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
![Leaves](/SiteCollectionImages/WisconsinLawyer/1999/05/leaves.jpg)
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 state's new certified capital
companies (CAPCO) legislation taps insurance companies as a source of
venture capital for investment in early-stage companies in Wisconsin.
Attorneys can help their clients benefit from this new
program. |
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).
![Branch](/SiteCollectionImages/WisconsinLawyer/1999/05/branch.jpg)
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.
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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.
Wisconsin's CAPCO legislation
authorizes premium tax credits of up to $50 million statewide for
qualified debt or equity investments in a Wisconsin CAPCO. |
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:
- the distribution is a "qualified distribution";
- 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
- 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
![](/SiteCollectionImages/WisconsinLawyer/1999/05/gillman.jpg)
Catherine M. Gillman, Minnesota 1996 summa cum laude, is an associate
in the Madison office of Foley & Lardner, practicing in mergers and
acquisitions, general corporate law, and business entity and succession
planning.
![](/SiteCollectionImages/WisconsinLawyer/1999/05/ross.jpg)
Anne E. Ross, Stanford 1981, is a partner in the Madison office of
Foley & Lardner. She advises for-profit and not-for-profit
enterprises on general corporate matters, licensing and distribution
arrangements, strategic partnerships, mergers and acquisitions, and
financing for growth. She serves on the boards of directors of Wisconsin
Lawyers Mutual Insurance Co., SECURA Insurance, and Associated Bank
South Central.
|
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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