Regional Update (April-June 1998)

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Cover Story - Emerging Venture Capital Investment in the Southeast

The Productivity Puzzle: Increasing Output in Tight Job Market

Emerging Venture Capital
Investment in the Southeast

V enture capital investment throughout the Southeast has increased dramatically in recent years. In fact, some states in the region have experienced a growth in venture capital investment that is four times the national average. This surge is the result of several trends: the region's overall economic expansion, the gradual emergence of regional venture capital firms, increasing competition in other venture markets and the growth of high technology and communications-related industries in the Southeast.

Venture capital investing is an important alternative source of funds for less developed, higher-risk entrepreneurial firms that may not be able to finance business expansion through bank loans or securities underwritten by investment banks.

In recent years, the nationwide average venture capital investment has risen steadily to $6.9 million, according to Whitney Johns, chief executive officer of Capital Across America, a venture capital company, and Whitney Johns & Co., an acquisition consulting firm, and a board member of the Nashville Branch of the Federal Reserve Bank of Atlanta. Venture capital has a history of being invested through the Northeast and Silicon Valley. About 30 cents of every venture capital dollar is invested through Silicon Valley, said Johns. But today, venture capital investments are becoming more widespread.

Venture capital investing involves professional investors who take a medium-term equity position in a firm and whose primary reward is an eventual capital gain, rather than interest income or dividend yield. When venture capitalists or investing partners sell or otherwise liquidate equity stake in the venture, their capital gain is realized, provided the investment is profitable.

Venture capitalists may be categorized in terms of their sources of investment capital — captive or independent — and the stage of business development in which they focus their investments. Captive firms are generally parts of banks or insurance companies, often funded through the parent institution, whereas independent firms must seek funding through third parties.

Venture capitalists pool investment funds from a variety of limited partners. In addition to making money, their primary goal, regardless of the stage in which the venture capitalists enter the financing, is to move the firm sequentially to an agreed-upon development stage. Once that agreed-upon stage is reached, the partners liquidate their equity and obtain any investment gains. (James Plummer of QED Research Inc. defines eight stages of venture capital investment. The first four are seed investment, startup, early development and expansion. The last four stages reflect various levels of a firm's liquidity, ranging from profitable but relatively illiquid to the final stage, at which venture capital investors can profitably gain liquidity from a substantial portion of their holdings in a company.)

Many businesses that otherwise would not receive conventional bank funding are able to start-up or expand through venture capital investments, and that trend is increasing. For example, with her new company, Capital Across America, Johns plans to target investing in the Southeast and the Midwest and offer women-owned and small businesses growth capital through use of a debt instrument.

Venture Capital Investment Returns

Because of their more intimate managerial control over the firms in which they invest, venture capitalists may make decisions that run counter to the interests of outside investors. A 1995 study by the Board of Governors of the Federal Reserve System cited some examples of these conflicts, such as general partners "spending too little time advising or monitoring the portfolio companies, charging excessive management fees, taking undue investment risks and reserving the most attractive investment opportunities for themselves and their associates." Potential misalignments of the interests of general and limited partners may be minimized by a variety of contractual methods.

Venture capitalists, however, generally assume a high level of risk when investing in a particular firm. According to William Sahlman of Harvard University, 34.5 percent of all venture capital invested results in losses. For many investors, the potential gain outweighs any risks. Research suggests that the return on venture capital investments has been quite high at times. Data from Venture Economics indicated that the average rate of return for liquidated venture capital partnerships formed between 1969 and 1982 was 18.2 percent, 17.8 percent for partnerships formed between 1969 and 1975, 29.7 percent for those formed between 1976 and 1979, and 13.1 percent for those formed between 1980 and 1982. These returns have been volatile, however, and vary by the stage of investment in which the venture capitalist specializes. A seperate Board of Governors' study found that the median internal rates of return as of 1993 for active venture capital partnerships formed between 1980 and 1989 was 6.3 percent.

Venture Capital and the Southeast

In the Southeast, venture capital has grown as a source of investment funding. Data from The Private Equity Analyst shows that venture capital raised by funds in the Southeast grew from $14 million in 1990 to $57 million in 1993 and $206 million in 1995. In 1997, Florida, Georgia and Alabama all experienced significant increases in venture capital investment over the previous year. According to data from Coopers and Lybrand's 1997 Money Tree Report, Florida's venture capital dollars increased 15 percent, Georgia's increased 66 percent and Alabama's increased 136 percent. Figures from Price Waterhouse indicate that in 1996 the Southeast (Alabama, Florida, Georgia, Mississippi, North Carolina, South Carolina and Tennessee) had 174 venture capital investments; this number grew to 265 in 1997.

"In recent years, the nationwide average venture capital investment has risen steadily to $6.9 million."

