1. ESTABLISHING NONTRADITIONAL
VENTURE CAPITAL INSTITUTIONS:
THE DECISION MAKING PROCESS
David L. Barkley, Clemson University
Deborah M. Markley, Policy Research Group
David Freshwater, University of Kentucky
Julia Sass Rubin, Harvard University
Ron Shaffer, University of Wisconsin
P2001-11C
Part 3 of 4 of the Final Report
RUPRI Rural Equity Capital Initiative
Study of Nontraditional Venture Capital Institutions
Funding provided by USDA Fund for Rural America

2. Rural Policy Research Institute’s (RUPRI)
Rural Equity Capital Initiative
The RUPRI Rural Equity Capital Initiative was funded by a grant from the U.S.
Department of Agriculture’s Fund for Rural America. The purpose of this project was to examine
innovative institutions that are making venture capital investments in rural places across the
country and develop lessons learned from these institutions that might be applied in other areas.
The project research team included Deborah M. Markley (chair), principal of Policy Research
Group, a consulting firm in Chapel Hill, NC; David L. Barkley, Professor and Co-Coordinator,
Regional Economic Development Research Laboratory, Clemson University, Clemson, SC; David
Freshwater, Professor, Department of Agricultural Economics, University of Kentucky,
Lexington, KY; Ron Shaffer, Professor, Department of Agricultural and Applied Economics,
University of Wisconsin, Madison, WI; and Julia Sass Rubin, Ph.D. candidate in Organizational
Behavior, Harvard University.
As part of this project, 23 case studies of nontraditional venture capital institutions or
programs were completed during 1998, 1999 and 2000. The information from these visits forms
the basis of a four-part series that describes the lessons learned from the experiences of these
institutions, the rationale for nontraditional institutions, the process for establishing nontraditional
venture funds, and detailed case studies of each institution. The specific publications are:
• Establishing Nontraditional Venture Capital Institutions: Lessons Learned. This
publication describes lessons learned from the case studies. Advantages and disadvantages
of different organizational structures are discussed and characteristics of successful
nontraditional venture funds are presented.
• Nontraditional Venture Capital Institutions: Filling a Financial Market Gap. This
publication provides an overview of the venture capital industry, discusses impediments to
making venture capital investments in rural areas and non-high tech business enterprises,
and suggests roles for nontraditional venture capital in small market areas.
• Establishing Nontraditional Venture Capital Institutions: The Decision-Making Process.
Based on information from the 23 case studies, the research team outlined a decision-
making process for establishing nontraditional venture capital funds. This publication
describes the sequential steps in this process and discusses the interrelated nature of the
decisions made at each point in the process. Specific examples illustrate the process.
• Case Studies of Nontraditional Venture Capital Institutions. This publication provides
detailed case studies of the 23 institutions included in this project. The history of each
institution is described, along with its organizational structure, investment experience, and
future concerns or opportunities for the fund. The perspective of some portfolio
companies is also included.
This report, along with other publications produced for this project, are available from the RUPRI
website (www.rupri.org/pubs/equitycap/index.html) or by contacting RUPRI at 573-882-0316.

3. Establishing Nontraditional Venture Capital Institutions:
The Decision Making Process
Rural areas, nonmetropolitan institution and increases the availability of
communities, and small geographically support to worthy area businesses.
isolated metropolitan areas often are This decision-making process is based
overlooked by traditional venture capital on on-site interviews with founders and
funds because of the relatively high cost of managers of 23 venture capital institutions
finding and managing investments in small across the country (Table 1). The decision
market areas. Yet opportunities for quality making is presented as a sequential
venture capital investments are present in process (Figure 1); however, clear
smaller markets, and successful feedback loops exist among the various
nontraditional venture capital institutions stages of the process. Decisions made
have been established to promote early in the process constrain later choices.
entrepreneurial and business development In addition, if constraints are subsequently
in such areas. In some cases, venture identified in the process, such as in
capital institutions focus on local small fundraising or deal flow, modifications
business communities, such as Northeast and adaptations to earlier decisions or
Ventures (NEV) in Minnesota, McAlester goals may be needed.
Investment Group (MIG) in Oklahoma, Based on the site visits, no single best
and Ames Seed Capital Fund (ASCF) in model for a nontraditional venture capital
Iowa. In others, a broader concern about institution exists. The organizational form
economic development prospects spurs chosen for an institution will depend on
state governments to provide venture the economic structure of the targeted
capital through groups like Kansas region; the capital needs of resident
Venture Capital Inc. (KVCI), Northern businesses; the goals of the organizers,
Rockies Venture Fund (NRVF) in managers, and investors; and for public
Montana, and the Oklahoma Capital entities, the statutes regulating public
Investment Board (OCIB). Whether institutions. However, despite the
venture capital is provided by private or underlying variability in market areas and
public institutions, organizers consider differences in goals, organizational
similar questions or issues when structure, and investment portfolios, the
developing and designing institutions. concepts outlined in the decision process
This paper provides an overview of appear applicable to all the institutions
the decision-making process followed in visited. Indeed, institutions that clearly
establishing nontraditional venture capital articulated how they approached each
institutions. An understanding of this decision element were more successful
process will enable communities to learn than those with a less precise notion of
from the experiences of others and to what they hoped to achieve and how they
develop venture capital institutions planned to accomplish it.
tailored to their goals, market conditions, The organizational frameworks of
and institutional constraints. A well- nontraditional venture capital institutions
organized decision-making process vary. The venture capital institution may
increases the probability of establishing a be a freestanding, independent entity. In
successful nontraditional venture capital other cases, the institution may be a
subsidiary of another organization, for
1

