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                                  Venture Capital
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                                                                             for Communities
                                                by Kerwin Tesdell, President, Community Development Venture Capital Alliance

              Community development venture capi-                           those that are environmentally fo-           jobs that pay a living wage. To pro-
              tal (CDVC) is one of the fastest grow-                        cused. They invest in such businesses        duce the financial portion of the double
              ing sectors in the field of community                         as new-economy manufacturing com-            bottom line, CDVC funds must seek
              development finance. From a handful                           panies and promising new service-sec-        out companies that hold the promise
              of funds in 1990, the industry has                            tor firms, which can offer good em-          of rapid growth. Companies that are
              grown to more than sixty funds in the                         ployment to large numbers of low-in-         growing and successful can afford to
              United States, and at least another                           come people. They seek to apply prin-        pay higher wages than companies that
              twenty funds operating or in forma-                           ciples that have helped create unprec-       are just scraping by. Successful com-
              tion in other parts of the world. In the                      edented economic growth in places            panies tend to offer better benefits to
              last year alone, CDVC under manage-                           from Silicon Valley to areas often left      their employees, as well as job train-
              ment in the U.S. has grown to $400                            behind such as rural Appalachia, in-         ing and opportunities for advancement,
              million, up $100 million dollars from                         ner-city Baltimore and Nizhny                and to attract and retain the workforce
              the end of 2000. Almost $40 million of                        Novgorod, Russia.                            they need for expansion.
              this increase was raised by three es-                                                                         By providing equity and near-equity
              tablished managers that have success-                         THE IMPORTANCE            OF   EQUITY        investments to businesses that other-
              fully closed on second funds.1                                CAPITAL                                      wise would not have access to them,
                                                                            Equity capital is vital to all businesses.   CDVC funds create a powerful engine
              THE DOUBLE BOTTOM LINE                                        It provides a cushion against slow           of economic growth. Equity invest-
              CDVC funds use the tools of venture                           business climates and is relatively pa-      ments are made through the purchase
              capital to create jobs, wealth and en-                        tient and flexible. As any banker ana-       of common or preferred stock, while
              trepreneurial capacity to benefit low-                        lyzing debt/equity ratios can tell you,      near-equity investments might be made
              income people and distressed commu-                           without sufficient equity, companies         through a subordinated loan that car-
              nities. They are mission-driven funds                         cannot borrow additional funds. Most         ries an “equity kicker,” such as royal-
              that invest in businesses that promise                        important for economic development,          ties or warrants to purchase stock.
              rapid growth. This growth creates not                         equity provides the seed funding to          These investments each carry signifi-
              only financial returns for the fund and                       start new companies and allows es-           cant risk of loss but are structured so
              its investors but also social returns in                      tablished companies to develop new           that the fund will share the “upside” of
              the form of good jobs for low-income                          products or build new plants—activi-         the business if the business does well.
              people—a double bottom line.                                  ties that create signifi-cant new em-
                 CDVC funds apply disciplined eq-                           ployment and economic opportunity.           MORE THAN MONEY:
              uity investment practices in places                              Equity capital is difficult for any       ENTREPRENEURIAL AND
              where other venture capitalists do not                        company to raise. Most entrepreneurs         MANAGERIAL ASSISTANCE
              go: inner cities and distressed rural                         raise initial equity capital from their      CDVC funds become part-owners of
              communities. They offer financing to                          own savings and those of family and          the companies in which they invest,
              minority- and women-owned firms and                           friends, but this is particularly hard to    tying their own success directly to the
                                                                            come by in low-wealth communities.           success of their portfolio businesses.
                                                                            A ready source of equity capital can         As a result, CDVC funds invest not just
                1              This includes Silicon Valley Community
                               Ventures of San Francisco, California,
                                                                            thus be an extraordinarily effective tool    money but a great deal of time and
                               which closed its second fund with a $10      for fueling the creation of new wealth       effort in helping the companies in
                               million commitment from the Califor-         in economically distressed areas and         which they invest succeed. They typi-
                               nia Public Employees’ Retirement             also new job opportunities for people        cally take seats or observer rights on
                               System—the first capital ever committed      who need them.                               the boards of their portfolio compa
                               to a CDVC fund by a retirement fund.            CDVC funds seek to create good

