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Vol. 72, No. 5, May 1999

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Attracting Venture Capital
for Business Start-ups

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.