4. example, a bank Small Business development corporation (CDC).
Investment Company (SBIC). Venture However, regardless of the organizational
capital investing also occurs as an form a nontraditional venture capital
extension of the core activities of an institution ultimately assumes, organizers
organization such as a state agency, rural can gain by using the decision-making
electric cooperative or community process outlined here.
Table 1. Site Visit Venture Capital Institutions by Category
A. Publicly Funded, Publicly Managed Institutions
Small Enterprise Growth Fund (Augusta, ME)
Minnesota Technology Corporation Investment Fund/MIN-Corp
(Minneapolis, MN)a
Iowa Product Development Corporation/Iowa Seed Capital Corporation
(Des Moines, IA)
B. Privately Managed Funds with Public Funding or Incentives
Iowa Capital Corporation (Des Moines, IA)
Colorado Rural Seed Fund (Boulder, CO)
Northern Rockies Venture Fund (Butte, MT)
Oklahoma Capital Investment Board (Oklahoma City, OK)
Partner Funds: Pacesetter and MESBIC Venture Funds (Dallas, TX)
Magnolia Venture Capital Fund (Jackson, MS)
Kansas Venture Capital, Inc. (Overland Park, KS)a, b
C. Community-Level Equity Programs
Ames Seed Capital Fund, Inc. (Ames, IA)
Siouxland Ventures, Inc. (Sioux City, IA)
McAlester Investment Group (McAlester, OK)
Montana Rural Electric Utility Cooperativesc
D. Certified Capital Companies (CAPCOs)
Louisiana CAPCO Program (Baton Rouge, LA)
Missouri CAPCO Program (Jefferson City, MO)
E. Community Development Venture Funds
Coastal Ventures Limited Partnership (Portland, ME)
Kentucky Highlands Investment Corporation (London, KY)
Cascadia (Seattle, WA)
Northeast Ventures (Duluth, MN)
Appalachian Ohio Development Fund (Athens, OH)
F. Small Business Investment Companies (SBICs)
First United Ventures (Durant, OK)
North Dakota SBIC (Fargo, ND)
North Carolina Economic Opportunities Fund (Raleigh, NC)
a
MIN-Corp and Kansas Venture Capital, Inc. recently became private venture capital institutions and MIN-
Corp is also considered a community development venture fund. However, both institutions were started with
significant public support (funding and/or management).
b
Kansas Venture Capital, Inc. is also an SBIC.
c
The Montana Rural Electric Utility Cooperatives’ investment activity occurred in a number of communities
throughout the state: Medicine Lake, Great Falls, Sun River, Opheim, and Culbertson.
2

5. Figure 1.
Steps in the Decision Making Process for Creating a Nontraditional Venture Capital Institution
1.Recognize
impetus for
creating a
nontraditional
venture institution
2. Conduct market
7. Manage analysis; estimate
investment activity local deal
flow/how to create
deal flow
6. Select legal and
3. Articulate
organizational
institution’s goals
structure
and objectives
5. Identify sources
of funds to 4. Select
capitalize institution’s size
institution and management
Impetus for Starting a Nontraditional indirectly stimulate income and
Venture Capital Institution employment. Institutions created to
Why create a venture capital stimulate regional economic development
institution? Some institutions visited were generally were established primarily to
created in response to concerns about the make investments in firms that could grow
level of state or local economic and remain in the region, increasing
development activity (Figure 2). The regional income and employment. For
founders believed that local business example, local business people created the
development and job creation were MIG, an organization of angel investors,
hampered by a lack of venture capital and to help stimulate business development in
that successful venture capital investments the town of McAlester, Oklahoma.
could be made in area businesses at rates Other institutions were established to
of return less than those sought by meet the venture capital needs of area
traditional venture capitalists. Investments businesses and, as a result, to demonstrate
in venture capital funds were made to that the local economy could support
3

6. venture capital investments. Founders of focused on creating economic
these institutions recognized a demand for opportunities within the distressed
venture capital in the region and the failure Appalachian region by developing
of national venture capital institutions to potential deals, investing in the region’s
meet that demand. Kansas bankers, businesses and entrepreneurs, and bringing
recognizing a need for venture capital, entrepreneurs into the region to create new
established KVCI, an SBIC. KVCI enterprises. In these examples, creating
focused on meeting the venture capital economic development and social benefits
needs of existing Kansas businesses, for specific segments of the population
although economic development concerns were important objectives.
were a secondary issue. OCIB responded
to the need for venture capital in Market Analysis and Estimation of
Oklahoma by investing in partner funds Local Deal Flow
that could, in turn, invest in Oklahoma Developing an appreciation for the
businesses. OCIB wanted to stimulate the need for venture capital in the relevant
Oklahoma venture capital market by local, state, or regional market area is a
bringing Oklahoma deals to the attention critical second step in the creation of a
of established regional and national nontraditional venture capital institution.
venture capital funds. However, This understanding, in turn, helps
investment in Oklahoma businesses is not determine whether an effective demand for
specifically required. NRVF was created the venture capital institution exists, what
to stimulate the private capital market in niche the institution might occupy, and
Montana after attempts to attract private what would be an appropriate size for the
investors to an earlier state program were fund. In addition to evaluating the need for
unsuccessful. While the earlier state venture capital, it is important to identify
program grew out of economic the climate for venture capital investing in
development concerns, NRVF was created the region. Are potential entrepreneurs
to address the inadequacies of the private familiar with venture capital investing
venture capital market in Montana and to available, or will some educational effort
earn good returns for the investors and be required to develop this familiarity?
managers of the fund. For some institutions, particularly
A third group of institutions was created to community development venture funds
use venture capital investments to create (CDVCs), adequate deal flow was not
jobs, entrepreneurial capacity and wealth central to their creation. Almost by
to benefit primarily distressed definition, CDVCs targeted populations
communities and low-wealth individuals. where deal flow was limited or
The institutions considered both financial nonexistent and had to be developed.
and social returns in making investments. KHIC had to create deals by attracting
For example, NEV was established in entrepreneurs to the region and by
response to the downturn in northeast providing extensive assistance to
Minnesota’s mining industry. The need for promising local entrepreneurs during start-
venture capital was identified as an up of new businesses.
impediment to the creation and expansion
of businesses in the region. Kentucky
Highlands Investment Corporation (KHIC)
4