Whitney Johns
CEO, Capital Across America
and Whitney Johns & Co.

Venture capital investments in firms in the Sixth Federal Reserve District states of Alabama, Florida, Georgia, Louisiana, Mississippi and Tennessee vary widely in industry type, stage of development and magnitude. Thirty-two percent of the funds invested in the Southeast by venture capital firms went to healthcare businesses. The next largest investments were communications companies (27 percent), followed by software and information (13 percent), consumer businesses (7 percent), business services (6 percent), industrial (6 percent), and electronics and instrumentation (5 percent).

The expansion of healthcare, though part of a nationwide trend, has been concentrated in the Southeast because of the large growth in the elderly population in certain areas of the region. While many of the firms that have received venture capital funding in the Southeast are service-oriented, such as long-term healthcare facilities, the area has also seen growth in healthcare technology-related firms. For instance, in Georgia during the fourth quarter of 1997, five healthcare-related firms, including medical instruments and devices and two software firms specializing in healthcare, received venture capital. Although the largest of these investments was in a company that owns and operates long-term healthcare facilities, other firms provide healthcare information systems for home-care nursing professionals and develop and sell integrated clinical healthcare software. Another firm is developing a magnetic device to reduce incontinence.

Like healthcare firms, the region's communications, software and information companies have experienced a rise in venture capital investments. One reason these firms have concentrated in the Southeast is that highly trained and technically proficient employees are available in certain areas of the region. Another reason for the massing of these industries in the region is that, as more firms are established in the region in a certain sector, other firms in the same industry are attracted by costs savings, access to employees and other inputs, such as information sharing.

Georgia's venture capital investments have been not only the largest in the Southeast but also the most diversified, with no one sector dominating the field. While the largest venture capital deal in Georgia in 1997 involved a healthcare firm that operates long-term care facilities, there were 15 venture capital deals in Georgia totaling over $46 million in the fourth quarter of 1997 alone that involved software companies.

Communications played a large role in Florida's venture capital market last year. In the fourth quarter of 1997, four of Florida's 13 venture capital deals involved communications firms, and one of the largest venture capital deals in Florida in 1997, $30 million, involved a communications company. Other communications deals ranged from a $3 million start-up investment to $20 million invested in a company's second stage of development.

Although Alabama's 16 venture capital deals were distributed in seven industries, most of the state's venture investment activity was in the healthcare industry. In Tennessee, Louisiana and Mississippi, as in Alabama, the largest single deal and largest percentage of venture capital distribution in 1997 were in the same industry. Mississippi's venture capital investments were the most limited of the six southeastern states. In 1997, Mississippi had only two venture capital deals compared with 81 deals in Georgia.

Venture Capital in the Southeast in 1997
(in dollars)
Industries Alabama Florida Georgia Louisiana Mississippi Tennessee

Biotechnology 500,000 2,539,000
Business services 24,307,000 4,374,000 22,250,000 500,000
Communications 5,000,000 140,268,000 79,641,000 700,000 9,463,000
Computers and peripherals 90,000 226,000 3,500,000
Consumer 7,500,000 12,000,000 28,300,000 9,420,000 1,200,000
Distribution/ retailing 3,800,000 20,320,000 500,000
Electronics and instrumentation 10,600,000 17,785,000 11,700,000
Healthcare 23,100,000 96,400,000 88,770,000 3,050,000 72,416,000
Industrial 10,965,000 18,680,000 8,100,000 15,000,000
Medical instruments and devices 5,305,000 1,000,000
Pharmaceuticals 6,450,000 1,025,000
Software and information 2,501,000 27,800,000 84,570,000 1,500,000
 
TOTAL 49,291,000 340,001,000 347,699,000 36,100,000 10,420,000 99,604,000
Number of deals (actual numbers) 16 59 81 12 2 21

Source: Price Waterhouse National Venture Capital Survey for 1997

While many southeastern states are experiencing clusters of venture capital investments, some, like Florida, Georgia and Alabama, not only have seen such investments made in a wide range of industries but also have experienced a fairly even distribution of venture capital assets across industries. In contrast, Tennessee, Louisiana and Mississippi have over 60 percent of their venture capital investments clustered in a single industry.

Venture capital has become an important element in the Southeast's economic growth, particularly in the development of start-up companies. Venture capital funds have helped spark development and retain jobs throughout the region and have enticed other firms to relocate to the Southeast. As technology expands and the need for healthcare continues to rise nationally as well as in the Southeast, opportunities for entrepreneurs, venture capitalists and other investors will likely grow. The combination of the firms and investors already present, expanding access to highly skilled personnel and the development of the Southeast's economy in general bode well for the expansion of venture capital in the region.

Editor's note: Edgar Parker of the regional research group contributed to this article.