are designed to ensure that the invested funds are used in ways likely to contribute to the growth of Wisconsin jobs and the Wisconsin economy. The qualified business must agree not to use the proceeds to relocate its operations, and it must agree that, as long as the CAPCO holds the investment, it will not relocate its headquarters out of Wisconsin; it will maintain at least 75 percent of its employees in Wisconsin; and it will maintain at least 75 percent of its employees at work sites that were maintained when the investment was made.¹¹ A CAPCO may seek a written opinion from the WDOC concerning whether a business in which it plans to invest meets these requirements.¹²

It is anticipated that the WDOC will promulgate rules setting standards to assist in determining when a business will be deemed to be "in need of venture capital" and "unable to obtain conventional financing." These definitions will be crucial to the WDOC's ability to ensure that the certified capital reaches its intended early-stage target businesses, rather than being used to refinance or transfer ownership in established enterprises, or for passive investment.

Finally, the qualified investments in qualified businesses must be made in accordance with the timetable set forth in the Act. A CAPCO must invest at least 30 percent of an investment pool within three years, and at least 50 percent within five years. In the aggregate, then, qualified Wisconsin businesses may receive $15 million or more of CAPCO funds before the end of 2002, and $25 million or more before the end of 2004. Rules to be promulgated by the WDOC may restrict a CAPCO's ability to take credit for funds that are "churned" through a qualified investment on a short-term basis, or rolled out of and back into the same qualified business.¹³ A failure on the part of the CAPCO to meet either the 30 percent/three-year or the 50 percent/five-year requirement will result in the recapture of part or all of the premium tax credits claimed by the investors.

Considerations for qualified businesses seeking CAPCO funding

Early-stage Wisconsin companies seeking venture capital would be well advised to monitor the progress of the CAPCO program, and consider submitting business plans to newly certified CAPCOs whose investment strategies are compatible with such companies' needs. A company that wishes to seek CAPCO funding should examine the criteria for a qualified business embodied in the statute and pending administrative rules, and consider its ability to meet such criteria. It also should consider its ability to issue the type of equity and debt instruments that would constitute "qualified investments" for a CAPCO. Early planning may enable a business to adjust its short- and long-term plans to ensure that an investment in it will constitute a "qualified investment" in a "qualified business." Depending upon the content of the administrative rules to be promulgated by the WDOC, it may even be possible for an early-stage Wisconsin business to apply for a WDOC determination that it is a qualified business, thus "preclearing" it to receive an investment by a CAPCO.

Of course, companies hoping to obtain CAPCO funds should expect to undergo the same level of "due diligence" examination by a CAPCO investor that would be conducted by any other institutional investor, and should prepare accordingly. In addition to the usual comprehensive investment representations, warranties, and covenants, recipients of CAPCO funding should be prepared to enter into the four covenants described above, and others that the CAPCO investor may feel are necessary and appropriate to protect its certification as a CAPCO and the qualification of the investment pool.

Recipients of CAPCO funds also should expect ongoing monitoring by the CAPCO during the term of the investment, although such monitoring may not be significantly more intrusive than the monitoring of a traditional venture capital investor.

Aside from the need to meet the qualification criteria, and certain nontraditional constraints imposed by means of the investment agreement between the qualified business and the CAPCO, it does not appear that companies that receive CAPCO funding will be subjected to significant additional administrative or financial burdens over and above those experienced by any company seeking outside venture funding.

Considerations for insurance company investors

The Act creates an initial aggregate tax credit allocation of $50 million.¹⁴ For an insurer to receive credit under the Act, the WDOC must certify the insurer's prospective investment in a certified CAPCO, making the insurer a certified investor under the Act. Unless the program is renewed or extended, the WDOC may not certify capital investments of more than the total initial allocation of $50 million statewide. Investments will be certified by the WDOC on a first-come, first-served basis. The total available tax credits will be allocated pro rata among investors whose applications are received on the same day.¹⁵ To ensure receiving a portion of the initial allocation, interested insurers should be prepared to request certification on the first day that certification is available.

Certified capital investments in a CAPCO may take the form of equity interests or "qualified debt instruments,"¹⁶ although a CAPCO must have at least $500,000 of equity to be certified under the Act. Qualified debt instruments are debt instruments that are issued by the CAPCO at par value or a premium, that carry an original maturity date of at least five years from the date of issuance, and have a level principal amortization unrelated to the CAPCO's profitability or the performance of its investments.¹⁷ In addition to tax credits, debt and equity investors in a CAPCO may receive distributions of principal and interest and/or dividends payable out of CAPCO profits, subject to the distribution limitations described below.

To enhance the likelihood that a CAPCO will invest 100 percent of its certified capital in qualified businesses, the Act restricts the CAPCO's ability to make distributions to investors. The Act provides that, unless and until the CAPCO has made qualified investments in an amount equal to 100 percent of the certified capital in each investment pool, the CAPCO may make a distribution only if it meets one of the following three conditions:

1. the distribution is a "qualified distribution";
2. the WDOC makes a written determination that the distribution may be made without adversely affecting the ability of the CAPCO to place 100 percent of its certified capital in qualified investments; or
3. the distribution is a payment of principal or interest owed to a debt holder of the CAPCO.¹⁸

A "qualified distribution" is defined by statute to include a distribution to the CAPCO's equity holders for formation costs, an annual management fee (which may not exceed 2.5 percent of the CAPCO's total certified capital), fees for professional services related to the operation of the CAPCO, or federal or state taxes related to the CAPCO's ownership, management, or operations.¹⁹ These distribution limitations should not affect certified debt investors, but may affect certified equity investors.