7. Figure 2. Impetus for Starting a Nontraditional Venture Capital Institution
For other funds, however, a market for venture capital. An estimate of the
analysis can help to determine the focus of potential need for venture capital can be
the venture capital institution and provide obtained by understanding the structure of
the information needed to make decisions the local, state, or regional economy. It is
on structure, size, and targeting of the important, however, to recognize that
institution. The need for venture capital measuring the need for venture capital is
varies with the stage, sector, and level of subjective.
technology of resident industries, as well Analysis of a market area determines
as with their potential for growth. whether potential deal flow is sufficient to
Established firms, experiencing only justify creating a venture capital institution
moderate growth, may have limited need (Figure 3). Because institutions tend to
for venture capital and may be able to invest in a small percentage of deals
meet capital needs from retained earnings reviewed, deal flow must be adequate. For
or borrowing. New, rapidly growing example, KVCI reviews about 150 deals
companies have more limited access to annually, yet it makes investments in only
debt capital and are more likely to have three or four deals. Analysis of investment
capital needs that outpace their ability to opportunities in specific industry sectors and
generate retained earnings. Consequently, development stages is equally important to
such businesses may have a greater need assessing overall deal flow. Venture capital
5

8. firms generally specialize in specific knowledge important to identifying potential
industries like manufacturing or computer deal flow.
software or in specific stages of If overall deal flow in the institution’s
development like start-ups, expansions, or proposed service area is considered
transfers of ownership. The targeting of inadequate to support a successful fund,
investments occurs because different types organizers can choose to cease the decision
of investments require different types of making process or investigate alternatives
expertise for the fund manager. for increasing deal flow (Figure 3).
How can a community assess Broadening the geographic region served or
potential deal flow? When the impetus for industry sector targeted can increase deal
creating a rural venture capital institution flow. Colorado Venture Management’s
comes from within a region, such as with (CVM) Colorado Rural Seed Fund (CRSF)
NEV, knowledge of potential deals is focused on the western slope of the Rockies,
typically part of the rationale for the an area with a small population and a limited
institution. NEV’s founder’s years of economy, was not successful. However,
experience working with small businesses NRVF, CVM’s recent initiative, fosters
in the region provided the baseline greater deal flow by operating statewide in
information that defined the need in Montana.
northeast Minnesota. Pacesetter, a venture The industry focus of an institution can
capital fund based in Dallas, Texas, was be expanded rather than limiting
established by its parent, MESBIC investments to a small number of specific
Ventures, because of an identified need for sectors. The Iowa Capital Corporation
later stage venture capital for minority (ICC), for example, focuses on industries
businesses in which MESBIC had strategic to the electric power industry, but
originally invested. However, in spite of ICC will consider firms in most
their assessment of deal flow, venture manufacturing sectors.
capital institutions may be faced with a Small community-based funds and
very different pool of potential deals than CDVCs may have difficulty broadening
anticipated. This situation affects their geographic region or industry focus.
investment strategies and the time frame They often are already generalists and
for exiting investments. For example, the cannot spread their staff and resources over
early market research undertaken by NEV a broader geographic region without
did not reveal that most of their deals compromising their potential impact. They
would be in early stage businesses. can, however, develop deal flow by
When nontraditional venture capital providing support services for entrepreneurs
institutions are created because of lack of and new businesses through incubators,
capital availability, however, assessing technology transfers, and assistance in
deal flow is more problematic. developing business plans. Institutions with
Networking with organizations that know a strong developmental orientation, like
the needs of small businesses and KHIC, have created deals by coupling
entrepreneurs takes on added significance. technical assistance with venture capital. In
Networking with banks, Small Business regions where role models for entrepreneurs
Development Centers, chambers of are limited, entrepreneurial development
commerce, and local economic must precede the development of sound
development offices can provide the local business deals.
6

9. Figure 3. Market Analysis
Assess Local Deal Flow
• Capital needs of industry
• Industry prospects for growth
• Prospects for return on investments
• Alternatives for exiting deals
• Good ideas/managers that could be
developed
Overall deal flow Overall deal flow
adequate inadequate
Is deal flow (industry sector,
stage and location) Cease decision
consistent with impetus making process
for institution?
• Increase deal flow by
broadening geographic or
industry focus
Yes, proceed to No, re-evaluate • Create deals through
institutional goals reason for technical assistance, deal
and organization institution, and/or development, import
cease process entrepreneurs
Re-assess local deal
flow
7

10. Articulation of Institution’s Goals process, although they are considered to be
After the need for venture capital has positive results of the investment process.
been demonstrated and potential deal flow However, investors in the venture capital
identified, the institution’s goals must be institution may be able to capture benefits
more specifically articulated (Figure 4). from other externalities, such as increased
Some nontraditional funds want to property values in the community or
maximize financial returns. Their improved general quality of life.
managers believe that investment Some institutions seek to maximize
opportunities in the area offer the potential social benefits or returns while earning an
for earning an overall annual rate of return IRR that is sufficient to ensure the
of 30 percent or more, an internal rate of institution’s long-term sustainability.
return (IRR) on a par with that earned by Institutions such as ASCF, Coastal
traditional venture institutions. These Ventures Limited Partners (CVLP), and
investments are not currently undertaken MIN-Corp, consider potential financial
by traditional institutions because of an and social returns in the decision making
imperfect flow of information, but the process. While both IRR and social returns
deals are available to regional investors can be considered, managers and investors
who recognize the investment opportunity. must determine how these two variables
Profit maximizing institutions face the are balanced, based on their mutual goals.
challenge of making sound investments For example, managers may choose to
while attempting to overcome the factors invest to achieve the highest possible IRR,
of distance, high transaction costs, and subject to achieving certain minimum
lack of information that discourage the social benefits. Alternatively, social
extension of traditional venture funds into benefits could be maximized subject to
more geographically isolated markets. achieving a minimum rate of IRR.
NRVF and OCIB are organized around Achieving consensus on these tradeoffs is
this principle. Finding a source of capital critical to the decision-making process.
to fund the demonstration effort constrains
the development of these types of Selection of Institutional Size and
institutions. In some cases, public Management Alternatives
investment can play an important role in Institution Size
this demonstration phase. The optimal capitalization of a
Other institutions also seek to nontraditional venture capital institution
maximize financial returns, but recognize depends upon the institution’s goals,
that investment opportunities in small organizational structure, and sources of
market areas offer potential IRRs that are funding. In addition, capital available
lower than those expected by traditional should be closely related to investment
venture funds. They work to maximize opportunities or deal flow. If capitalization
IRR, given that the expected rate of return is large relative to deal flow, the institution
will be lower than those accepted by may be encouraged to make questionable
traditional venture funds. Social returns investments. If capitalization is low
from investments such as jobs, income, compared to estimated deal flow, then
retail sales, and housing starts are not investment opportunities may go
valued explicitly in the decision-making unfunded.
8

