The Equity Partnership As A Seed For Start-ups

Since the limited partners get the early losses, they demand less equity from founders at the time of tax-free conversion.

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Venture capitalists have invested more than $1 billion in each of the past two years, but very little of the money has found its way to start-up companies. In fact, many of the newest and biggest suppliers of investment dollars, notably pension funds and large companies, instruct venture fund managers to invest only in more mature enterprises needing second- or third-stage financing. Yet however scarce true "seed" capital may be, a small but growing number of venture capital groups are gearing up to meet early financing needs of at least some entrepreneurs through a vehicle rare in money-raising circles: equity research and development partnerships.

Equity R&D partnerships are cousins of the more straightforward R&D limited partnerships that recently have been in the spotlight (see INC., March, page 63). But instead of providing investors with a current tax shelter and a future royalty interest in a single product, the equity R&D deals are designed to launch not just products but entire new companies. In the early years, investors get tax benefits as limited partners in start-up (and money-losing) enterprises, but later on, as the initial losses disappear, they are asked to convert their partnership interests into an equity stake in the company.

Venture capital experts based on the West Coast expect several new equity R&D partnerships to be up and running by year-end with newly raised pools of capital earmarked for start-ups. And many believe that the timing couldn't be better. As some of the more established and well-funded venture capital pools chase after secondand third-stage multimillion-dollar investments, "there's been a real hole in the marketplace for smaller deals in newer companies," says Nicholas Moore, an equity partnership specialist in the San Jose, Calif., office of Coopers & Lybrand, a Big 8 accounting firm. Indeed, unlike the big funds, which aim at relatively riskless investments on behalf of ension funds and corporations, managers of the new-style equity partnerships say they want to put their cash principally into attractive -- and risky -- young companies seeking less than $1 million.

One fund moving aggressively to capitalize on the dearth of seed capital is Crosspoint Venture Partners of Palo Alto, Calif. Having already assembled more than a dozen equity R&D partnerships under the name of Crosspoint Financial Corp. for its own founders, it intends to expand on the approach with the money it raises from outside investors. While previous deals have involved only one company at a time, by year-end, says John Mumford, a managing general partner, the group expects to have $15 million for investment in many start-up businesses at once. Crosspoint, however, is not the only venture capital player doing equity R&D deals. Among the others in the field are Bay Partners II of Mountain View, Calif., and Alpha Fund of Palo Alto.

Mumford characterizes Crosspoint's perspective and role as "that of both the entrepreneur and the venture capitalist." Having worn both hats, he is convinced that the approach offers important advantages for each. "For the manager, the key is that he gets to retain the maximum amount of equity in his company," Mumford explains. But the tax benefits of the limited partnership, he adds, enable the investor to commit less money on an aftertax basis than other equity investments not eligible for tax write-offs.

The mechanics of equity R&D partnership investments are relatively simple. Since the $15 million Crosspoint Venture Partners Fund, which will invest in as many as 40 separate deals over a three-or four-year period, is itself set up as a partnership, the investors -- for the most part, individuals in the highest personal tax bracket of 50% -- can use the early year losses of the businesses as deductions against other ordinary income. Later, when profits loom or a product is ready for commercialization, the limited partnership interests in a particular business -- held by the fund and the company founders -- are converted in a tax-free exchange for equity in a new corporatior based on a formula set when the deal was negotiated. (The managing partner in each investment of Crosspoint's fund will be Crosspoint Financial Corp. or one of the general partners.)

Unlike conventional venture capitalists seeking only an equity position, an equity R&D partnership is structured to lure investors willing to settle for somewhat less in the way of up-front ownership. Investors demand less because the tax deductions from early losses reduce the economic risk of the investment.

In today's market, according to Mumford, a conventional equity venture capital investment in a start-up business with a good product and marketing plan but with an unproven management track record might require founders to hand over 50% to 65% of the equity. But by using an equity R&D partnership under similar circumstances, he says, "investors would look for 35% to 50% of the equity." In a recent deal involving a company started by scientists and engineers from Stanford University, Mumford notes that the founders gave up just 35% of their ownership in the $1 million start-up.

In addition to the tax features, investors also are often willing to take a smaller share because they expect the eventual appreciation in the equity interest they do get to be substantial. "We are targeted at the highest risk/highest reward sector of the business," says MumfordWhile he won't be specific about earlier deals-most venture capitalists look for aftertax earnings of 30% to 40% per year -- Mumford says, "aftertax returns on our own equity R&D partnership investments have been significantly higher than conventional venture capital returns."

The ability to generate such lofty returns stems, in Mumford's view, from his own experience as an entrepreneur and general manager and the expertise and training of other principals. With a background in both accounting and law, Allan Anderson has been running an electronic-controls company. And Jim Willenborg is an engineer who has worked at Hewlett-Packard, Rolm, and Data General. Before establishing Crosspoint Venture Partners, the three were putting together equity R&D deals one at a time. Among the dozen or so new ventures they have financed are RoBind Corp. of Palo Alto, a start-up that merged with 3M; and Inmac Corp. of Santa Clara, Calif., a leading supplier of miniand microcomputer accessories.

In early October, Mumford says, Crosspoint was studying about 10 possibilities for the new pool of money, including a maker of medical lasers, a computer soft ware developer, and several companies in communications and electronics. The emphasis is undeniably on high tech, but Mumford says, "We're open to any company with a proprietary product or marketing concept." Geographically, the fund will focus on California, Arizona Colorado, and the Pacific Northwest.

But no matter what their business or location, all of Crosspoint's investments will be in an early development phase. "Many venture capital pools now are so institutionally oriented that they don't have the management background to handle start-ups," Mumford believes. "We like to get involved with the entrepreneurial/technical team." To Mumford and his associates, that means helping to structure the business, marketing, and financial strategies, and to select the proper management -- "functioning like one of the founders."

While royalty-oriented R&D limited partnerships, built around the financing of a single product, have existed for some time, equity R&D partnerships have been slow to catch on, despite a Supreme Court ruling in 1974 that clarified the deductibility of R&D expenses for limited partners. But as advantageous as the more established R&D limited partnerships may be for financing development of new products, Mumford says, "the royalty arrangement doesn't work very well in an early-stage financing because most start-ups don't have the cash flow needed to pay a royalty." Furthermore he notes, many venture capitalists would be reluctant to get involved with later-stage financings of companies committed to royalty payments.

Given such drawbacks, Coopers & Lybrand's Moore is one expert who expect. interest in equity R&D deals to rise. "They offer a high level of support to entrepreneurs," he says. But thanks to the way the tax benefits work, Moore adds, "they enable founders to keep more of their companies."