equity finance and the economic transition of rural america · lion or 31.6 percent live in rural...

Equity Finance and the EconomicTransition of Rural America:A New Framework for Private-Sector Initiatives

and Positive Economic Public Policy

David J. Brophy and Wassim Mourtada

The economy of rural America is undergo-

ing major structural change, impelled by

product and process innovation and

accelerated by market and political forces in its

basic industries. These forces are creating dislo-

cation in rural communities, especially in cases

where market flexibility may be impaired by

lack of skills, education, or access to capital.

They also create opportunities for entrepre-

neurial activity to identify and develop new

sources of employment, income, and wealth. To

encourage economic transition, rural America

must develop improved access to equity capital

and debt finance to support the redirection of

existing firms and the development of new firms

to better serve local and regional markets and to

adapt to the new economic realities faced by the

area. The objective of this paper is to suggest

ways in which private sector initiative and pub-

lic sector support may work in combination

toward that end.

In the body of the paper, we first demonstrate

the minimal extent to which rural America is

participating in the operation of the U.S. equity

market system. Our analysis shows that the flow

of capital from the organized equity markets to

rural America is heavily directed to small areas

in which the degree of urbanization is relatively

high and the area is located proximate to metro-

politan centers. We argue that this finding

reflects the received notion that entrepreneurial

activity and its related equity financing is asso-

ciated with the clustering of the human and

other resources identified with entrepreneurial

activity (e.g., Silicon Valley, Route 128). We

argue that our “degree of urbanization” metric

provides a new basis upon which the issues of

capital market access should be approached by

public policymakers within any state or region

of the country. The main contribution of our

paper is the proposal of a community centered

entrepreneurial cluster development framework,

within which access to local and non-local

equity and debt capital is a key component.

As a context for our analyses and recommen-

dations, we examine the system of financial

intermediation by which equity finance is made

accessible to entrepreneurial, fast growth-oriented

companies in the United States. Based upon this

examination, and as part of our entrepreneurial

cluster framework, we offer practical ways in

which links may be forged and participation

achieved between the population interested in

living and working as entrepreneurs and em-

ployees in rural America and participants in the

private sector investment community. We also

Mr. Mourtada is the Assistant Director of the Office for

the Study of Private Equity Finance at the University of

Michigan Business School, Ann Arbor.

show how the effectiveness of this framework

can be strengthened through the joint efforts of

public policy at all levels of government.

BACKGROUND OF THE PROBLEMAND NATURE OF THE RESEARCH

At the macroeconomic level, the structural

changes affecting rural America have contrib-

uted significantly to the strong growth of the

U.S. economy in the 1990s. Entering the 21st

century, the changes seem irreversible and con-

tinued movement in this direction, to take

advantage of new technology and to accommo-

date economic globalization, appears inevita-

ble. There is a strong economic future ahead for

those involved in the growth-producing parts of

the new structure.

At the microeconomic level, the rural part of

the United States is participating in the growth

of the national and international economy in dif-

ferent ways and to different degrees. By anal-

ogy, insight on this is provided by comparing the

U.S. condition with that observed in Canada by

the Canadian Rural Restructuring Foundation in

a 1996 report. Because the percent of rural

population (25 percent) and the percent of the

landmass that is rural (92 percent) are similar,

we believe the analogy to be apt. The Foundation

recommends that the rural area should be

viewed as three closely associated yet distinct

economies. The first (Rural Economy 1) is a

healthy part of the competitive global economy,

having more in common with global competitors

than with rural communities. It is focused on

industrialized production and international trade

and is integrated with corporate big business

and the world economy. It accounts for roughly

10 percent of the rural population and 80 percent

of the market value of basic commodity output.

Government policy regarding this part empha-

sizes industrialization, information technology

geared to exports, and global competitiveness.

It is world class and is supported by sectoral

policies, i.e., industry-based policies on agricul-

ture, energy, and fisheries, rather than regional

or population segment-based policies.

The second (Rural Economy 2) produces niche

products and services focused on local and

regional needs. It supports Rural Economy 1

with services and employees and continues to

produce basic commodities in the fishing, farm-

ing, and energy industries at uneconomic pro-

duction levels which often are sustained by

price supports and subsidies. Its population

households usually have more than one source

of income and commute to work in medium to

large urban centers and meet national viability

standards. It accounts for about 75 percent of

rural population and 25 percent of the market

value of agricultural output.

The third (Rural Economy 3) focuses on sur-

vival, consisting of 15 to 20 percent of the rural

population and producing 5 percent of market

value output. Its population is infrequently

employed and depends largely on government

transfer payments. It is the residual of the other

two, provides nonmarket services (scenery, rec-

reational “free goods”) from which it is difficult

to extract revenue, and contains impoverished

households, communities, and regions that are

facing deprivation and exclusion from the rest

of the rural and urban nation.

On the assumption that these three economies

reasonably represent the general economic

structure of rural America, it seems clear that

the interests and conditions of Rural Economy 1

communities and regions are already well

aligned with the nation's public policy, both

domestic and global, and are well served by sec-

toral policies. The Canadian Rural Restructur-

ing Foundation concluded that Rural Economy

2 is the appropriate target for market driven,

public policy assisted, economic transition

108 David J. Brophy and Wassim Mourtada

entrepreneurial activity. The opportunity exists

in that economy for individuals, communities,

and regions to find ways to gain a greater multi-

plier effect from the growth of Rural Economy

1. They also can link into entirely new market

opportunities, e.g., spillover economic activity

such as flexible manufacturing, telecommuni-

cations-related businesses involving software,

and internet opportunities. This requires entre-

preneurial initiative, which in turn requires mar-

ket flexibility within which such activity is

unimpeded and encouraged. It also requires

access to equity and debt capital, which is the

focal point of this research.

Within Rural Economy 2, transitional devel-

opment is likely to occur at different rates in

different locations within the area, some show-

ing more initiative, adaptability, flexibility, and

capacity for handling market-based solutions to

growth more quickly and substantially than oth-

ers. These areas and community locations will

be smaller, separate, and may be significantly

different from each other, requiring different

policy initiatives to aid transition. We argue that

the leaders will probably be those communities

that quickly build clusters of successful entre-

preneurial talent, linked both internally to other

cluster members and externally to members of

other clusters regionally, nationally, and glob-

ally. As part of this paper, we demonstrate the

extent to which this process has already begun,

reflected in the flow of private-sector equity

investment over the 1986-98 period.1

As in the Canadian framework, Rural Econ-

omy 3 communities may gain little immediate

trickle-down benefit from this process, requiring

initially direct intervention and subsidy in edu-

cation, infrastructure, and social services over a

long period of developmental time and eventu-

ally benefiting from spillover and the clustering

around appropriate developmental activity. Our

data show that the “purely rural” set of small

areas has attracted very little private sector

equity and has instead been almost totally reli-

ant upon government-subsidized U.S. Small

Business Administration (SBA)-guaranteed

loans as a source of capital for small business.

As Rural Economy 1 gains economic momen-

tum, its large firms are less directly connected

with rural communities. Because small farms,

independent energy commodity producers, and

other traditional rural businesses are declining

in number and population and becoming more

reliant on nonfarm income, those communities

benefit less from increases in agricultural and

energy commodity total output and are attempting

to become more economically diversified, i.e.,

take on the characteristics of Rural Economy 2,

in order to survive and grow. Those communi-

ties that cannot develop new sources of growth

lose their tax base and their ability to provide

education and other public goods. Local wealth

declines as property values drop and that part of

the population which is flexible leaves.

These and other pressures are pushing rural

America to become more urbanized, a pattern

which is generating controversy over urban

sprawl, overdevelopment, and attendant envi-

ronmental problems. It is likely that the exis-

tence of urban areas within rural communities

and regions will provide the base upon which

clusters of entrepreneurial activities and firms

will develop. If these activities follow national

trends, they are not likely to be linked to the pro-

duction of physical commodities in agriculture,

fisheries, or energy, but rather value-added

products and services related in part to basic

industry and in part to knowledge-based indus-

tries of the new economy. This type of business

development could provide a double benefit to

rural communities: providing new sources of

employment, income, and wealth and doing so

with minimal environmental problems.

Policy Options for Rural Equity Capital Markets 109

In this paper we first address the geographic

distribution of the U.S. population to show the

extent to which it is urbanized and located

proximate to metropolitan areas, according to

the 1990 census. We then show the flow of

equity capital and U.S. government-guaranteed

loans to small business approved through the

SBA by small areas (using U.S. Postal Service

zip codes) according to degree of urbanization

and proximity to metropolitan areas. This enables

us to measure the extent to which rural America

gained access to private-sector equity capital

and SBA-guaranteed business debt during study

period and the internal geographic distribution

of that finance. It also demonstrates the extent to

which rural America is linked to and currently

participating in the operation of the U.S. equity

market system.

As a context in which to discuss these issues,

we then examine the system of financial inter-

mediation by which equity finance is made

accessible to entrepreneurial, fast-growth-

oriented companies in the United States. If rural

America is to gain access to equity and debt

markets, it must develop effective demand for

capital and express that demand to this system

through strong links. Based upon these analy-

ses, we suggest practical ways in which market

links and participation can be strengthened

through joint efforts of public policy at all levels

of government and the active involvement of

private-sector participants, especially the

investment community and the population

interested in living and working as entrepre-

neurs and employees in rural America.

ANALYSIS OF DISTRIBUTION OFPOPULATION AND FINANCING

Previous bodies of research on this subject

have addressed the urban/rural distinction by

breaking financial flows along one of two lines

of distinction. The first is by classifying the

United States as “Rural Heartland” or “non-

Heartland U.S.” Rural Heartland states are typi-

cally defined to be Colorado, Iowa, Kansas,

Minnesota, Missouri, Montana, Nebraska, New

Mexico, North Dakota, Oklahoma, South

Dakota, and Wyoming. Population figures are

shown in Table 1.

A shortcoming of this distinction is that while

the total population in these states is 26.9 mil-

lion according to the 1990 census, only 8.5 mil-

lion or 31.6 percent live in rural areas.2 In the

United States, 61.6 million people reside in

rural areas, leaving 53.1 million rural inhabi-

tants unaccounted for. Further, when examining

the capital flows on the level of a state, one can-

not tell whether such flows go to the cities and

urbanized areas or to the rural areas that are the

subject of inquiry.

The second, more refined level of analysis

breaks the United States into Metropolitan Sta-

tistical Areas (MSA) and Nonmetropolitan Sta-

tistical Areas (nonmetro).3 This is a step closer

in addressing the issues raised with the Heart-

land approach. This second method, however,

does not address the facts that (a) within these

MSAs, there exist certain rural populations, and

that (b) outside these same MSAs, there exist

urban areas. We also need to account for the fact

that MSAs are further defined to be either regu-

lar MSAs or larger (primary) PMSAs (constitut-

ing CMSAs).

If we believe that there exists more than one

“Rural Economy,” as suggested by the Cana-

dian study, we need to identify the differing

areas and then quantitatively analyze in detail

the types and amounts of capital flows that are

reaching these characteristically different areas.