11. Figure 4. Goals of the Institution
Deal flow adequate or
investment opportunities can be
developed to support venture
capital institution
Maximize financial
returns
Goal A: Maximize rate of Goal B: Maximize rate of
return (assume rates will be return (assume rate of
competitive with those return will be less than
sought by traditional market rate)
venture capital funds) Investors may capture
external benefits from
investments Goal C: Maximize
economic development and
social impacts while
earning rate of return
sufficient for long-run
sustainability
The institution should also be institutions have a requirement that no
financially able to support a professional investment account for more than 10 to 15
management team. While it is difficult to percent of total capital in the institution.
set an absolute minimum size for a venture And fourth, a management fee of 2 to 3
capital institution, an estimate can be made percent of total capital is charged annually
for funds driven by rate of return based on to cover operating expenses. Therefore, a
observations from site visits. First, each fund with a 10-year life allocates
partner or manager in an institution approximately 20 to 30 percent of the
generally can manage six to eight deals or initial value of the fund to management
investments. Second, investments must be fees.1
large enough to justify a seat on the board Based on observations from the site
of a portfolio company, if that is a visits, a minimum of $10 million enables a
requirement of the institution. Third, most freestanding institution to operate without
9

12. subsidy of operating expenses. A $10 subsidized by the parent organization,
million fund with a 10-year planning enabling the smaller venture capital fund
horizon would have $7 to $8 million to be viable. Alternatively, the Small
available to invest in portfolio companies Enterprise Growth Fund (SEGF) in Maine
after allocations for management fees. uses a volunteer board for due diligence
Such a fund could make seven to eight and investment decisions to reduce
investments averaging $1 million per management costs. Small, local funds such
investment. Generally, the initial as ASCF and Siouxland Ventures Fund
investment in a portfolio company would (SVF) rely on the local chamber of
be less than the $1 million average since commerce for administrative support.
part of the fund’s investment capital will Management Alternatives
be set aside for additional investments. With the goals and size of the institution
More than seven to eight investments established, a professional management
could be made if initial deals are exited team must be secured to run the venture
profitably and earnings are reinvested in capital institution. Most institutions noted
the fund. that professional management was critical
For small community-based to the success of the fund. In small market
institutions and CDVCs, operating budgets areas, organizers must consider whether
may be covered by grant money, monetary experienced professional investors can be
and in-kind contributions from partner hired from within the local labor pool or
organizations and retained earnings. As a whether professionals can be attracted to
result, institution size may have less the local area. In addition, the institution’s
influence on the ability of these goals will play a role in determining the
institutions to hire experienced, committed characteristics of the management team. If
managers. the goal of the institution is to maximize
If prospects for raising a $10 million IRR, the fund must be large enough to
fund are limited given the goals and focus support an experienced management team,
of the institution, then the organizers have relying primarily on an average
other alternatives (Figure 5). One, the management fee of 2½ percent. In
organizers can cease planning for a addition, the potential to earn significant
venture capital institution and investigate returns on the investments must be
other means of assisting new area sufficient. For institutions with dual goals,
businesses. Two, the organizers can management must be motivated by
reevaluate the proposed goals, area, and concern with the social benefits of
industry focus of the institution to investments and be comfortable with the
determine whether the institution can tradeoff between financial and social
become more attractive to potential returns. Since the community development
investors. Three, alternatives to a venture capital industry is relatively young
freestanding venture capital fund such as compared with traditional venture capital,
partnerships with public or private the pool of professional, socially
organizations, could be investigated as a motivated investors is more limited.
means to subsidize management of the Consequently, institutions with dual goals
fund. For example, CVLP, a $5.5 million may have to rely more heavily on hands-
fund, is part of Coastal Enterprises, a on training than more traditional venture
community development corporation in capital funds.
Maine. Operating costs for CVLP are
10

13. Figure 5. Fund Size and Management Alternatives
Prospective fund
size significantly
Prospective fund less than $10 m
size approximately
$10 m or more
Cease planning
process
Establish self-standing Re-evaluate goals, Develop partnerships
fund with professional target industries, with other organizations
management team and service areas such as state or
development
organizations to
subsidize management
costs
Seek additional
capitalization
of fund
In addition to finding professional If the incentive system does not reward
management, attention must be given to good investment decisions, the institution
establishing an incentive structure for may not achieve either its financial or
management that is consistent with the social goals. The Magnolia Venture
goals of the institution. Most traditional Capital Corporation (MVCC) in
and profit maximizing nontraditional Mississippi provides the classic example
funds are structured so that the of potential problems with an institution
management team shares in any profits when oversight is inadequate (in this case,
earned when investments are exited. Even public oversight) and the incentive system
smaller community-based and community fails to reward sound investments and fund
development venture funds provide some growth. Lax oversight of Magnolia’s
way for fund managers and staff to share management and board and questionable
in the returns from profitable investments. business practices by employees resulted
11