nies. Fund staff may help with such         vided a little over a third of the eq-        raising money to start second funds and
activities as raising additional capital    uity capital to CDVC funds started            two new federal programs have been
or marketing a new product. Fund staff      before 1998, banks provided about             introduced that will further boost the
may even fill the chief financial officer   two-thirds of the equity capital raised       field: the New Markets Venture Capital
function for a company for a period         by funds formed after that year. And          (NMVC) and New Markets Tax Credit
of time, then help recruit a new head       the range of legal structures used by         (NMTC) programs, both enacted in
of finance. Extensive entrepreneurial       CDVC funds offer banks a variety of           December of 2000.
and managerial assistance is central to     investment options including the pur-            In July of 2001, the Small Business
the economic development function           chase of interests in a limited part-         Administration conditionally designated
of CDVC funds and often proves as           nership or limited liability company,         seven new NMVC companies. The
important to the success of portfolio       the purchase of stock in a corpora-           NMVC program provides capital in the
companies as the financing itself.          tion, straight debt, equity equivalent        form of zero coupon debentures3 and
   Taking this assistance a step further,   investments2 and capital grants.              operating assistance grants to NMVC
several funds have learned to act as           Based on a survey of 25 CDVC               funds that invest in small businesses in
intermediaries between local                funds, the average capitalization per         low-income areas. NMVC companies
workforce development programs and          fund was $12.7 million at the end of          must raise matching funds from the
the businesses in which they invest.        2000 and the median for these funds           private sector for both the capital and
Adding value to portfolio companies         was $6.2 million. However, newer              the technical assistance grant. The seven
by helping to recruit trained employ-       CDVC funds are starting out larger.           funds aim to raise between $5 million
ees from distressed areas and disad-        The three funds that raised capital in        and $12.5 million in private capital and
vantaged populations augments a             2001 each began life in the $12 to            an additional $1.5 to $3 million in pri-
fund’s social and financial bottom          $13 million range.                            vate operating assistance grants. The
lines. Likewise, some funds have               Because most CDVC funds are rela-          target date for a second round of NMVC
learned how to help their portfolio         tively young, it is impossible to quan-       selection is the fall of 2002.
companies use government tax incen-         tify precise financial or social returns.        The New Markets Tax Credit provides
tives and other programs in empow-          However, a sample of the older funds          a dollar-for-dollar credit of 39% of the
erment zones and other economically         indicates that they have created ap-          amount invested in a community de-
distressed communities. In this way,        proximately one job for every $10,000         velopment venture capital fund, spread
the funds make it not only financially      invested. These job creation numbers          out over a period of seven years. A com-
possible but also attractive for a busi-    are particularly impressive in light of       munity development venture capital
ness to locate in a low-income area         the fact that the funds surveyed were         fund that wishes to participate in the
and hire area workers.                      all operating in very depressed rural         program would apply to the Commu-
                                            areas. And, of course, the money in-          nity Development Financial Institutions
FACTS    AND    FIGURES                     vested is not spent, but returned to          (CDFI) Fund for an allocation of tax
While CDVC funds share a common             investors or recycled to invest in other      credits. If such an allocation is awarded,
mission, they take a number of legal        companies to create more jobs in the          the fund can go to the market to raise
forms, including: limited liability com-    future.                                       capital with the tax credit as a strong in-
panies; limited partnerships; regular                                                     ducement to investors. The NMTC pro-
“C” corporations; and not-for-profit tax-   OPPORTUNITIES                                 gram will pump $15 billion into com-
exempt corporations. Their capital          AND CHALLENGES             AHEAD              munity development venture capital
comes from sources that share their         The environment in which CDVC                 funds and other investments in low-in-
interest in a double bottom line re-        funds and their investors operate has         come urban and rural areas of the coun-
turn, including foundations, banks ful-     changed significantly during the past         try with $2.5 billion available in 2002.
filling their Community Reinvestment        year. New funds are forming at a rapid           These two programs together offer
Act obligations, other corporations,        pace, mature funds are successfully           unprecedented opportunities to the
government and wealthy individuals.
    Although foundations and other
socially motivated investors led the        2   For more information on equity-           3   Unsecured debt backed only by the
way in the development of the indus-            equivalents (or EQ2s), please refer to        integrity of the borrower, not by
try, banks have now supplanted these            Mark Pinksy’s article on page 10.             collateral, and documented by an
investors as the leading source of capi-                                                      agreement called an indenture. One
tal for the industry. While they pro-                                                         example is an unsecured bond.