Methodology

The first step we employ to address these


issues is to examine the population and capital

flow data on the smallest level of detail for

which information is available. For the popula-

tion breakdown, we employ data provided by

the U.S. Census Bureau and the Office of Man-

agement and Budget (OMB). The 1990 census

gives population figures for each zip code area,

as well as figures for the rural and urban popula-

tions for the same zip codes.

While most of the population resides in zip

code areas that are totally urban or totally rural,

a significant number reside in zip code areas that

are mixed. For a financing event that occurs in

such a mixed area, one cannot tell whether the

company receiving the financing was in the

urban or the rural areas within this zip code area.

To address this problem, we classify each zip

code area into degree of urbanization categories

between 1 and 10, where the first scalar decile,

1, represents zip code areas where the fraction

of the population residing in urban areas is

between 0 percent and 10 percent. Similarly, the

highest degree of urbanization, 10, represents a

zip code area where the fraction of the popula-

tion residing in urban areas is between 90 per-

cent and 100 percent.

Using data from the OMB, we also classify

each zip code area by Primary Metropolitan Sta-

tistical Area, Metropolitan Statistical Area, and

Nonmetropolitan Statistical Area.

The result of this effort is a matrix that distrib-

utes the population according to our two catego-

rizations. The result is shown in Table 2.

A significant observation is that while 60.5


Table 1

POPULATION DISTRIBUTION OF THE RURAL HEARTLAND

1990 total

population

1990 total

urban population

1990 total

rural population

Colorado 3,294,394 2,715,517 578,877

Iowa 2,776,755 1,683,065 1,093,690

Kansas 2,477,574 1,712,564 765,010

Minnesota 4,375,099 3,056,474 1,318,625

Missouri 5,117,073 3,516,009 1,601,064

Montana 799,065 419,826 379,239

Nebraska 1,578,385 1,043,984 534,041

New Mexico 1,515,069 1,105,651 409,418

North Dakota 638,800 340,339 298,461

Oklahoma 3,145,585 2,130,139 1,015,446

South Dakota 696,004 347,903 348,101

Wyoming 453,588 294,635 158,953

TOTAL 26,867,391 18,366,106 8,500,925

Source: U.S. Bureau of the Census.

million (24.8 percent) of the population live in

rural areas, only about 20.6 million live in rural

areas that are not part of an MSA or PMSA, nor

have any urban areas within the zip code area.

Clearly, this rural set is fundamentally different

than the remaining rural set by geographic prox-

imity alone, with important implications as to

the characteristics of the companies that are

operating within these areas.

Next, we analyze capital flow data provided

by the SBA and Securities Data Company.

Using zip codes, we indicate on the matrix each

company receiving any of public-sector SBA

loan guarantees or private-sector equity in the

form of venture capital (VC) financing, initial

public offering (IPO) or seasoned equity offer-

ings (SEO). We do this both by dollar volume

and by number of financing events (count). The

results are presented in Appendix 1. We then

determine the capital flows on a per capita basis,

again by dollar volume and by count. The

results are presented in Appendix 2.

To establish a better sense of the relative pro-

portions within each of the four financing types,

we express our results by standardizing the base

figure for the nonmetropolitan areas with de-

gree of urbanization of 1 to 100 percent and then

scaling the remaining regions accordingly. The

results are presented in Appendix 3.

To test for the consistency and accuracy of the

mapping process, we compared the resulting

totals for the mapped sample with the raw fig-

ures before mapping. The results of this com-

parison are presented in Table 3.

Only a very small portion of the population

data was lost in the mapping process, while rela-


Table 2

POPULATION DISTRIBUTION COVERED BY SAMPLE

Degree ofurbanization Nonmetro MSA PMSA Rural Urban

Percent

urban

Total of

population

1 20,630,951 8,808,796 3,053,398 32,429,621 63,524 .20 32,493,145

2 423,412 601,927 467,059 1,259,683 232,715 15.59 1,492,398

3 1,168,709 1,541,961 725,100 2,536,262 899,508 26.18 3,435,770

4 2,665,251 2,077,611 870,403 3,610,638 2,002,627 35.68 5,613,265

5 4,143,808 3,369,757 936,247 4,622,549 3,827,263 45.29 8,449,812

6 4,792,746 3,199,962 1,589,088 4,270,614 5,311,182 55.43 9,581,796

7 5,326,868 5,040,081 1,632,267 4,185,090 7,814,126 65.12 11,999,216

8 5,143,410 6,405,159 2,283,722 3,415,928 10,416,363 75.31 13,832,291

9 3,677,400 10,894,110 4,251,611 2,805,135 16,017,986 85.10 18,823,121

10 1,767,562 56,342,494 79,741,739 1,344,945 136,506,850 99.02 137,851,795

Totals 49,740,117 98,281,858 95,550,634 60,480,465 183,092,144 75.17 243,572,609

Source: U.S. Bureau of the Census.

tively larger losses were exhibited in the figures

for capital flows. We identified two sources of

errors to which these losses may be attributed.

• Some of the financing data provided by the

SBAand SDC had missing zip code fields.

• Population figures and the corresponding

urban/rural and PMSA/MSA/nonmetro

information are from the 1990 census,

while the financing data span a longer

period of time (1986-98 for private-sector

finance and 1976-97 for public-sector

finance). Over this extended period, the

U.S. Postal Service occasionally commis-

sions new zip codes and decommissions

others. As such, financing data before 1990

will have some outdated zip codes, while

data after 1990 will have zip codes that are

too new to match with census data.

On the whole, a very large portion of the data

was matched and we believe the resultant map-

ping is a very good representation of the original

universe of data.

Analysis of results

With few exceptions, the trends going from

non-metro to MSA to PMSA, and from degree

of urbanization 1 to degree 10, are smooth and

consistent. We present the data for the “corner

points” in Table 4.

The only exception point here that introduces

a departure from the general trend is the figure

for IPOs in PMSA degree 1 regions. The dollar

volume here is 102 times that of the base figure

in terms of dollar volume and 18 times that of

the base figure in terms of count. Upon further

investigation, we find that all the deviation can


Table 3

RETENTION RATES OF POPULATON AND FINANCING DATAAFTER MATCHING WITH U.S. BUREAU OF THE CENSUS ANDU.S. POSTAL SERVICE DATA

Sample Actual Absolute loss

Percent

loss

Percent

retention

Population Urban 183,092,144 187,053,487 3,961,343 2.12 97.88

Rural 60,480,465 61,656,386 1,175,921 1.91 98.09

SBA $ vol 70,559,365,973 77,432,984,103 6,873,618,130 8.88 91.12

Count 415,725 454,362 38,637 8.50 91.50

VC $ vol 63,553,843,00 70,489,495,000 6,935,652,000 9.84 90.16

Count 20,893 23,320 2,427 10.41 89.59

IPO $ vol 350,605,234,000 416,051,917,000 65,446,683,000 15.73 84.27

Count 5,760 6,418 658 10.25 89.75

SEO $ vol 416,975,662,000 502,662,238,000 85,686,576,000 17.05 82.95

Count 5,226 5,951 725 12.18 87.82

Sources: Securities Data Company, U.S. Bureau of the Census, Small Business Administration, and OSPEF Analysis.

be attributed to financing events in a part of

Plainsboro, New Jersey (zip code 08536).

Plainsboro is home to financial groups that man-

age about 65 publicly traded financial funds. If

we were to exclude the Plainsboro funds from

our data, we find the figures for the IPO trends

as presented in Table 5.

There are two large generalizations that we

make from our results as presented in Tables 3

and 4. The first is that as we go from rural to

urban areas, we observe that the per capita levels

of capital flows increase for all types of financ-

ing types. Interestingly, when we compare the

base case (nonmetro degree 1) with (a) the non-

metro degree 10 and (b) PMSA degree 10, we

get consistent proportions in the private-sector

financing. In (a), it is 5.9x, 5.8x, and 4.5x the

base case and in (b) it is 32.7x, 28.5x, and 38.0x

the base case for VC, IPO, and SEO financing,

respectively. This may well be an indicator of

the efficiency with which financial markets are

serving these areas.

The second generalization that we can make is

that per capita levels of financing increases as

we go from nonmetro to MSA to PMSA, except

in the case of SBAloans. For the SBAfinancing,

we observe that it is consistent only with the

first general trend. In the absence of explicit

government policy directing the SBA to

approve a larger proportion of loans in non-

metro areas vis-à-vis MSAs and PMSAs, we

argue that there is less of an effective demand

for SBA financing in the MSA and PMSA

regions. Typically, SBAloans are made to small

businesses that serve the local and regional

community. These represent the full range of

local businesses, i.e., smaller retail grocery,

clothing, hardware, and smaller manufacturing


Table 4

STANDARDIZED GOVERNMENT SBA LOANS AND PRIVATE SECTOREQUITY INVESTMENTS(By number and dollar volume of transactions)

Area

Dollar volume per capita Count per 1,000,000

Degree of

urbanization Nonmetro MSA PMSA Nonmetro MSA PMSA

SBA 1 100% 64% 72% 100% 62% 61%

10 148% 116% 91% 154% 109% 70%

VC 1 100% 212% 411% 0% 129% 505%

10 575% 2,060% 5,584% 589% 1,382% 3,271%

IPO 1 100% 508% 10,205% 100% 234% 1,858%

10 614% 3,131% 7,505% 584% 1,629% 2,852%

SEO 1 100% 227% 872% 100% 204% 819%

10 415% 4,622% 7,960% 453% 2,584% 3,799%

Source:Securities Data Company, U.S. Bureau of the Census, Small Business Administration, and OSPEF Analysis.

firms. In MSAs and PMSAs, we believe that

these services are for the most part provided by

larger regional and national players which have

access to the IPO and SEO market at the loca-

tion of their home offices, typically in an urban

area (e.g., Target, Hudson's, Wal-Mart, and

Builder's Square). The economies of market

scale that allow these large providers to compete

on a regional or national basis do not exist in the

nonmetro areas. This leaves room for smaller

players whose main source of capital, beyond

personally financing their businesses, is the

SBA bank loan guarantees, and whose major

financial need is access to equity capital.

Clearly, there is a growth and financing discon-

tinuity between the SBA loans and the private-

sector equity financing. The two trends outlined

above and the apparent growth/financing dis-

continuity are further illustrated in Charts 1 and

2. Chart 1 shows the relative composition of the

different types of capital flows to the three areas.

The numbers are derived by taking the average

of the total annual capital flows for each type of

financing over the time period starting January 1,

1986 and ending December 31, 1996 and stan-

dardizing to 100 percent. (Actual averages of

total annual flows are in the table on the chart.)

Using the same set of averages calculated

above, in Chart 2 we present the relative alloca-

tion of capital flows by the destination of each

of the four types of financing.

While we can attribute a large part of this SBA

discontinuity to the above reason, it is also clear

that regional, national, and globally oriented

businesses would tend to locate in big cities by

default, in order to gain access to resources

beyond financial capital (e.g., human capital,

professional service providers, etc.). That is not

to say that some of the companies in rural areas

cannot eventually become regionally, nation-

ally, or even globally competitive. On the con-

trary, given sound, enabling public policy, we

believe that some of them will.