14. in a program with high costs and no benefits. Federal investment funds come
discernible economic benefits.2 from the Small Business Administration
(SBA) for Small Business Investment
Sources of Funds Companies (SBICs) and investments made
Potential sources of funds must be by the Community Development Financial
considered throughout the decision- Institutions (CDFI) fund. NEV, CVLP,
making process. When organizers begin to and KHIC received CDFI funding, and
discuss the creation of a nontraditional North Dakota SBIC and First United
venture capital institution, it is important Ventures (FUV) in Oklahoma tapped the
that they have a realistic view of leveraging available through SBA. Title
alternative sources of funding for VII (no longer available) program funds
capitalizing the institution and the for community development corporations
implications of these sources for provided capital to KHIC.
management structure. In addition, The experience of site visit
organizers need to understand any institutions suggests several caveats to the
restrictions or covenants that are placed on use of public funds, particularly state
funds invested in the institution. For funds. Funding for a venture capital
example, if foundations are identified as institution should be provided in one lump
lead investors, their goals will be sum as opposed to annual appropriations
instrumental in setting the goals of the over a period of time. Annual
institution. If the state is the lead investor, appropriations of state funding tend to be
restrictions on investments to in-state subject to the vagaries of the political
firms will be likely. These constraints will process. This uncertainty with respect to
influence the decision-making options future funding availability may encourage
available to institution organizers.3 suboptimal investment decisions on the
Funding for the capitalization and part of the venture capital institution; for
management of the site-visit institutions example, the institution may feel pressure
came from public funds, private funds to invest the year’s appropriations
(individuals, commercial banks, public regardless of the availability of good deals.
utilities), quasi-private funds backed by In addition, failures among the
public incentives (tax credits), and institution’s portfolio companies are likely
nongovernmental organizations (nonprofit to occur before successes, cooling
foundations). Each funding source has its legislative support for future
own advantages and constraints. appropriations for the institution.
In some cases public funds come with
Public Funds restrictions, such as limiting investments
A number of institutions were to in-state firms or firms in a particular
capitalized either completely or in part by industry sector or region. While such
public funds, both state and federal. KVCI, restrictions may meet certain economic
MIN-Corp, NRVF, Iowa Seed Capital development objectives, they create
Corporation (ISCC), CRSF, and SEGF obstacles that limit the institution’s ability
received substantial state investments. to develop sufficient deal flow or to
Public capital may be compatible with partner with venture capital investors
goals of maximizing IRR in the low to outside the state or region. The ICC has
moderate range or meeting the dual reimbursed Iowa and KVCI has refunded
objectives of moderate IRR and social the state’s investment in the institution in
12

15. order to overcome limitations resulting If public funding is available for
from public investment. In both cases, capitalization of the venture capital
however, the repayment plans were institution, considerations must be given to
beneficial to both the state and the venture the tradeoffs between public and private
capital institution since state resources management of the funds. For example,
were made available for other uses. A state public funds can be invested directly into
constitution may limit the type of portfolio companies through a public or
investments an institution can undertake quasi-public institution like SEGF or
with public funds. SEGF was prohibited ISCC. SEGF is administered through the
from making pure venture capital Finance Authority of Maine, using staff
investments and, as a result, used a resources and an advisory board to make
complicated debt with warrants investment investment decisions. The state is engaged
structure that initially limited the number in direct investing in this institutional
of deals. After changes to SEGF’s structure.
investment structure were made within the The publicly managed approach, then,
confines of the state’s constitutional has the advantages of better targeting
restrictions on venture capital investments, investments and of subsidizing
deal flow increased. management costs. The principal
A venture capital institution with disadvantages are the potential for political
significant public funding may have interference in fund management and the
difficulty raising capital from private difficulty in attracting experienced venture
sources or finding private venture capital capitalists to run the public program.
firms willing to coinvest in potential deals. As an alternative to public
MIN-Corp, for example, found that private management, public capital can be
sources of capital were reluctant to invest managed by private venture funds like
in the fund because they presumed the NRVF, OCIB, and KVCI. In the OCIB
fund could continue to draw on public model, capital comes from institutional
resources. In addition, federal programs lenders and investors through the
such as the CDFI fund will not invest in Oklahoma Capital Formation Corporation
institutions with state control. More (OCFC). Principal and interest, if
seriously, private venture capital firms are necessary, are guaranteed by $50 million
reluctant to coinvest with public funds in state tax credits with limits of $10
because they perceive public funds may be million per year. The funds are used to
subject to political interference. They fear form partnerships with private venture
political pressure to invest in specific funds that have successful records of
firms, industries, or geographic areas at venture capital investing. These
the expense of the fund’s return on partnerships, in turn, focus their efforts on
investment. According to the site visits, identifying and making investments in
the potential for and impacts of political Oklahoma businesses, although they are
interference are perceived to be serious not restricted to in-state investing. This
enough that public funds must be model is particularly relevant when
organized in a way that insulates them prospective deals in the region are
from external pressures. Potential expected to achieve relatively high IRR.
investors must see clearly that this Private management of public funds
political interference is eliminated. provides greater insulation from political
pressure and higher potential for
13