                                                                                         Community Investments March 2002          25
                                                        community development venture                      difficult task of trying to define for in-
ABOUT THE AUTHOR                                        capital industry. At the same time, they           vestors this unusual activity with few
                                                        offer some challenges. The industry                points of reference; now those raising
                                                        must be careful that the regulatory                funds have an entire industry to point
                                                        definition of New Markets investing—               to. Investing in CDVC funds is an es-
                                                        based on geography—does not re-                    tablished activity and a number of
                                                        place the more nuanced and power-                  larger institutional investors have staffs
                                                        ful methods that mission-driven CDVC               of people with expertise and budgets
                                                        funds use to produce their social re-              dedicated to that purpose. People are
                                                        turns. These methods take into ac-                 building careers in CDVC funds, de-
                                                        count not only the area in which a                 veloping a unique set of skills that
KERWIN TESDELL is president of the Community            business is located but also a com-                combine those of venture capital fi-
Development Venture Capital Alliance                    plex mix of factors including the types            nance and economic development. At
(, the trade association of com-          of jobs the business is likely to create           the same time, the CDVC field is
munity development venture capital (CDVC)               and the types of people who are likely             changing rapidly, with an unusual
funds. It provides training, technical assistance       to take those jobs.                                spirit of experimentation and learning
and consulting services to the field; operates a           Perhaps more important than any                 that will serve it well in the search for
Central Fund that invests in and co-invests with        legislation is the fact that community             innovative ways to produce double
CDVC funds; performs and publishes research;            development venture capital is be-                 bottom line results. CI
and advocates for the field.                            coming an established and recognized
Community Development Venture
                                                        industry. Someone raising a CDVC
Capital Alliance
                                                        fund six or seven years ago faced a
330 Seventh Avenue, 19th Floor
New York, New York 10001

                                          THE FEDERAL RESERVE BANK                    OF   SAN FRANCISCO
                                                                   IN PARTNERSHIP WITH

                                               THE UNIVERSITY          OF   SOUTHERN CALIFORNIA
                                                                                                                         LOS ANGELES BRANCH
                                                                      PRESENT THE

                                                                  JULY 21–25, 2002

    Join Us
      for five days of intensive training on the key issues and current industry trends relevant to community development lending in today’s business
      environment. Training in five core areas—single-family and multi-family housing, small business, commercial real estate and community-based
      facilities lending—stresses the day-to-day mechanics of underwriting community development loans and ensuring their long-term profitability.
         A redesigned and challenging curriculum has been developed by an advisory committee of community development bankers, training
      professionals and representatives of bank regulatory agencies to focus on structuring and underwriting community development loans. Each
      course is developed to ensure that students receive the most current, relevant, challenging and applicable instruction available. In addition,
      students will have the opportunity to participate in evening roundtables and seminars that focus specifically on issues that have been raised
      during the day’s courses.

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                               REGULATORY OVERVIEW


Definition:    Community development venture capital organizations (CDVC) use the tools of venture capi-
               tal to conduct community and economic development activities as defined in the CRA regu-
               lation. CDVC funds make equity and equity-like investments in small businesses that hold the
               promise of rapid growth and a “double bottom line” of not only financial returns, but also
               community and economic development benefits. CDVC funds come in many different forms,
               including not-for-profit, for-profit, and quasi-public organizations. Their structures encom-
               pass for-profit “C” corporations, limited partnerships, limited liability companies, community
               development corporations (CDCs) and Small Business Investment Companies (SBICs). CDVCs
               fund investments ranging from the purchase of preferred and common stock to the provision
               of subordinated debt with equity “kickers” such as warrants or royalties. Investments in
               CDVCs should be carried as investments on the investing institution’s balance sheet in accor-
               dance with Generally Accepted Accounting Principles (GAAP).

CRA            A lawful investment, deposit, membership share or grant to a community development ven-
Applicability: ture capital fund that has as its primary purpose community development will be considered
               a qualified investment/community development investment under the CRA regulation.


                                       Please mark your calendars for
                                 The Federal Reserve System’s
                                Sovereign Lending Conference
                   “Banking Opportunities in Indian Country”
                             A national conference to encourage initiatives and partnerships
                       that increase access to credit and capital and strengthen local economies

                                   THE DOUBLETREE PARADISE VALLEY RESORT
                                           SCOTTSDALE, ARIZONA
                                         NOVEMBER 18–20, 2002

                                           More information will follow