The differences in amounts and proportions

of finance acquired in these three market loca-

tion categories may reflect either differences in

effective demand for equity capital in each cate-

gory, the depth and breadth of the supply side of

the financial market among the categories, or a

combination of both. In rural areas, the demand

for capital leading to IPO issuance may have

declined in response to the low and declining

level of commodity prices in basic industries in


Table 5

STANDARDIZED INITIAL PUBLIC OFFERING DATA(Excluding financial funds from Plainsboro, New Jersey)

Area

Dollar Volume Count per 1,000,000

Degree of


IPO 1 100% 508% 346% 100% 234% 486%

10 614% 3,131% 7,505% 584% 1,629% 2,852%

Source: Securities Data Company, U.S. Bureau of the Census, and OSPEF Analysis.

the 1987-98 period. Companies replacing this

demand in rural areas have been slow to appear,

reflecting the transitional economic development

problem to which this research is directed.

On the supply side of the market, private-sec-

tor providers of equity funds (venture capital

funds, and investment banking firms) are princi-

pally located in urban areas, proximate to the

infrastructure (e.g., lawyers, accountants, and

financial printers) necessary to the investment

business. The financial services business tends

to be concentrated in urban areas, especially in

PMSAs, but also in MSAs.

It has been argued that for equity-seeking

firms in nonmetropolitan areas, even if effective

demand for investment exists, access to the sup-

ply side of the market is difficult and the search

and transactions “frictional” costs are substan-

tial. The degree of the frictional costs is highest

in VC finance. In the next section, we demon-

strate that even VC has some mobility. Further it

is of great interest that a Rural Heartland state,

such as Colorado, was able to overcome these

frictional and effective supply problems and

succeeded in being the third-largest recipient of

VC in the United States in 1998. This may be a

model of a predominantly rural state making a

successful transition.

Clearly, the problem lies less in the supply of

capital and more in the hands of those that must

make a successful transition from agriculture

and other commodity-based industries to the

knowledge-based economies that have success-

fully attracted capital, as in the case of Colorado.

The basis for rational and enabling public policy


Chart 1

RELATIVE FINANCING PROFILES OF THE THREE STATISTICAL AREASBY FINANCING TYPE(Average annual capital flows from 1986 to 1996)

IPO

100 100

80 80

00Nonmetro MSA PMSA

PercentPercent

SEO

SBA

VC

6060

4040

20 20

must be rooted in a firm understanding of the

nature of fast growth and entrepreneurial com-

panies and the techniques used to finance them.

FINANCING ENTREPRENEURIAL,FAST GROWTH-ORIENTED FIRMSTHROUGH THE U.S. EQUITYMARKET SYSTEM

Because of the wealth-creating contributions

of equity investment in entrepreneurial, fast

growth-oriented businesses over the past sev-

eral decades, parts of the U.S. financial system

have developed an efficient intermediation sys-

tem designed to profitably provide equity and

debt finance for such firms. This system is at its

most active in geographic areas characterized

by clusters of successful firms based upon tech-

nological entrepreneurship, of which Silicon

Valley is the most prominent, as shown by Saxe-

nian (1994). It also serves firms across the

nation and in other countries and is sensitive to

opportunities whatever the location. The chal-

lenge for rural America is to generate effective

demand for this capital, i.e., a deal flow of credi-

ble entrepreneurial firms, and to gain linkage

between its entrepreneurial clusters and the

framework of institutions and intermediaries

involved in the equity finance system.

Such clusters of entrepreneurial activity and

emerging growth companies are appearing and

growing in various parts of this and other coun-

tries, in part as a reflection of what is being

called the new economy, anchored increasingly

by knowledge-based industry and the financing

of conditional growth options. These clusters

result from the accumulation of highly skilled


Chart 2

RELATIVE ALLOCATION OF CAPITAL FLOWS TO STATISTICAL AREASBY TYPE OF FINANCING(Average annual capital flows from 1986 to 1996)

100 100

90 90

80 80

30

10 10

00SBA IPO SEO

PercentPercent

30

VC

PMSA

Nonmetro

MSA

7070

50 50

6060

4040

20 20

and motivated entrepreneurial people who build

and possess intellectual property and knowl-

edge focused through their companies on the

production and marketing of products for which

there is a large and growing national and global

market demand.

As they have throughout history, financiers

have responded to the wealth-creating potential

of the derived effective demand for capital by

developing ways to evaluate, structure, and

price investments in such companies and orga-

nizing specialized pools of capital dedicated

toward this type of investment. Such financiers

have created impressive wealth by becoming

involved with these communities of entrepre-

neurs, joining as equity-financing partners in

the projects of resident and newly attracted

entrepreneurs, sharing the technology risk and

the market risk, and conditionally sharing the

wealth created as well. We argue that such fin-

anciers will turn their attention to sources of

economic rent regardless of where they are

located and will accommodate themselves to

the financing opportunities in the most efficient

way possible whether rural or urban.

As this observed track record of successful

equity investment has grown, and the under-

standing of the equity investment process has

spread, “entrepreneurial finance” has gradually

become an accepted part of the risk and return

continuum of the financial intermediation sys-

tem and is generating a level of competition

increasingly attractive to entrepreneurs. The

question central to this research is whether rural

America can become home to this type of eco-

nomic activity in some manner and measure and

attract to this use, from sources both local and

distant, the equity capital and debt financing

needed to support its development and growth.

To realize this objective, practitioners and pol-

icymakers must understand the challenges

faced in building such an entrepreneurial com-

munity and the requisite system of equity and

debt finance for entrepreneurial activity. In the

body of this section we demonstrate these chal-

lenges by reviewing the characteristics of the

U.S. system of entrepreneurial finance.

The role of equity in the observedfinancing pattern of entrepreneurial, fastgrowth-oriented firms

The prospective development of entrepreneu-

rial activity in rural America faces both an

equity capital and debt-financing problem. This

is reflected in previous research done on rural

America's financial market facilities by the

Rural Policy Research Institute (RUPRI) and

discussed later in this presentation. That

research concluded that routine debt financing

and specialized agriculture-linked debt finance

is reasonably available while debt for certain

more complex types of projects and companies

is not. It showed that debt finance is not readily

available for projects beyond the experience,

understanding, and skill of local bankers in rural

America, for projects requiring large amounts

of capital, and for infrastructure projects requir-

ing immediate outlays and long-term, condi-

tional payoffs. It also showed that the equity

market facilities that have become so important

in financing entrepreneurial firms are almost

totally lacking in rural America and there is no

effective systematic connection between rural

communities and national equity markets.

Characteristics of an hypothetical entrepre-

neurial fast growth-oriented company. With

specific respect to the types of entrepreneurial

companies that are the focal point of this study, a

growing equity base is the foundation upon

which debt financing of growth-oriented firms

is predicated. Public policy initiatives intended

to encourage and enable entrepreneurial firms

in rural America or any other region must facili-

tate the availability of equity capital to such


firms. These initiatives must remove barriers

and provide incentives which will improve the

intermediation of local savings into local equity

and broaden the investment scope of indigenous

financial institutions to include equity invest-

ment and equity-linked credit facilities.

Policymakers must understand the nature and

characteristics of entrepreneurial, fast growth-

oriented companies as they address the barriers

and incentives mentioned above. An overview of

the life of a representative entrepreneurial,

emerging fast growth-oriented company, organ-

ized by life cycle stages, is presented in Chart 3.

As shown in Chart 3, the characteristics of an

individual firm change across these stages and

influence the financing needs of the firm, the

alternative sources available, and the implica-

tions of the financing choices made by the firm.

The stages may differ in duration among firms

as a function of their industry, e.g., biotechnol-

ogy firms may have a longer development stage

than computer software companies. The stages

and the financing needs of the company also dif-

fer by size of firm. Unlike the fast-growth-

oriented company depicted in Chart 3, a small-

business firm which is unwilling or unable to

strive for rapid growth toward large size may

have neither the need for nor access to the types

and sources of finance shown in the chart.

Chart 3 traces the firm's life cycle with respect

to its annual net income at each stage of devel-

opment and time. In its earliest (R&D and

startup) stages, the firm is shown to be in a nega-

tive net income position, with revenues insuffi-

cient to cover product development and

organizational costs. Financing is needed to

compensate for this deficit and to purchase any

longer lived assets that might be needed. While

the founders and equity investors may be con-

vinced that the firm is pursuing “positive net

present value” projects, the commitment of

equity capital to its start-up and development is

typically a sunk and irretrievable cost, essen-

tially the purchase of a growth option. The

investment is illiquid, with discretionary pre-

mature exit accompanied at best by a substantial

discount from original cost and the surrender of

claims to residual values if realized. Even in

cases of successful development, the only

return available to the investor at intermediate

stages is in the form of unrealized appreciation

in the equity value of the firm. This may be

reflected in the “step-up” in valuation which

occurs at subsequent rounds of private equity

financing, but is even then difficult to extract

from the venture. At this stage, the financial

payoff for founders and early investors is still

highly uncertain and probably distant in time. It

is the stage at which risk capital is needed by the

firm and is the stage at which the most severe

capital gap occurs.

In our example of a successful company, the

net loss pattern reverses itself as the firm enters

the “early growth stage” and progresses to break

even on an annual, current account basis. The

operating loss declines until the annual break

even point is achieved. This represents the

maximum point of the cumulative deficit and, in

a business with low capital asset intensity, i.e., a

service company, trading company, or virtual

corporation, is a good approximation of the

maximum amount of external financing the

firm will need under its plan of operations.

Capital expenditures could be included in this

analysis directly by substituting “free cash

flow” for “net income” as the variable being

tracked.

The firm then proceeds through a stage of

accelerating growth, achieves the ability to be

self-sustaining in its growth (and able to be

financed without personal collateral by com-

mercial bank credit), and at some point in that

stage, reaches cumulative break-even. This is



Chart 3

LIFE CYCLE OF A GROWING BUSINESS

0

R&D-None-

1

Start-upUp to $2.0

2

Early growth$2-10

3Accelerating

growth$10-15

4Sustaininggrowth$25-40

5

Maturity$40 and up

Actualbreak-even

point

Cumulativebreak-even

pointCumulative net income (loss)

$500,000-1,000,000

1-5

Founder

No organization

2-3

$100,000 (private)

$500,000-2,500,000

1-3

Founder & associates

Very loose

organization

1-3

$750,000 (private)

$2 - 6 million

2-3

Founder or

professional

Manager: emerging

organization

2-3

$1,500,000

(private)

$6 - 15 million

3-4

Founder or

professional

Formal organization

1

$7,500,000

(public or senior

private placement)

$15 - 30 million

2-5

Professional

managers

Complex organization

1-2

$15,000,000

(insurance company

and other long-term

capital)

$30 million +

-

Multilayered complex

Management

organization

Ongoing

(various)

Annualnetincome(loss)

$8N 7E 6T 5

4I 3N 2C 1O 0M 1E 2

(millions) 3456

I. Company characteristics

Capitalization

Length of phase (years)

Management and

organization

�Equity� financings:

Number

Avg. size

(Nature)

II. Applicable government

regulations

Tax rate

Depreciation allowance

Sub-chapter �S�

IRS Rule 1244

SEC Rule 144

SEC Rule 146

Regulation �A�

SEC: 1933 Act

III. Principal financing

sources

Private:

Personal investment

Individual investment

Investment firms

(VCs)

Commercial bank-

personal

Commercial bank-

corporate

Insurance companies

Public financing

Phase:

Activity stage:

Revenues in millions

the point at which the total operating losses have

been recouped and a basis is established for the

equity investors to realize an economic return.