16. competitive rates of return on the state’s capital. Utilities, for example, may invest
investments. However, private managers in venture capital institutions that operate
generally are less interested in the in their region. The principal sources of
economic development impacts of funding for ICC were two regional electric
investments. Thus, some targeting of cooperatives, and NEV received an
privately managed funds might be needed investment from a state utility.
to make this strategy relevant to the Alternatively, in Montana, utility
creation of nontraditional venture capital cooperatives made direct venture capital
funds.4 investments in existing and start-up
businesses in their service areas. Utility
Private Funds cooperatives are in a unique position to
For nontraditional venture capital provide venture capital to business
institutions that expect to achieve only enterprises because they may be willing to
moderate IRR or to focus on achieving accept a moderate rate of return on their
social benefits as well as moderate IRR, funds in order to maintain businesses
private funds have certain limitations. within their service area as customers.
Private investors interested solely in Most utility cooperatives also are in a
earning high IRR are unlikely to invest in position to take a long-term view of
venture capital institutions with dual investments, given their commitment to
objectives or in institutions where the region and their members’ strong roots
expected returns are below traditional in the community. However, state
venture capital market targets. However, regulatory constraints may limit the ability
the focus on social benefits and economic of a utility cooperative to make venture
development goals may enable an capital investments.5 Moreover, with
institution to attract investments from industry deregulation, electric power
banks seeking to meet Community cooperatives will have less incentive to
Reinvestment Act (CRA) requirements. participate in venture capital programs
Although the CRA has been used most since the new businesses will not
effectively in urban markets, the necessarily be power customers of the area
increasing presence of national banks may cooperative.
increase CRA’s usefulness in small towns
and rural areas. The Appalachian Ohio Public Incentives for Private Investments
Development Fund (AODF) was State tax credits to encourage private
successful in using CRA requirements to investments in private venture capital
attract bank financing for capitalization of funds are a hybrid of the public funding
its fund. and private funding alternatives. The
Angel investors can be an important certified capital companies (CAPCO)
source of private capital for a venture programs of Louisiana, Missouri, and
capital institution. In addition, angels can other states are one example of this
be coinvestors in deals made by venture funding process. Under CAPCO programs,
capital institutions. Angel investors also the state provides tax credits to insurance
are an important source of matching companies that invest in certified venture
capital for public funds that have private capital companies. In general, the
matching capital requirements like SEGF. insurance companies receive one dollar of
Some regions or states use tax credit spread out over 10 years for
unconventional sources of private venture each dollar invested in a CAPCO. The tax
14

17. credits are applied to the taxes paid on Legal and Organizational Structure
premiums earned by insurance companies In choosing an appropriate legal and
on insurance policies written in that state. organizational structure, organizers should
The CAPCOs, in turn, must invest in consider the goals and constraints under
specific types of state businesses which they will operate. In some cases,
according to a specified time schedule. institutions can operate independently,
CAPCO programs have been without affiliation or subsidy from a
successful in attracting private funds for parent organization. However, particularly
venture capital investments and in for the smaller funds created by some
encouraging the expansion of the venture nonmetropolitan communities, an
capital infrastructure in the states adopting independent structure may not be viable.
the program. However, under CAPCOs, As a result, affiliation with an existing
unlike the public funds alternative, the organization may be crucial for success.
public bears significant costs for tax
credits with all or most of the fund’s For-Profit vs. Nonprofit Organization
returns on investments going to the Venture capital institutions typically
CAPCOs and insurance companies.6 are for-profit enterprises. However,
particularly for institutions balancing IRR
Funding from Nongovernmental with economic development goals, a
Organizations nonprofit subsidiary or partner provides
Nongovernmental organizations, such institutional flexibility. The nonprofit can
as foundations, are more likely to be receive grants for technical assistance to
focused on economic development help offset the venture capital fund’s
objectives and to accept lower returns on operating costs. NEV’s institutional
their investments than private sources of structure features both nonprofit and for-
funding. National foundations provided an profit entities. KHIC features a parent
important impetus to the creation of some institution organized as a nonprofit
of the first venture capital funds focused community development corporation and
on rural or developmental markets. For several for-profit subsidiaries, including an
example, primarily national and regional SBIC.
foundations initially capitalized NEV. This Limited Liability Partnerships and
foundation support, in turn, helped Corporations
determine the institutional structure of the Most private venture capital funds are
fund. As more venture capital funds are organized as limited liability corporations
created, foundation support will likely (LLC) or partnerships (LLP), where the
change. Foundations may look to some general partners manage the investments
intermediary that can conduct due and the limited partners provide the
diligence on funds and reduce the burden majority of capital for the fund.7 These
of dealing with individual funds. For funds typically have a limited life of ten
nontraditional venture capital institutions, years. Investments are made during the
support from regional foundations may first three to five years and then exited
become increasingly important in the during the later stages of the fund. Returns
future. to investment are distributed to partners,
not retained in the fund to support future
investments.
15

18. LLPs are attractive if the institution is its SBA interest costs. Since this
seeking significant private funding, for instrument is not well suited to
example, NRVF. Private investors prefer investments in start-up enterprises, SBICs
LLPs because of the limited financial generally focus on later stage enterprises
liability, absence of managerial and expansion capital.
responsibilities, and fixed investment time In 1992, the SBIC program changed
period. Alternatively, LLCs provide more to facilitate more venture capital investing.
flexibility than LLPs and do not have a Participating securities SBICs can defer
limited life. LLCs provide a more interest payments until the SBIC realizes
permanent presence with more favorable gains through the sale of the investments,
tax treatment of gains than corporations so obstacles to making pure equity
have. investments are fewer. In addition to
interest payments, SBA receives a 10
Corporations percent participation in the SBIC’s profits.
Some institutions are organized as This new institutional structure is better
corporations. NEV, established to serve suited to making investments in promising
the northeast Minnesota region, used a early stage companies. North Carolina is
corporate structure because the investors, in the early stages of capitalizing a rural-
primarily foundations, wanted to create a focused state venture capital fund, using
permanent presence in the region. The the participating securities SBIC model.
corporate structure was in line with the The fund has received an initial $30
economic development goals established million commitment from large banks in
for the fund. However, when a corporation the state, with more fundraising planned
realizes a gain from the exit of a from smaller state banking institutions.
successful investment, corporate tax
liabilities place a significant burden on the Angel Networks
institution. The tax treatment for LLPs and An angel capital network is a less
LLCs is more favorable since gains are institutionalized form of venture capital
taxed at individual, not corporate levels.8 institution. Angel investors have high net
worth and are successful entrepreneurs,
Small Business Investment Companies providing capital and management
(SBIC) expertise to a limited number of start-up
Although not a separate legal form, companies. As part of the informal capital
the SBIC is a popular way to establish market, they are estimated to be the largest
venture capital funds. SBICs are private source of capital to new firms.9 While
venture capital institutions, licensed by the angels typically operate independently,
SBA. The license allows an institution to networks are formed to share information
leverage private capital with SBA- and pool capital resources. The MIG and
guaranteed funds, where SBA funds are ASCF, angel networks serving a very
offered at a fixed interest rate payable specific geographic region, pool the
semiannually. Until recently, most SBICs resources of successful business people to
borrowed money from the SBA. SBICs make investments in their communities.
typically provided subordinated debt with MIN-Corp, a nonprofit institution
the option to acquire equity in their operating in Minnesota, represents a more
portfolio companies, an investment institutional approach to angel networks. It
instrument that enabled the SBIC to cover is organizing angel investment networks,
16