Prior to Aug. 1, 2000, the WDOC may not certify an investment under the Act if, after certification, the investing insurer, alone or together with its affiliates, would have more than $10 million in certified capital investments.²⁰ As a further limitation, no certified investor may own, alone or together with its affiliates, 10 percent or more of the outstanding equity interests of a CAPCO or be a general partner or manager thereof.²¹

Within the statutory constraints, CAPCOs can take, and have taken, various forms. To the extent that all of the certified capital is invested in the form of qualified debt with a fixed repayment schedule and rate of return, the downside risk and upside profit potential of the equity interests in a CAPCO may be retained by a corporate sponsor who is willing and able to finance the minimum capital requirement. At least two major corporate sponsors have organized CAPCOs in other states using this model, and are reportedly working on similar funds in Wisconsin. Alternatively, money contributed in the form of certified capital (whether debt or equity) could be used to supplement and enhance the equity contributed by other outside investors in a more traditional venture capital fund, thereby compounding the economic development benefits to be derived from the legislation.

Before closing on a CAPCO investment, an insurer should determine that the CAPCO is properly certified, as described above. Any investment in an investment company prior to its certification as a CAPCO is not eligible for a tax credit. Second, the insurer should consider whether the investment will have an adverse impact on the insurer's surplus calculation or its rating by key financial rating agencies. A CAPCO can be structured so that the surplus calculation issue will not preclude investment even by those insurers who cannot afford any reduction in surplus. Collateralized qualified debt instruments issued by CAPCOs in other states have enjoyed a Moody's rating as high as AAA and an investment rating of 1 by the National Association of Insurance Commissioners. The Office of the Wisconsin Commissioner of Insurance is currently reviewing the appropriate asset classification and statutory accounting treatment under Wisconsin insurance law for investments in CAPCOs. Third, an insurer should review the compliance mechanisms that the CAPCO has in place and should retain the ability to monitor the CAPCO's ongoing compliance with the Act, in light of the recapture issues discussed above.

Effective date

The Act takes effect on July 1, 1999. The WDOC must submit proposed rules under the Act by Nov. 1, 1999.²² Members of the WDOC staff have indicated that they expect to submit proposed regulations this spring, so that the certification of CAPCOs and investments may begin in mid to late 1999. Persons who wish to organize CAPCOs or make certified investments should be actively pursuing the opportunity at this time. Potential qualified businesses should begin planning now to take advantage of the CAPCO program and learning about the CAPCOs that are formed once the Act takes effect.

Summary

CAPCOs have been used in Louisiana and Missouri, and are under formation in New York and Florida and under consideration in other states, to spur venture capital investment within their states of operation. Wisconsin's CAPCO legislation authorizes premium tax credits of up to $50 million statewide for qualified debt or equity investments in a Wisconsin CAPCO. Due to the "credit enhancement" represented by the 100 percent premium tax credits available for certified investments, investments in CAPCOs may be structured so as to involve substantially less risk than investments directly in traditional venture capital funds or early-stage companies. The credit enhancement is expected to generate "new" money to be invested in early-stage Wisconsin companies, money that otherwise would not have been invested as venture capital. Based on the limited experience in other states, this legislation should be successful in its goal of creating an increased pool of venture capital for investment in early-stage companies in Wisconsin.

Endnotes

¹ The Act is codified at section 20.143, 76.635, and 560.30 - .38 of the Wisconsin Statutes.

² 1983 La. Acts 642.

³ Seth Fineberg, CAPCOs Come of Age, Venture Cap. J., Nov. 1997, at 44, 45.

⁴ These figures were obtained from an untitled report contained in the legislative history to the Act.

⁵ See Michael Selz, Enterprise, Wall St. J., Jan. 13, 1998, at B2 (quoting principal of Missouri CAPCO).

⁶ Wis. Stat. § 76.635(5).

⁷ Wis. Stat. § 76.635(4).

⁸ Wis. Stat. § 560.31(2).

⁹ Wis. Stat. § 560.31(2)(f).

¹⁰ Wis. Stat. § 560.35(4).

¹¹ Wis. Stat. § 560.34(1).

¹² Wis. Stat. § 560.33.

¹³ Wis. Stat. § 560.34(1m).

¹⁴ Wis. Stat. § 560.32(2)(b).

¹⁵ Wis. Stat. § 560.32(2)(d).

¹⁶ Wis. Stat. § 560.30(4).

¹⁷ Wis. Stat. § 560.30(9).

¹⁸ Wis. Stat. § 560.36.

¹⁹ Wis. Stat. § 560.30(10).

²⁰ Wis. Stat. § 560.32(2)(c).

²¹ Wis. Stat. § 560.32(3).

²² 1997 Wis. Act 215 § 4.

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