Beyond that stage, in this example passing $40

million in annual revenues and beginning to

approach sustainable growth, the firm's growth

rate begins to more closely resemble that of the

markets it serves.

The chart also shows that total capitalization

grows in dollar amount across life cycle stages.

The bulk of this capital cannot be generated

internally, especially prior to the firm's annual

break-even. It must be raised externally through

equity financing or debt, principally from the

savings or guarantee of owner/managers them-

selves, independent individual investors, and

professional venture capital investment groups.

Even beyond annual break-even, rapidly

expanding firms with high-capital intensity

often require amounts of capital that may

exceed the rate at which their retained earnings

and net cash flow are growing. This capital is

usually invested in periodic rounds, with the

amount and pricing of each round conditionally

related to the firm's performance relative to

expected realizations of its growth options.

With this type of financing, pricing reflects not

an interest rate on a loan that must be repaid but

a percentage of the firm's permanent equity

exchanged for the capital. Clearly, companies

which are able to maximize their pre-money

valuation and arrange their spontaneous financ-

ing terms in order to minimize their funding

deficit while not missing the growth opportu-

nity window will maximize the amount of

equity retained.

Past the point of operating break-even, com-

mercial banks become a direct source of funds

for the firm, along with larger institutional lend-

ers and equity investors. As the firm moves

toward sustainable growth, the early investors

may seek liquidity through a harvesting event,

which is consistent with the position of the com-

pany. The alternatives usually include, in order

of preference, a public offering of some of the

firm's stock, or the sale of the company to

another firm, or to a management group (often

through a leveraged buyout), or the retirement

of the investors' securities by the company

through a sinking fund drawn from operating

cash flows. This preference reflects the fact,

shown by research, that public offerings tradi-

tionally return a higher multiple of the original

value of the investment than do mergers and

acquisitions.

The challenge of financing entrepreneurial,

fast growth-oriented companies. Equity

financing of entrepreneurial firms is a challenge

for much of the US. financial system and fund-

ing is a continuing problem for young, small

entrepreneurial firms whose main assets are

growth options and whose success is predicated

on change. This challenge emanates from

important characteristics of the entities

involved, both financiers and entrepreneurs, as

well as the characteristics of the investment.

The most daunting investment factor in this

type of financing is that, against the sunk and

irretrievable front-end capital investment, illi-

quidity and uncertainty must be endured while

the company attempts to achieve market stature

and sustainable positive cash flow over time.

Many of these companies are novel with respect

to their product or market approach and are

devoted to creative destruction of established,

often formidable, competitors. In combination,

these factors make the investment seem very

risky for most investors, especially relative to

attractive risk-adjusted equity returns available

in the broad equity markets.

Chart 4 demonstrates that uncertainty is a vir-

tually constant condition in the development

life of an emerging entrepreneurial company


over time. The financial implications of this

uncertainty are unattractive to many and result

in a limited supply of capital within the financial

community being directed to this type of inves-

tment. Such investment is made through a filter

designed to finance only firms which are

expected to generate acceptable private returns

to invested capital, with the investment's social

return to the community only a collateral con-

sideration at best. While it may be argued that

firms of all sizes face uncertainty on a continu-

ous basis, it is generally accepted that this type

of risk in younger, smaller companies poses par-

ticular difficulties in the financing of such firms.

As a result, seed and early-stage funding is con-

sidered the major financing challenge of the

young, small, fast growth-oriented company.

Because these smaller, entrepreneurial busi-

nesses are typically private and closely held,

they are informationally opaque and therefore

risky to the outside, minority-position investor,

who fears that asymmetric information will lead

to adverse selection and moral hazard. While

due diligence investigation is a potential cure

for these problems, it is by its nature imperfect

and quite costly. Majority control by investors is

often considered undesirable because of lack of

expertise, low motivation to be operationally

responsible, and the liabilities implied by con-


Chart 4

EVOLUTION OF SMALL COMPANIES

Stage IExistence

× B

Fail

Exist

Fold

Sell× A(1)

Fail

Prosper

Sell

Mini-mally

Suffi-ciently

Disen-gage

Head for growth

× +

Continue

Sell ormerge

Notadapt

Adapt(3)

(4)

Retrench

Fail

Make it

Re-trench

Sell× + +

Suc-cess-fully

Unsuc-cess-fully

Regroupfor growth

Operate

(6)

(5)

Fall wayback

× B

Fold

(7)

Stage IISurvival

Stage IIISuccess

Stage VResource maturity

Stage IVTake-off

× BBankruptcyAdapt and continue as is

temporarily or permanently

Change in strategy

× +Sell at a profit

×+ +Sell at a greater profit

× ASell assets

× −Sell at a loss

RetrenchFailure

SuccessSell or merge

Operate

× + + +

×

× B

Fold

× B

Fold

× B

Fold

trol. Further, it is often unavailable to the inves-

tor due to the unwillingness of the entrepreneur.

Because of their instability, such firms must

use a financial structure that accommodates and

mitigates the resulting financial shocks. Flexi-

ble access to cash, either through reserve bal-

ances, ability to sell equity securities quickly, or

the availability of ready cash from banks and

other lenders is required to assure survival and

the ability to be opportunistically sensitive to

input or output markets. This requires access to

equity capital channels and sources and to a debt

market willing and able to meet their needs.

Assets of such firms are often considered to

make poor credit collateral, either because they

are use-specific or, as intellectual property, are

felt to be difficult to value, control, and transfer,

especially for financial institutions unable to

fully understand the values contained in the

company and its business. Further, many invest-

ments are purchases of options, the anticipated

values of which may simply not work out. Also,

such firms are often organizationally incom-

plete, without a track record upon which to base

an investment. Because their business plans often

depend on displacing entrenched competitors,

they are not considered likely to succeed by finan-

cial institutions and their regulators who are often

strongly rooted in the present if not the past.

Because entrepreneurial, fast growth-oriented

firms often offer small “deal size,” the implied

fees for financial intermediaries have been

smaller, more distant and more probabilistic

than fees on larger deals of more established

firms. Thus, intermediaries and investors often

view the payoff potential as insufficient to jus-

tify the “learning effort” required and the invest-

ment return potential too conditional on an

unacceptably low probability of success.

The standard historic response of orthodox

U.S. financial intermediaries (debt and equity)

to such demand for capital has ranged from vir-

tually red-lining such financing transactions, to

doing them only with government (Small Business

Administration) guarantees, to requiring liquid

collateral consisting of assets not linked to the

firm, and to offering financing contracts that put

the financiers in very strong, “me first” positions

of control. Equity investment to fund entrepre-

neurial ventures is a decidedly scarce resource,

not so much because of a lack of available

capital but because of the difficulty of “proving”

the worth of the intended investment, monitor-

ing the investment once made, and harvesting it

when appropriate. The good news of the past sev-

eral decades has been the increased understand-

ing of the venture capital investment process by

individuals, lending institutions, nonfinancial cor-

porations, and government agencies and the ow-

ing availability of such equity in the United States

and other countries.

However, individual and institutional inves-

tors now fund venture capital investment

because it has delivered risk adjusted rates of

return well above the norm over the past several

decades. To attract such investment to a geo-

graphic area or industry requires not just a need

for the fruits of economic development but

rather proof of a productive, effective demand

for the capital. This effective demand takes the

form of a comparative advantage in the provi-

sion of goods or services for which there is a

demonstrably large and growing market. It

involves the hard work of binding the entrepre-

neur to the task of the venture and the sharing of

the risk and financial return between entrepre-

neur and venture-financing partner.

For entrepreneurial, fast growth-oriented

companies seeking to start up or restructure

themselves, institutional debt is at best difficult

to obtain without transparent collateral or a

well-established track record. Such collateral


must combine liquidity and such high strategic

value to the equity holder that the lender's pay-

ment will have priority over all other obligations

of the company and the equity holders. Equity

capital, invested by founders and their financing

partners, is the key to financing development

and growth and is the central element in the

development of entrepreneurial activity.

As a result, credit becomes available either

when founders or equity investing partners pro-

vide such collateral or the firm accumulates liq-

uid and strategic value sufficient to support

debt. In short, equity capital, as a base on which

to attract debt, is the key to the successful launch

or restructuring of entrepreneurial firms. Some

lending institutions are beginning to make

equity-linked credit available and progress in

this direction is a positive sign for entrepreneu-

rial companies. These banks—generally those

serving areas which feature clusters of

knowledge-based industry firms—are willing

to lend on the basis of collateral control rather

than on collateral liquidity. That is the ability to

withhold access to the collateral (e.g., a soft-

ware company's source code) by the founder,

managers, and equity-holders of the com-

pany—if the bank's loan is not kept current.

They are essentially trading on the equity of the

firm's owners and investors. Such banks have

developed pricing schemes based upon interest,

balances, fees, ancillary services, and option-

based equity kickers which enable them to profit

handsomely from this type of lending. This is

nothing new from a regulatory or public policy

viewpoint, but is new from a competitive bank-

ing viewpoint (Brophy 1984). Beyond the early

stages of growth, the more orthodox sources of

funds become involved and the company pro-

gresses toward a harvest through initial public

offering, merger, or acquisition. Venture capital

firms find the technology risk unattractive and

are most comfortable entering in the post-R&D

stage of company life.

After the company passes break-even and

begins to grow, the wider array of institutional

and public sources of funds become interested

financing candidates. While venture capital

funds are very interested as the company grows,

the interest of the non-venture capital private

equity funds increases as the firm stabilizes and

develops an appetite for larger volumes of funds

for less risky expansion or restructuring pur-

poses. At some point, our hypothetical firm will

decide to go public, merge, or be acquired by or

acquire one or more other companies. These

events can produce either a need for more pri-

vate equity finance or provide the harvest event

through which early-stage equity investors real-

ize the return on investment in compensation for

the risk and illiquidity they carried over the

development period.

The U.S. venture capital and privateequity finance system

The post-World War II period has seen the

development in the United States of a system of

financial intermediation which effectively

delivers equity capital and credit to entrepre-

neurial, fast growth-oriented firms. This system

is referred to as the venture capital and private

equity finance system. Prior to this develop-

ment, entrepreneurs were limited to financing

the equity needs of their companies by using

personal savings and capital they could attract

from individual or corporate investors. The core

of the venture capital and private equity finance

system is the intermediation of individual, cor-

porate, and institutionalized savings to private

equity investment in companies with wealth-

creating growth potential, subject to fiduciary

oversight. This system, considered very effi-

cient, is still a work in process, evolving toward

becoming broader in its reach and inclusiveness

and deeper in the nature and level of risk that it is

able to accommodate. The productivity of the

U.S. system is the envy of the world and, with


adaptation to reflect local conditions, is emu-

lated by other countries wishing to be interna-

tionally competitive in entrepreneurial activity.