19. structured as LLCs. While three networks The fund can operate at lower cost by
are currently operating, ten are planned.10 using the volunteer advisory board, but
As with most nontraditional venture this system limits the number of deals that
capital institutions visited, the level of can be considered. In addition, it is
coordination, the quality of due diligence, difficult to coordinate this type of
and success of investments of angel organization, and the costs of coordination
networks can vary significantly. More may become burdensome to the
analysis of these networks and their institution. Under the SEGF model
applicability to rural markets is needed. volunteer members of the board are not
considered part of the management team, a
Management of Investment Activity significant limitation. While they are given
Finally, decision makers must responsibility for conducting due
determine how to conduct the institution’s diligence, they are not accountable for
investment activities (Figure 6). their investment or strategic decisions.
Specifically, how will the institution Their lack of accountability could affect
screen prospects, select investment the quality of investment decisions made.
instruments, and exit deals? To a large Due diligence on prospective
extent earlier decisions will dictate investments for the small, local fund
choices. For example, a decision to use a ASCF is provided by several resources.
volunteer board will affect how due Businesses seeking funding from ASCF
diligence for prospective investments is agree to counseling with the Small
conducted. A decision to focus on very Business Development Center or Iowa
early stage investments will dictate an State University Innovations System. After
investment instrument structured more like prescreening, applicants are reviewed by
pure equity than debt. the executive director of the Ames
Economic Development Committee, a
Screening Prospective Investments division of the Ames Chamber of
Establishing a thorough system for Commerce, the fund investment review
conducting due diligence on prospective committee, and a private venture capitalist
investments is a key component to under contract with ASCF.
building a sustainable venture capital Venture capital institutions can also
institution. In many institutions, spread the risk or burden of due diligence
professional managers conduct due by partnering with other institutions, such
diligence with very limited input from as larger venture capital funds, on
investors. KVCI uses this approach. The investments or by requiring a matching
general partners make all the investment investment from another source. The
decisions for the investors, over 300 managers or advisors for each institution
Kansas banks. In other cases, an advisory conduct their own due diligence, reducing
board provides the technical expertise to the risk that a critical flaw in the business
conduct due diligence, aided by fund staff. plan, for example, might be overlooked.
SEGF operates in this manner since the This strategy is particularly important for
fund does not have a full-time professional smaller venture capital institutions,
manager. Members of the advisory board because larger deals can be put together
review business plans, visit entrepreneurs, through partnering and the burden of due
and do the market analysis required to diligence can be shared.
identify viable investment opportunities.
17

20. Figure 6. Management of Investment Activity
Screening Prospective Investments
• Responsibility for due diligence (fund managers,
volunteer advisory board, partner venture capital
funds)
• Identify management expertise
Select Appropriate Investment Instrument
• Subordinated debt
• Debt with warrants
• Convertible debentures
• Convertible preferred stock
• Preferred stock
• Participation agreements
• Royalties
Select Exit Strategies
• Initial Public Offering (IPO)
• Acquisition or merger
• Employee or owner buyout
18

21. In some cases, due diligence One cautionary note on investment
performed on a prospective company instruments is drawn from SEGF. The
concludes that the company has a good fund originally used a complicated
proposal, but the venture capital institution subordinated debt instrument with puts
is not confident that current company and calls. Portfolio companies had to incur
management can achieve what is the expense of hiring legal expertise to
proposed. Therefore, a second part of the interpret the instrument in order to make
screening process determines if the needed an investment decision. As a result, some
management expertise is available locally firms simply did not pursue the potential
or can be attracted to the area. If the local investment. The complicated structure was
economy provides infrastructure and due, in part, to state constitutional
support services, entrepreneurial restrictions on the fund taking a pure
development and small business growth equity position in the firm. However, the
will be more successful. CRSF noted fund recently restructured the investment
difficulty in finding people willing to instrument as a convertible debenture and
relocate to rural Colorado to manage and has had more success in attracting new
grow their portfolio companies. As a potential deals and meeting the needs of
result, portfolio companies did not develop their existing portfolio companies.
as anticipated. Alternatively, KHIC and Structuring venture capital deals can
NEV brought entrepreneurs into the region also be difficult in markets where the
and built deals around them. The provision entrepreneurs are unfamiliar with equity
of venture capital alone may not be capital. An equity investment requires
sufficient to build successful businesses giving up some ownership stake in the
that can contribute to the overall economic business, at least in the short term. For
development process. family-owned businesses, the owner’s
goals of passing the business to the next
Selecting Investment Instruments generation may be threatened by an equity
Investment instruments used by a investment in contrast to an investment
venture capital institution include pure instrument structured as debt with equity
equity such as stock and quasi-equity features.
instruments such as debt with warrants,
debt with equity kickers, royalties, Involvement in Portfolio Company
participation agreements, and convertible Management
debt. Most institutions have a preferred The level of involvement with
investment instrument, and the choice of portfolio company management is a
instrument will depend, to some extent, on function of the expertise of the venture
the source of funds and the institution’s capital institution’s staff. Many traditional
preferred exit strategy. For example, venture capital funds require a seat on the
SBICs traditionally used subordinated debt portfolio company’s board as a condition
or debt with warrants to generate a stream of investment. The managing partners
of current income that could be used to have technical expertise that they can
cover interest costs on SBA leveraged contribute to the company’s board. This
funds. board presence allows investors to follow
management decisions and, if necessary,
19

