Response to February 20, 2002 Tax Update



You unfortunately have misconstrued the structure and operation of the Iowa

Fund of Funds, part of the new Iowa Capital Formation Act recently passed by

the Legislature.  You apparently believe that this fund will be similar to

that of a certified capital company, known as CAPCO, a dramatically

different approach which was passed by the Iowa Legislature two years ago

and vetoed by the Governor for the very reasons you cite. Your newsletter to

clients was quoted as noting:


"In other words, the investors in the FOF get the upside, but the state

absorbs the downside - and even some of the upside, to the extent that there

is a positive return lower than the amount set by the certificate. In other

words - heads, the investors win, tails the state loses."


In fact, you fail to notice that, due to the tax credit which provides full

repayment security to Iowa taxpayers purchasing the preferred stock of the

Fund of Funds, their required rate of return will be similar to that on

medium-term governmental debt instruments.  In Oklahoma, where this plan was

first implemented, the return on their Fund of Fund instruments (circa 1995)

was approximately 8 percent.  In today's environment, it will approximate 5

to 5.5 percent.  However, the average long-term rate of return on

investments in venture capital limited partnerships has been in excess of

fifteen percent over an extended period.  Oklahoma experienced a 19 percent

positive return during the five year period from inception through 2001.

The Iowa Seed Capital Corporation, under its last management team,

experienced approximately 15 percent compounded annual return.  The

difference between what is due the investors in the Fund of Funds (i.e.,

5.5%) and the net return on the Fund's investments in VC limited

partnerships, expected to approximate 15 to 20 percent over their lifetimes,

will be retained by the Fund of Funds and be used for two purposes: first,

to be reinvested in additional VC partnerships, and second, to redeem

outstanding preferred stock in the Fund of Funds so that it becomes

self-supporting, without the need for tax credits, once the credits expire

after twenty years.  At the end of fifty years, the entire net assets of the

Fund of Funds revert to the General Fund of the State of Iowa.


As a result, appropriate compensation-for-risk-assumed is in fact given to

the State, the grantor of the contingent tax credits.  For what is likely to

be zero cash outlay, the State of Iowa, (at the end of the FoF lifetime)

receives all accumulated net profits above a nominal return in the range of

5.5%.  Of course, the probability of this occurring is directly related to

the skill sets of the VC managers selected to invest the funds.  Because VC

historical returns are in fact measurable and venture managers' skills may

be examined in detail, and because good managers tend to have consistent

track records, the Fund should be able to select those managers able to

deliver above-average results.  Hence, the Fund can improve its ability to

deliver stellar returns to the State (the residual legatee) by carefully

selecting and supervising its venture capital limited partnership managers.

It will do so through the judicious selection of a skilled, experienced

"gatekeeper" fund allocation manager, a common practice in the venture



I hope that this clarifies the operation of this fund.  Because your

newsletter is disseminated to a variety of clients who have less insight

into this new bill and may likewise confuse it with a CAPCO, I also hope

that you will publish a correction by email so that your clients are not

misled by the intent and operation of the new statute.


As to your comments about tax efficiency, you are quite correct in noting

that many investments by venture fund limited partnerships may be "tax

inefficient" for either Iowa or federal purposes because of the form of

organization adopted by their investee companies.  Subchapter S is

unavailable to most VC-funded firms because the issue of a preference class

of shares will cause an automatic conversion to C.  In such cases, tax

efficiency is traded for the benefits of a more complex capital structure.

Limited liability companies and partnerships are increasingly being used to

avoid the limitations of S while preserving pass-through advantages, and you

rightly point out that they do not benefit from the apportionment changes in

Iowa.  However, any LLC or LLP seeking equity capital in public markets will

generally convert to a C form. Despite all this, one of the least concerns

in making a venture investment is the tax status of the entity: most

investees are loss-making or on carryforward status through the point of

liquidation by the fund.  The fund itself, being a pass-through entity,

passes its capital gains and other attributes through to its partners, whose

status in many cases is tax exempt.  For all of these reasons, your point is

therefore only of academic or technical interest and bears little relation

to the needs or actions of venture capital partners or the Fund of Funds.


Please contact me with any questions.

Best regards,

Stephen Ringlee