Rural America, much like a transitional national

economy, must join this system in a manner

predicated on local comparative advantages and

adapted to reflect local conditions if it wishes to

participate in the market economy of the United

States and the world.

The major elements of this system are shown

in Chart 5. The system consists of three play-

ers—individuals, corporations, and institutions

which are the ultimate providers of investment

capital, the entrepreneurial companies in which

the equity investments are made, and the set of

specialist fund organizations which serve as

market intermediaries. These players are bound

together by contracts between investors and

intermediaries and between intermediaries and

investee firms. The intermediary serves the

investor by finding and filtering investment

opportunities, negotiating investment contracts,

monitoring and exercising influence or control

over the investee firm, and guiding the harvest-

ing of the investment through public offering or

company sale. The intermediary returns the

investors’ original investment and accumulated

gains by distribution of cash or appreciated

securities to the investors. Satisfied investors

typically recycle the capital by investing in

newly formed funds directed to areas of pro-

spective wealth increase.

Within the system, the mobility of venture

capital and private equity finance is for the most

part unconstrained by legal or regulatory barri-

ers and investors are able to pursue opportuni-

ties anywhere in the country. Certain sub-

markets, because of the nature of their industrial

base, provide a greater number and larger dollar

volumes of venture capital and private equity

investment opportunities than others. This

demand may be met by locally domiciled

investment funds and competitively supple-

mented by investors from other states. Insight

into this process is provided by data on the state

of origin of venture capital investment in the top

five states nationally (Table 6).

These data show that investments in the five

states attracted venture capital investors from

located in that state plus an array of other states,

thus increasing the supply and competitiveness

of investment funds in each state. This provides

a very interactive venture capital system, sensi-

tive to opportunities and conditions in virtually

every part of the country. The level of local and

out-of-state investment varies by state and

across time, due to the lumpiness of investment

opportunity and the randomness of opportunity

arrival time. In order of national significance,

California firms provided 63.6 percent of the

venture capital funds invested during the year in

California and provided funding for deals in

each of the other states. At the other extreme,

Colorado provided just 20 percent of its home

deals. Texas provided 32.9 percent of local capi-

tal and investment in two other states, Massa-

chusetts 54.6 percent and two other states, New

York invested 31.1 percent of its home total and

two other states.

While the system is, for the most part, market-

driven, it is the result of contractual agreement

among parties (investor, intermediary, and

investee firm) and depends for its evolving

effectiveness upon the nation's rules of law and

regulation. It is considered a good example of

how public policy at all levels of government

has been shaped to enable private initiative to

channel effort and funds into their highest and

best use in the achievement of improved living

standards and derived wealth creation through

innovation-based entrepreneurial activity. The

venture capital system has evolved over time by

combining the private sector initiatives of

investors, entrepreneurs, and intermediaries


with enabling public policy. In that sense it has

been a successful public/private partnership,

although rarely referred to in those terms. Some

of the influential contributing pieces of legisla-

tion in this partnership are shown in Table 7.

The effect of uncertainty and risk in this type

of financing is not exclusive to very young and

small startup companies. As shown by Gompers

and Lerner, the venture capital business in gen-

eral experiences very wide swings in fund avail-

ability and in rates of return. There is a strong

positive relationship evident between realized

returns and the flow of new money to the ven-

ture capital community. Given the search costs

and the monitoring costs involved in investing


Chart 5

ORGANIZED PRIVATE EQUITY MARKET

Corporate pension funds

Public pension funds

Endowments

Foundations

Bank holding companies

Wealthy families andindividuals

Insurance companies

Investment banks

Nonfinancial corporations

Other investors

Limited partnership

� Managed by independent

partnership organizations

� Managed by affiliates of

financial institutions

Other intermediaries

� Small business

investment companies

(SBICs)

� Publicly traded

investment companies

New ventures

� Early stage

� Later stage

Public companies

� Management or

leveraged buyouts

� Financial distress

� Special situations

Middle-market privatecompanies

� Expansion

- Capital expenditure

- Acquisitions

� Change in capital

structure

- Financial restructuring

- Financial distress

� Change in ownership

- Retirement of owner

- Corporate divestitures

Placement agentsfor partnerships

� Locate limited partners

Placement agentsfor issuers

�Advise issuers

� Locate equity investors

Investment advisersto investors

�Evaluate limited partnerships

�Manage �funds of funds�

INVESTORS INTERMEDIARIES ISSUERS

DIRECT INVESTMENTS(includes direct investments of both BHC-affiliated SMICs

and venture capital subsidiaries of nonfinancial companies)

Dollars

Limitedpartnershipinterest

Dollars

Equity claimon intermediary

Dollars,monitoringconsulting

Private equitysecurities

Dollars

Private equity securities

in companies of this type, it is understandable

that such investors have very refined investment

evaluation filters.

The observed early stage “financing gap”faced by entrepreneurial companies in theUnited States

Despite the development of the venture capital

and private equity finance system, entrepreneurial,

fast growth-oriented firms still face a serious

financing gap. The gap is defined to exist

between the observed upper level of angel

capacity to finance a company and the lower

bound of the institutional venture capital fund

desired investment amount.

This problem is considered so serious that

many suggest that it is a pervasive condition. Its

characteristics are reflected in Chart 6. As

shown in the study “The 1995 Census of Early

Stage Financing,” there is compelling evidence

of a systematic capital gap for smaller, younger

firms in the early stages of development. This

also shows a weakness in the existing system of

local access to finance for such firms, since in

their infancy they are best known locally and

candidates for support by local investment

groups. This weakness may derive from local

financial deficiencies and from inconsistencies

in the laws governing equity financing within

the state of location. Acombined private-sector/

federal government/state government effort is

needed to resolve these interrelated problems.

In Chart 6, these parameters are shown to

be $250,000 to $500,000 for angel investment

and $2 million as the lower bound for venture

capital funds. Given the rise of the broad equity

market and the larger amounts of capital now


Table 6

ORIGINATION OF VENTURE CAPITAL INVESTED IN THE TOPFIVE STATES IN THE UNITED STATES(By dollars invested, by state of investment origin, as a percentage of each state’s total

investment, 1998)

California (#1) Texas (#2) Colorado (#3) Massachusetts (#4) New York (#5)

California 63.6 Texas 32.9 Illinois 26.4 Massachusetts 54.6 New York 31.2

Massachusetts 9.4 California 14.6 Colorado 20.8 New York 13.5 California 18.1

Minnesota 5.7 New York 11.3 Massachusetts 13.2 California 13.1 Connecticut 14.3

New York 5.4 Massachusetts 10.4 California 10 Connecticut 5.1 Massachusetts 11.5

Connecticut 2.3 Illinois 10.3 New York 7.5 Illinois 1.7 Ohio 8.7

Illinois 1.4 North Carolina 6.6 Texas � Maryland � Illinois 4.9

Texas 1.4 Minnesota � Minnesota � Minnesota � New Jersey �

Maryland � Connecticut � Other 22.1 Pennsylvania � Pennsylvania 2.2

Pennsylvania � Pennsylvania � New Jersey � Other 4.8

Other 10.5 Other 13.9 Other 12.0

Source: The Money Tree Report, PriceWaterhouseCoopers, LLP, 1998.

required to establish an entrepreneurial com-

pany, these parameters have steadily risen and

arguably are now closer to $1 million and $5

million. Based upon this claim, there appears to

be a need for an established or newly designed

intermediary to fill the gap. Some argue that, in

the absence of such an entity, emerging growth

companies would face extreme financing diffi-

culty at a critical stage of development.

Because of the diseconomies of small-parcel

finance, the uncertainty and risk associated with

start-up and early stage investment, and the time-

intensity of investor involvement with early

stage firms (especially complex, technology-

intensive firms), many investors and interme-

diaries prefer to focus attention on later stage,

lower risk, less complex companies. Institu-

tional investors may have encouraged this


Table 7

LEGISLATION RELATED TO VENTURE CAPITAL INVESTMENT1952-93

Act Goal

Small Business Act of 1952 Established the U.S. Small Business Administration

Small Business Act of 1958 Increased the availability of venture capital to small business

1969 Tax Act Reduced tax incentives favoring equity investment, including in-creasing the level of the tax rate on capital gains to the level on or-dinary income

1978 Revenue Act Provided capital gains tax incentive for equity investments. Capitalcommited to venture capital increased by $556 million from pre-vious year

1979 ERISA's “Prudent Man”Rule

Clarified investment guidelines for pension investors. Encouragedinvestment in venture capital funds

1980 ERISA's “Safe Harbor”Regulation

Stated that pension fund trustees would not be fiduciaries of “planassets”

1981 Economic Recovery Act Lowered the capital gains tax rate. Capital commitments to venturecapital doubled to $1.3 billion

1986 Tax Reform Act Reduced incentive for long-term capital gains

1992 Small Business CreditEnhancement Act

Shifted SBIC program focus from debt to equity

Source: C.A. Beltz, T.A. Soja and J.E.Reyes, Investment Benchmarks: Venture Capital (Needham, MA: Venture

Economics, Inc., 1990), p.202.

tendency, inasmuch as attractive returns with

shorter holding periods and lower risk have

been available in great supply. As the private

equity finance market grows, more institutional

investors are entering the business and those in

the business are increasing their investment

allocation percentages to this asset category.

The gap issue is the source of continuing

debate, with entrepreneurs adamant in their

arguments that the gap exists. Private-sector

investors argue that market forces are sufficient

to control the proper rate of company start-up

and expansion and the proper flow of capital to

such investments. They argue that, while the

expected social rate of return (in jobs, personal

income, and taxes) from such investment may

be considered to be positive and attractive to

politically motivated public-sector investors,

the expected return to private investors on such

investments is insufficient—in the absence of

offsetting subsidies and incentives—to justify

consistent investment of private investment

funds at any except the highest cost of capital.

They claim that as attractive start-up opportuni-

ties are brought forth, for example, by new

waves of technology or regulatory dislocations,

the private-sector venture capital community is

prepared to invest appropriately.

Public policymakers decry this unwillingness

and offer several arguments. They point out that


Chart 6

THE ENTREPRENEURIAL CAPITAL GAPThe “Grand Canyon” of seed capital financing

Seed capital funds

$0

Capitalrequired

“GAP”

Venture capital void

Personal

savings

Private

investors

$25

$100k$250k

$500k

Capitalshortfall

Source: The 1995 National Census of Early Stage Capital Financing, Albuquerque, N.M. (The Anderson Schools of Manage-

ment, University of New Mexico, 1995), p. 56. Richard T. Meyer and Emory Business School, copyright 1992.

government tax incentives already exist, that

institutional investors are mostly tax-exempt

and that capital gains tax rates have been

reduced. They argue that government subsidies

to pure science (government scientific insti-

tutes), technological innovation (the SBIR pro-

gram), to small-firm equity (the SBIC program)

and to small-firm credit (the SBA-loaned guar-

antee programs) already exist, along with

government-financed training facilities (the

Small Business Development Center [SBDC]

program).