22. intervene in the decision-making process. manufacturing firms that dominate small
The nontraditional venture capital towns and rural areas, IPOs are less likely
institutions visited are involved in the to be successful, particularly in the current
management of their portfolio companies volatile market. While acquisition is a
at different levels. Some institutions viable strategy in small market areas, this
require a board seat and maintain active strategy may not work for institutions that
involvement in company management. In have the dual objectives of competitive
some cases, new management, such as a IRR and economic development benefits.
chief financial officer, is brought into the The sale of a company to an outside party
company as a condition of investment. may provide positive financial returns to
Other institutions, such as SEGF, do not the venture capital institution, but if the
always take a seat on a company’s board plant relocates, economic development
since oversight of investments is the impacts may be negative. For institutions
responsibility of a volunteer board. with an interest in economic development,
The level of involvement with an employee or owner buyout provides
portfolio companies also varies over the liquidity to the venture capital institution
life of the investment. If a company is and retains economic benefits in the local
doing well, the venture capital institution area. However, unless the owner or
is unlikely to intervene in management employees borrow funds to finance
decisions. If the company encounters purchase of the business, payments are
problems, the managing partners may usually structured to fit within the cash
provide assistance themselves or through flow limitations of the business and are
outside consultants, they may make an typically made over a relatively long
additional investment to strengthen the period of time. As a result, the financial
company, or they may be involved in return on the investment is likely to be
replacing an existing company smaller for the venture capital institution.
management team with a new team. The
level of involvement depends on the Summary and Conclusions
expertise and resources of the venture The establishment of a venture capital
capital institution’s managers. institution is complicated, time-
consuming, and expensive. It is even more
Exiting the Deal difficult in small market areas than urban
Exit strategies present important centers. Nonmetropolitan communities
challenges to venture capital investors. In and rural areas have a relatively small
a recent study of Canadian markets, survey number of firms that are familiar with and
results show the importance of exit receptive to the concept of venture
potential to venture capital investment investments. These areas often lack the
decisions. According to the study, venture management expertise, support services,
capitalists consider the prospects for a and infrastructure beneficial for
profitable exit when deciding whether to entrepreneurial and small business
invest and what the terms of investment development. Businesses have relatively
will be.11 Most venture capital institutions few options for exiting deals with venture
exit successful investments through an capitalists. The costs of managing a
initial public offering (IPO) of stock, venture capital institution with a small
acquisition by another firm, or employee market focus also can be high due to the
or owner buyout. For traditional
20

23. geographic dispersion of portfolio their costs and can capture the external
companies. benefits.
The relatively unfavorable Despite the success of a number of
environment for venture capital nontraditional venture capital institutions,
investments in small market areas partly all institutions interviewed for this study
explains why venture capital investments said that they would do things differently
are highly concentrated in metropolitan if they had the opportunity to start anew.
areas. Yet this study finds examples of That is, earlier decisions regarding goals,
successful venture capital institutions that funding, management and investments
are located in nonmetropolitan would have been made differently had the
communities and rural areas. In general, institution known the implications of their
these nontraditional venture capital decisions. They would have benefited
institutions can function in the limited from a formalized decision-making
investment environment because (1) they process demonstrating the linkages
have a patient source of investment funds, between early decisions and those that
(2) they are willing to accept less than the followed. The decision-making process
market rate of return in exchange for described here can be used as a guide to
external or social benefits, or (3) they are creating nontraditional venture capital
affiliated with organizations that subsidize institutions in small urban centers and
rural communities across the U.S.
21

24. Endnotes Julia Sass Rubin, 2001. “Certified
Capital Companies (CAPCOs): The
1. An option for smaller funds may be to Latest Wave in State-Assisted
have a staggered fee schedule. Fees Venture Capital Programs,” Economic
can be higher in the initial years and Development Quarterly, forthcoming.
then be reduced over time so that the
average is 2 to 3 percent. 7. For a discussion of LLPs and LLCs,
see Sahlman, W. A., 1990, “Structure
2. Barkley, David L., Deborah M. of Venture-Capital Organizations,”
Markley, and Julia Sass Rubin, 1999, Journal of Financial Economics,
“Public Involvement in Venture 27:473-521.
Capital Funds: Lessons from Three
Program Alternatives,” Columbia, 8. Executives with Iowa Capital
MO: Rural Policy Research Institute, Corporation noted that they would not
University of Missouri, P99-9. have selected the corporate structure
had they known how successful the
3. Organizers also must consider who fund would be. ICC is investigating
will be responsible for the costs of alternative structures such as LLC or
creating the venture capital institution. LLP to reduce the fund’s tax
Both time and money are required to liabilities. Northeast Ventures is in the
create an organization and raise the process of converting from a C
funds to capitalize it. According to corporation to a nonprofit corporation
Pete Bloomer of Colorado Venture largely because of the tax
Management (Boulder, Colorado), it consequences associated with the
takes approximately one year and corporate structure.
$300,000 to create a venture capital
fund. 9. Gaston, Robert J., 1990, “Financing
Entrepreneurs: The Anatomy of a
4. Interested readers may refer to Hidden Market,” chapter in Financing
Barkley, Markley, and Rubin (1999) Economic Development: An
for a more thorough discussion of the Institutional Response, edited by
advantages and disadvantages of Richard D. Bingham, Edward W. Hill,
alternative publicly-assisted venture and Sammis B. White, Sage
capital programs. Publications.
5. For more information on the Montana 10. For more information, see Jossi,
cooperatives, see Freshwater, David, Frank and Paul Duncan, 1998,
1998, “Utility Cooperatives as a “Angels take Wing,” Ventures,
Source of Equity Finance: Montana (October): 34-36.
Examples,” Department of
Agricultural Economics, University of 11. MacIntosh, Jeffrey G., 1997, “Venture
Kentucky, Staff Paper No. 386, Capital Exits in Canada and the
(November). United States,” Financing Growth in
Canada, edited by Paul Halpern,
6. For a more in-depth discussion of University of Calgary Press.
CAPCO programs, refer to Barkley,
David L., Deborah M. Markley, and
22