Entrepreneurs and SME owner/managers

argue that both the government and private-sec-

tor investors are deficient and self-serving in

their performance. They claim that the compe-

tence levels of venture capitalists and govern-

ment representatives are often insufficient to

provide proper selection and monitoring of

investments, that little value is really added by

either, and that the high price of capital (whether

measured by percentage of equity surrendered

or by bureaucratic entanglement) is driven more

by contrived scarcity than by value added. They

take the position that the social rate of return is

high, that it should be pursued, and that those

private returns would be sufficiently attractive if

finance as a barrier to entry were reduced.

Given the high levels of the stock market, the

lower costs of entry to many businesses (e.g.,

service, software, Internet), and the ability of

entrepreneurs to fund their companies with

credit cards, home mortgage loan proceeds, and

other innovative techniques, the gap contro-

versy nationally has cooled down for the

moment. When the global expansion slows

down and the current flood of liquidity abates,

the gap problem will reappear. In the meantime,

the gap remains strong in equity-disadvantaged

areas such as rural America, inner-city America,

and in the developing and transitional countries

of the world.

IMPROVING ACCESS TO EQUITYFINANCE FOR ENTREPRENEURIALVENTURES IN RURAL AMERICA: ANATIONAL AND LOCAL FRAME-WORK, PUBLIC POLICY OPTIONS,AND PRIVATE SECTOR INITIATIVES

The problem of improving access to equity

finance in rural America is similar in some

respects to the problem of providing equity

finance for transitional and emerging economies

in other parts of the world. In the international

case, the World Bank, through the International

Finance Corporation (IFC), makes direct equity

investments in projects in those economies and

invests in venture capital and private equity

funds in those countries as well. In this respect,

the World Bank acts in a similar vein to the U.S.

Treasury Overseas Private Investment Corpora-

tion (OPIC), which makes direct investments

and insures the “country risk” of the investment

by U.S. investors in venture capital and private

equity funds formed in transitional economies.

In many respects, the motivations which have

triggered these initiatives of policy and practice

are no less important with respect to rural Amer-

ica than to transitional economies around the

world.

While the analogy is not perfect, given the

absence of the political risk and other factors,

rural America is going through an economic

transition with important social implications.

The transition is triggered by positive structural

changes in its basic industries, which threaten

the viability of small producers which have

traditionally been a mainstay of the industries

and the rural communities and regions of which

they were a part. The replacement of this activ-

ity with new sources of employment, income,

and wealth creation in a highly competitive new

economy world is proving to be a challenge due

to problems of distance and lack of appropriate

business and financial infrastructure. We argue


that direct and indirect involvement in the

development equity finance aspects of this tran-

sition is an appropriate function of government

at all levels and that a public/private partnership

with U.S. financial market participants and non-

financial business firms is required. Within this

framework, we recommend a community-

centered system of entrepreneurial development

and finance built around the clusters of popula-

tion, knowledge, and facilities which exist in the

communities and regions of rural America.

In this setting, the ability of rural America's

communities and regions to accommodate the

market implications of these structural changes

and to offer competitively attractive employ-

ment, income, and wealth-generating opportu-

nities will determine the shape and nature of the

future economy of those parts of the United

States and the related flow of equity capital

investment. In a system of fully flexible competi-

tive resource markets, the dislocative effects of

otherwise positive restructuring and innovation

are quickly absorbed in shifts of land, labor, and

capital away from old combinations and uses

toward ones appropriate for the new conditions.

In the economic and social life of rural America,

evidence of this flexibility abounds in the sec-

torial dimension of the economy, reflected in

the adaptation of basic industries to the new com-

petitive realities of global commodities,

described earlier as Rural Economy 1. It is with

respect to Rural Economies 2 and 3 that evidence

of “sticky” inflexibility exists.

An important requirement of such flexibility

is access, through an effective intermediation

system, to savings, both local and nonlocal,

available to finance equity investment in

transition-related projects. Like the urban clus-

ters in the United States which enjoy high levels

of economic and financial market activity, Rural

Economy 1 enjoys such access and is linked to

global financial markets through big business

involvement in its basic industries. We show in

this paper that rural America's communities—and

especially the purely rural communities with

low degrees of urbanization and low proximity

to metropolitan areas—have achieved very low

penetration of the national equity financing mar-

kets. We argue that this is attributable in combi-

nation to a lack of effective demand for equity

capital and to inadequate financial intermedia-

tion facilities. To expedite the current economic

transition required in Rural Economies 2 and 3

in a timely, less wasteful, and more effective

manner, a focused public/private partnership

framework is needed. This should fuse appro-

priate actions of government and the private-

sector community of business and finance with

an entrepreneurial, community-centered organi-

zation and action plan.

An entrepreneurial, bottom-up solution is

most likely to provide a successful economic

transition and access to equity finance is

required in that process. In this context, access

to equity capital means the ways and means of

approach to the market and not some automatic

receipt of capital upon request. Investment will

flow from equity markets not to meet need but

to satisfy effective demand, that is, the credible

promise of a risk-adjusted return on investment

sufficient to meet prevailing competitive market

standards. Entrepreneurial initiative depends

upon the confidence that resources and capital

will be available when required to accomplish the

entrepreneurial goal. Mismatches in timing,

financing gaps, market failures, and failures of

government programs impede the smooth link-

age of these processes and demand the interven-

tion of public policy, on behalf of the nation as a

whole, to remove impediments and facilitate

progress. Cooperation between the equity

finance community and federal government

policymakers is largely credited with shaping

the modern venture capital, private equity

finance, and public equity market mechanisms.


Similar cooperation is capable of accommodat-

ing the transitional needs of this very important

portion of the country and providing new ave-

nues of wealth-creating investment for the

nation's equity market community.

In this section, we first review the evolving

national framework within which to consider

improvement of access to equity finance for

entrepreneurial ventures in rural America. We

then review two sets of recent public policy

proposals directed to this issue, one from the

Rural Policy Research Institute (1997) and one

from the Clinton Administration (1999), the

first intended to improve access to capital for

rural America and the second directed to rural

and urban areas of the country felt to be

underserved by private market financial service

facilities. In light of these proposals, we suggest

a community-centered policy framework that

we believe will help the combined efforts of

government and the private sector succeed in

improving access to equity capital for entre-

preneurial initiatives in rural communities and

regions. We conclude this section with sum-

mary recommendations for public policy and

private-sector initiatives.

An evolving national framework toimprove access to equity finance forentrepreneurial ventures in ruralAmerica

The problem of improving access to equity

finance for entrepreneurial initiatives within

rural America must be framed in the light of

public policy toward entrepreneurial activity

and its financing in the nation as a whole as that

policy has emerged over the past two decades.

Public policy is generally defined as a course of

action adopted and pursued by a government,

either as a matter of prudence or expediency, on

behalf of the general interest of the public.

While the proportional extent to which steering

and intervention by government policymakers

should relate to free-market determination in

the economic and social life of the country is a

continuing source of debate and political initia-

tive within the U.S. system of political econ-

omy, the concept of a market-driven economy

has gained ground on the concept of a mixed

economy in the United States and the rest of the

world since the early 1980s.

This public policy is evolving in the direction

of encouraging a greater level of economic self-

reliance among individuals, a lower degree of

direct involvement in the economy by govern-

ment, and greater access at lower cost to equity

capital and debt finance for entrepreneurial initia-

tives. Examples of U.S. public policies directly

relevant to access to equity capital for entrepre-

neurial initiatives include the following:

Tax policy modifications to encourage equity

investment in entrepreneurial initiatives. Low-

ered effective tax rates on capital gains in gen-

eral encourage individuals to invest more of

their savings and accumulated wealth in

growth-oriented equity ownership than in

dividend-producing assets. While lifting the

entire equity market, this policy has a positive

direct effect on equity investment in entrepre-

neurial initiatives. Potentially powerful tax

incentives have been developed to encourage

entrepreneurial small businesses. For example,

the introduction and improvement of the limited

liability corporation (LLC) permits the pass-

through of tax losses to ease the burden of start-

up financing and permits the avoidance of

double taxation. Equity investments made in

originally issued equity securities of qualifying

small businesses and held for five years are sub-

ject to a capital gains tax which is effectively cut

in half, thus encouraging “patient capital” invest-

ment. Also, the small business capital gains tax

rollover provision permits the capital gain on

sale of a business asset, stock, or units of a unit


trust to be deferred for tax purposes. Capital

gains taxes upon sale of a small business where

the proceeds are to fund retirement for owners is

also subject to exemption from capital gains tax.

Provisions such as these increase market flexibil-

ity by reducing the cost of changing the deploy-

ment of capital and favoring investment in

change-oriented assets. They can play an impor-

tant role in providing equity capital to fund the

economic transition facing rural America.

While these policies are reflected in legal and

regulatory modifications at the federal level,

they owe their genesis and formation to the

input of the voting public in general, representa-

tives of the private-sector entrepreneurial and

financial markets communities, and the initia-

tives of public and private-sector participants at

state and local community and regional levels.

The combined effect of these policies and

actions has been a significant increase in action-

oriented, interactive entrepreneurial activity at

all levels of society and business in the United

States and a related increase in the attractiveness

of enterprise-ownership-based employment

relative to wage-earner-oriented employment.

Policy modifications by the Securities and

Exchange Commission (SEC) to improve access

to equity capital markets with lower cost and

fewer regulatory barriers for smaller offerings.

As the financial system of the United States and

the world becomes more complex and inter-

twined, the question of government's appropriate

role in these markets becomes more important.

Sound regulation of financial markets is consid-

ered essential to their efficient operation. At the

same time, allocative efficiency on a broad (i.e.,

covering many markets) and deep (i.e., extend-

ing financial services to smaller and riskier sub-

markets) basis is a target of public policy and

private-sector participants. The pursuit of these

objectives requires joint cooperation between

those parts of government involved with writing

financial laws and enforcing regulations and

private-sector market participants.

As the demand for equity capital by young,

small, and innovative firms has grown, along

with the appetite for equity investment by indi-

vidual and institutional investors, the SEC has

responded by adapting its regulatory program to

the need for faster, less expensive access to

equity markets. A variety of short-form SEC

application procedures has increased the speed

and lowered the cost of equity capital acquisi-

tion, while providing investor protection. His-

torically, the transactions cost of small private

and public offerings of equity securities per

dollar of capital raised has been quite high. As

telecommunications technology has lowered

transactions costs in financial markets, the SEC

has moved positively to accommodate small

capitalization offerings while maintaining the

quality level of market regulation. This is being

done by reducing market-entry regulations

while increasing monitoring and sanctioning

activity. As a result, significant financial inno-

vation is being brought to the process of raising

equity capital for young, small, and entrepre-

neurial firms regardless of their location. Internet

offerings of equity securities are now common

and new methods of sale and distribution are

beginning to appear. As integration of state and

federal securities laws proceeds, the use of Small

Capitalization Offering Registration (SCOR)

issues is increasing. This, along with the SBA's

computerized angel investor network (ACE-

Net), is encouraging the involvement in entre-

preneurial companies of qualified individual

private investors. The liberalization of access

to equity capital through technology cum appro-

priate federal and state regulation is a powerful

public policy driver of entrepreneurial activity.

The restructuring of the commercial banking

industry, including the restoration of the ability

of commercial banks to engage in investment


banking. Financial law and regulation are in a

period of significant change, with the restructur-

ing of commercial banking at its core. The

rationalization of banking, including a return to

its pre-1933 structure to include investment

banking services, can be made to bring a uni-

form set and quality of resources and services to

U.S. business, regardless of industry, location,

or size. There is considerable current debate over

bank reform, including the issue of ultimate

bank regulation control (i.e., the U.S. Treasury

or the Federal Reserve System) and the extent to

which laws such as the Community Reinvest-

ment Act should influence bank lending and

investment behavior. The outcome of these

debates will be very important to the issue of

equity capital access for rural communities.

Increased programmatic access to sources of

equity capital and debt finance through federal

and state sources and private-sector economic

development entities. The availability of financ-

ing for entrepreneurial activity, small- and

medium-sized businesses and microenterprise

through programs funded by federal and state

agencies and made available through the bank-

ing and nonbank financial intermediation sys-

tem and not-for-profit economic development

entities has increased in volume and is being

extended to the local community and regional

level. The SBA is the federal government's pri-

mary channel for serving as advocate and pro-

moting the interests of small business and

underserved markets. The importance of SBA-

guaranteed business credit was shown in data

presented earlier. With respect to equity capital,

the 1992 Revision of the Small Business Invest-

ment Company Regulations is particularly

important. These revisions have shifted the

SBIC to a stronger equity orientation with the

ability to sell equity participation certificates to

the federal government and to institutional

investors, such as pension funds. For SBIC

chartered within rural America, these equity

securities offer an opportunity for local public

and private institutional investment pools to

invest, through a federally regulated entity, in

the equity securities of emerging or restructur-

ing companies in their area of domicile. These

SBICs may be formed by local banks and non-

bank financial intermediaries, by groups of

individual and corporate investors. Because

they are regulated and financed in part by the

federal government, SBICs may be accepted as

qualified investments by ERISA-regulated pen-

sion funds and other investment pools.

Access to federal and state government financ-

ing sources are now available to SME and entre-

preneurial initiatives at the local and regional

level in virtually every state. In North Carolina,

for example, the array of sources shown in a

state publication (Capital Opportunities for

Small Businesses 1998) include the following:

Federal Government Sources:

Small Business Administration

U.S. Department of Commerce

U.S. Department of Agriculture

U.S. Department of Energy

U.S. Export-Import Bank

U.S. Bureau of Indian Affairs

State Government Sources:

N.C. Department of Agriculture

N.C. Agricultural Finance Authority

N.C. Department of Commerce

Specialized Private Sources:

N.C. Biotechnology Center

N.C. Technological Development

Authority

N.C. Rural Economic Development

Authority

Centennial Campus at N.C. State

University

Piedmont Triad Research Park

Telecommunications Development Fund


Private Investment Capital Sources:

Venture Capital Funds

Individual Investors Network

Joint Ventures and Strategic Alliances

State Securities Offerings

Private, Non-Profit, and Local Programs:

Self-Help

Business Consortium Fund

Mountain Commercial Lending

Consortium

Community Development Credit Union

N.C. Association of Community

Development Corporations

Appalachian Regional Development

Comission

Local Government Programs

Access to sources and programs of this type is

available to companies in virtually any state as

part of what is coming to be known as the eco-

nomic development industry. Involvement in it

seems to be dependent mostly on the degree of

initiative and resolve shown by the residents of

entrepreneurial clusters, i.e., communities and

regions, which want to pursue their own devel-

opment. Through organization and politically

astute activity, individuals and entities within

these clusters are able to pursue these opportuni-

ties as they discover them, often expanding the

vision and energizing the agenda of the state and

local governments and institutions which exist

to serve them. There is little excuse, regardless

of domicile, for businesses not gaining access to

these sources of development and growth capital.

The marriage of positive public policy with a

set of conditions that encourage entrepreneurial

activity has facilitated a strong upsurge of interest

in entrepreneurial growth in the United States

by entrepreneurs and the investment commu-

nity. To date, this upsurge has occurred at differ-

ent rates of speed and levels of dollar volume at

different places within the nation at different

points in time over the past two decades. For the

most part, rural America has lagged behind in

this process, perhaps due to overreliance upon

its basic industries and the government policies

that have sustained them over time. As these

industries become less connected to the econ-

omy of local communities, the people wishing

to work and live in these communities must find

new sources of employment, income, and wealth

generation. In this sink-or-swim setting, entre-

preneurial initiative is an important ingredient

to survival and must be vigorously pursued by

individuals and communities at the local level.

As suggested above, interested parties will find

available to them a variety of government pro-

grams, not-for-profit economic development

entities and financing sources, and a network of

entrepreneurial associative groups which is fast

becoming a potent political force in the United

States and other countries.

Federal, state, and local public policyinitiatives to improve access to equitycapital in rural America recentlyrecommended (1997) by the Rural PolicyResearch Institute

RUPRI has addressed many aspects of eco-

nomic development in rural America, including

the role of debt and equity finance in that devel-

opment. RUPRI has conducted extensive pri-

mary research on this topic and has presented

testimony on issues of related public policy to

representative bodies of government at all lev-

els. Rural America has been its primary devel-

opmental focal point and its concern has been

the redirection of that part of the nation's econ-

omy in the face of new economic realities.

In a 1997 report, “The Adequacy of Rural

Financial Markets: Rural Economic Develop-

ment Impacts of Seven Key Policy Issues,”

RUPRI concluded that the ability of communi-

ties in rural America to react effectively in the


face of changing economic conditions was

impaired by the inability of its residents to gain

access to capital with which to redirect and

restructure its economy. RUPRI stated that the

system of local financial institutions was domi-

nated by banks which had severe limitations of

size, management, and lending preferences and

was relatively disadvantaged by the nation-

wide set of banking and financial regulations.

As a result, bank credit availability and service

is considered suitable to the “rural farm econ-

omy of the past”—for which there is declining

demand—but not in tune with the requirements

of a rural economy in transition which is in need

of larger infusions of finance for projects based

on entrepreneurial response to new opportunities.

Most serious of all was the recognition that

virtually none of the equity finance mechanisms

which have become rather standard throughout

the rest of the United States and in transitional

economies around the world were in place in

rural America. Rural equity markets were found

to be nonexistent and networks of informal

sources of equity capital found to be unorga-

nized. To the extent that rural America is

dependent on entrepreneurial activity to lead its

economic transition, the lack of equity capital

facilities, and the deficiencies of the banking

system pose significant barriers to progress.

The following capital gaps were considered

the most serious and evident:

1. The trend toward accelerated bank mergers

threatens the community bank concept and may

reduce lending to local business and change the

newly merged bank's business focus.

2. Compliance with bank regulation imposes

costs on the small banks that currently serve rural

communities and impose standardization and size

limits on the projects available to those banks.

3. While routine credit needs are adequately

served, large projects, start-up companies, and

business opportunities unfamiliar to lenders are

not well served by community banks.

4. Equity capital markets, other than informal

activities of individual investors, are unorga-

nized and virtually nonexistent in rural commu-

nities. The absence of organized rural equity

capital funds, business angel networks, and

technology-oriented business incubator and entre-

preneur development networks in most rural

communities arguably slows both the growth of

existing business and prevents the start-up of

otherwise promising businesses.

5. Rural communities, particularly smaller

communities, often have more difficulty financ-

ing infrastructure projects due to smaller tax-

base revenue potential.

6. Financing housing construction and owner-

ship in rural communities is difficult, thus

impeding economic development recruiting

and retention efforts.

7. Intergenerational transfer of assets presents

an opportunity as well as a chronic threat

regarding the ability of financial institutions to

regenerate investment and debt capacity for

rural communities.

RUPRI proposed a number of public policy ini-

tiatives to address these gaps and inefficiencies.

1. Modify the charter of the Federal Mort-

gage Assistance Corporation to enable it to

provide a secondary market for rural develop-

ment loans that meet U.S. Department of Agricul-

ture business and industry loan criteria. This

would allow banks and a variety of other lend-

ers to initiate larger and longer term loans and

would permit the interest rate and local project

risks of loans to be transferred to a large and


diversified pool, which could be marketed

nationally.

2. Modify the charter of the Federal Home

Loan Banks to permit FHLB to include small-

business loans, farm loans, and infrastructure

loans under rural development loan authority to

provide another source of liquidity and risk

pooling for community lenders.

3. Broaden the charter of the Federal Credit

System to include nonagricultural business and

industry loans, housing, infrastructure, and

equity participation beyond FCS affiliates in

order to fund, for example, local and regional

economic development corporations and

Small Business Investment Companies.

4. Permit all of the charter amendments pro-

posed above, in the interest of providing a com-

prehensive system of investment flexibility,

liquidity, and risk pooling through institutions

that already exist.

5. Facilitate rural equity markets by organiz-

ing networks of rural community business incu-

bators and entrepreneur development programs

to generate viable business projects and orga-

nize rural equity capital networks, funds, and

foundations that can spread risks and evaluate

viable entrepreneurial projects so that rural

landowners and main-street professionals can

invest with reasonable risk.

6. Create improved access and flexibility for

rural housing.

7. Encourage infrastructure flexibility and

regional planning so that infrastructure purpose

and cost can be pooled.

8. Empower rural capital markets through

technical assistance in utilizing existing pro-

grams and facilities.

As part of its preparation for the 1996 Farm

Bill debate, a RUPRI panel put forth a set of

principles to judge the rural development impli-

cations of any suggested rural finance reform.

The reform should:

1. Strengthen market-driven debt and equity

markets so that rural America can fully utilize

its resources, income-generating capacity, and

overall contribution to the economy.

2. Strengthen community access to appropri-

ate financing expertise for each opportunity for

community development.

3. Provide community access to wholesale

debt capital markets and intermediation neces-

sary for sustainable economic development.

4. Provide community access to equity capital

necessary for sustainable economic development.

5. Encourage coordination, partnering, and

integration of sources of rural capital to match

risk-bearing capacity, responsibility, and

reward with appropriate size and diversification

of rural portfolios.

6. Facilitate appropriate levels of intergenera-

tional transfer of business assets necessary for

stable investment and rural economic growth.

7. Increase ease of identification and access to

assistance programs by local government and

private-sector development groups.

8. Provide for rural community representation

in addressing finance and capital needs of rural

communities.

To focus specifically on the problem of

improving rural equity availability, The RUPRI

Rural Equity Capital Initiative conducted a

1998 survey of facilities engaged in rural equity


investment across the country. They located and

interviewed 15 institutions including Small

Business Investment Companies, private ven-

ture capital funds, public venture capital pro-

grams, and community development programs.

Perhaps the most important insight gained in

this preliminary study is the dependency of vir-

tually all aspects of the fund characteristics and

activity on its objectives. Where generation of

social rate of return through economic develop-

ment is the objective, economically targeted

investment is pursued. Where private rate of

return is the objective, wealth-creating criteria

guide investment and economic development

impact is not a primary concern. These objec-

tives influence sources of capital for each fund

as well as its organizational form. The study also

produced evidence that, in many cases, the

founders and sponsors of funds dedicated to

economically targeted investments believe that

they will subsequently transform these funds

into private, profit-oriented funds or form new

ones as market opportunities become proven.

Effective demand for equity, reflected in deal

flow, was found to be a complex issue. Finding

deals is time consuming and expensive, especially

in the thinly populated parts of rural America.

Equity capital alone is not an effective inducement

to attract a company to a rural community. The

best results are obtained in areas where clusters

of existing business exist and opportunities are fed

to the funds by lenders and other business connec-

tions. These findings mirror the results of our

research, presented in this paper, suggesting that

effective demand is a major problem.

Federal public policy “new marketsinitiatives” to improve access to financefor underserved markets in the UnitedStates recently recommended (1999) by theClinton Administration

As part of the proposed federal budget for

2000, the Clinton Administration has included a

New Markets Initiative to increase business oppor-

tunities in underserved rural and inner-city com-

munities. The stated goal of the program is to

have it emulate domestically the comprehen-

sive economic development program directed

toward transitional and emerging nations inter-

nationally. The plan is intended to be a public/

private partnership, the elements of which include

tax credits, loan-guarantee incentives, a net-

work of private venture capital companies as

well as technical assistance and mentoring pro-

grams. The magnitude of financial commitment

exceeds previous levels of funding available

through SBA, permitting $14.1 billion in SBA

loans and $2.4 billion in equity through the

SBIC program. No specification of geographic

or population proportional distribution has been

indicated, and rural communities have the

opportunity to compete for these funds.

SBAhas defined New Market firms as current

and prospective small businesses owned by

minorities, women, veterans, and handicapped

individuals who are underrepresented in the

population of business owners compared to

their representation in the overall population, as

well as businesses located or locating in low-

and moderate-income urban and rural areas.

The components of the proposed initiative

include:

1. Provision of tax credits worth up to 25 per-

cent for investments in community develop-

ment banks, venture funds and corporations,

and other targeted investment funds.

2. Creation and funding of New Markets Ven-

ture Capital Companies, operating like SBICs,

which will offer equity investment and techni-

cal assistance to smaller businesses located in

low- and moderate-income (LMI) areas.


3. Presentation of LMI Investment and Out-

reach Workshops will offer matching funds

to licensees investing in LMI areas, with

workshops held to stimulate deal flow and

investment.

4. Creation of America's Private Investment

Companies (APICs) which will provide com-

bined private capital and government-backed

funding to finance equity capital investment

incentives for the creation or relocation of

large-scale businesses in inner-city or rural

areas.

5. BusinessLINC, a partnership between

SBA, the Treasury Department and the business

community to encourage large businesses to

work with small-business owners and entrepre-

neurs as technical advisors and mentors in

inner-city and rural areas.

6. New Markets Lending Companies, a pilot

program to involve nondepository lending

institutions that will make SBA loans to small

business.

This proposed initiative will be subject to the

Congressional political process and will be part

of the debate over the disposition of the pro-

jected federal surplus. It will attract Congres-

sional public interest because it represents

targeted spending in support of a wide constitu-

ency of people who are felt to be disadvantaged

with respect to financial markets. The improved

performance and perception of the SBA in

recent years add credibility to the proposed pro-

grams. Given the general success of the various

U.S. development programs in emerging

nations, despite recent crises and current hostili-

ties, the logic of providing development assis-

tance for domestic markets in transition will be

difficult to oppose politically and some version

of the initiative will probably become law.

A recommended new policy framework,policy options, and action steps toimprove the flow of equity capital toentrepreneurial initiatives in ruralAmerica

To improve access to equity capital in rural

America, we propose a public policy framework

and policy options based upon a community-

centered system for development and financing

of entrepreneurial initiatives in rural America.

This proposal reflects our findings regarding

the relationship between equity flows over the

1987-98 period and the combination of degree

of urbanization and proximity to metropolitan

areas documented in the body of this paper.

These results suggest that the best chance of

improving rural America's access to equity capital

markets is to provide the means, incentives, and

encouragement for local residents and institutions

to build upon this relationship and to focus on

increasing the interaction among clusters of

population and equity capital-attracting entrepre-

neurial activity already observed. Through this

framework, communities which organize clusters

of people and institutions interested in entrepre-

neurial activity may avail themselves of govern-

ment initiatives and programs according to their

needs and preferences. As has been the case in

improving the viability of the venture capital,

private equity finance and initial public offerings

markets over the past two decades, the private-

sector financial community and government can

cooperate to extend the benefits of these equity

markets to the parts of rural America which can

generate effective demand for such capital.

Relevant Public Policy Priorities for Federal,

State, and Local Government. In order for the

proposed local entrepreneurial development

and financing system to be effective, govern-

ment at all levels should focus attention and

efforts on a set of policies and activities which

includes the following:


• Maintain stable, noninflationary economic

growth at its highest sustainable level;

• Pursue a steady improvement in the

nation's standard of living: education,

health, and recreation and strive to attain

full participation of all residents in these

benefits;

• Raise the importance of small business and

entrepreneurship in public policy consid-

erations;

• Include in all policy deliberations the

explicit positive and negative effects upon

small business and entrepreneurship;

• Facilitate the development and exchange of

information relevant to finance and other

aspects of small business and entrepreneur-

ship (e.g., ACE-Net);

• Ease and make equitable the tax and regula-

tory burden on small business and entrepre-

neurship;

• Protect intellectual property so as to stimu-

late the free flow of innovation while pro-

tecting the wealth-creating incentive of the

intellectual property production process;

• Provide an effective system of education

and training in order to produce an educated

population, which includes a technologi-

cally proficient work force;

• On behalf of society, raise and allocate pub-

lic funding for basic research and technol-

ogy transfer rates and low compliance

costs, without market-distorting incentives

and accounting;

• Monitor the effects of existing and prospec-

tive laws and regulations, both economic

and social, which affect entrepreneurship

and small- and emerging-growth compa-

nies within the nation; and

• Protect the commercial, legal, and political

rights of U.S. citizens and business in inter-

national market settings.

In conjunction with pursuit of these public

policy objectives, the private-sector market par-

ticipants must be expected to address the

required factors set forth below.

Factors affecting access to equity capital in

rural communities and regions. As previously

discussed, the U.S. system of providing access

to equity financing for entrepreneurial activity

is unsurpassed in the world. While its growth

may be credited in large measure to the market-

driven entrepreneurial instincts of its investors

and investment professionals, government pol-

icy has played an important role in its successful

development. For example, the initiation of the

Small Business Investment Company as a ven-

ture capital vehicle in 1957 supplemented the

existing set of investment partnerships and pro-

vided points of entry for many investment spe-

cialists as well as capital for many young

companies. The revision of the Employees

Retirement Investment Safety Act (ERISA) in

1982 provided access to pension fund capital for

venture capital and private equity funds and the

initial public offering market, triggering the

rapid expansion of capital inflow to this part of

the investment market. Favorable effective tax

rates on capital gains and liberalized status for

stock options provided incentives for people to

opt for careers in entrepreneurial activity. In

these and many other ways, public policy initia-

tives have contributed to the growth of entrepre-

neurial activity in general and the availability of

equity capital for such activity in particular.

We believe that improving rural community


access to equity capital, and especially early-

stage development capital, is an extension of

earlier public policy initiatives to further the

development of equity finance for entrepreneu-

rial activity. We believe that the current situation

calls for such public policy intervention both as

a matter of prudence and expediency. As sectoral

restructuring in rural America's basic industries

is driven by market forces, unintended but seri-

ous economic and social side effects are experi-

enced by those communities and regions which

do not benefit immediately and directly from the

changes. To the extent that flexible market

responses to these side effects are not spontane-

ously forthcoming, and to the extent that they

impose social costs, an expeditious public pol-

icy response is appropriate.

The central problem facing structural transition

in these communities involves both the identifi-

cation of credible net present value-producing

equity investment projects and the timely involve-

ment of investment sources and financial inter-

mediaries capable of funding and supporting

such projects. Production of such investment

projects may emanate from recognition of opportu-

nities in rural areas by local, regional, or national

entrepreneurs. Access to equity capital to pursue

these opportunities also may come from local,

regional, national, and international sources,

both in the government and private sectors.

While the investment quality of the project is the

key to attracting the capital, the certifiable exis-

tence and involvement of local intermediaries

and investors are conditionally important to the

launch of entrepreneurial activity.

In this and previous research we have shown

that equity investment made in the United States

in the 1987-98 period was significantly greater

in urban areas than in rural areas, as measured by

number and dollar volume of financing. In the

earlier research, we showed this difference

between the Heartland states and the remainder

of the nation classified by zip code analysis as

“urban” and “rural.” In this paper, we have

extended that analysis to deeper levels of detail,

and we conclude that these differences are even

more significant and are related to fundamental

factors, which must be recognized in any public

policy initiatives proposed.

The most important factor to be recognized by

policymakers is that, within this context, there

are two “predictors” of venture capital, IPO

and SEO capital inflow to small geographic

areas: a) degree of urbanization and b) proxim-

ity of the area to metropolitan areas. These fac-

tors are multiplicative rather than additive.

They reflect the advantage enjoyed by small

areas endowed with clusters of people and

resources in generating entrepreneurial activity

and its related financing. To increase rural com-

munities' and regions' access to equity capital,

the benefits of clustering and financial interme-

diation must be brought to those areas. In the

less densely populated communities and

regions, provision of telecommunications serv-

ices and access to the Internet is an important

part of providing these benefits.

This conclusion is consistent with findings of

a large body of research and we believe we have

confirmed their importance with respect to rural

equity investment. Trends in census data sug-

gest that the solution to the equity issue will be

ultimately resolved by the increasing urbaniza-

tion of what is defined as rural America,

although this brings its own set of social and

environmental problems, a recitation of which

is beyond the scope of this paper. As we have

shown, the “purely rural” part of the country

constitutes only about 8 percent of the popula-

tion and, since entrepreneurship and equity

investment are associated with urban clustering

of population, spillover pressures will bring

development opportunities for these areas and

investment will follow. These will differ


according to locational correlation and the

nature of proximate industrial development.

If rural development follows the pattern of

entrepreneurial company development in the

rest of the United States, it will be associated

first with clusters of population and resources

such as those observed in this study— “critical

masses in one place of linked industries and

institutions—from suppliers to universities to

government agencies—that enjoy unusual com-

petitive success in a particular field”—which

determine and define successful economic

development in geographic areas (Porter 1999).

We believe that the relevant clusters within rural

America have at their core the urbanized popu-

lation concentrations, which we identified in the

findings presented earlier in this paper.

Porter argues that such clusters affect compe-

tition in three broad ways: by increasing the pro-

ductivity of companies based in the area, by

driving the direction and pace of innovation,

and by stimulating the creation of new busi-

nesses within the cluster. Geographic, cultural,

and institutional proximity provides companies

with special access, closer relationships, better

information, powerful incentives, and other

advantages that are difficult to access from a

distance. The more complex, knowledge-based,

and dynamic the economy becomes the more

this is true. Competitive advantage lies increas-

ingly in local things—knowledge, relation-

ships, and motivation—that distant rivals

cannot replicate, despite the Internet. Our analy-

sis shows that a great deal of rural America con-

tains urban clustering and that the incidence and

dollar volume of equity financing over the last

decade was higher in these areas of greater

urbanization. It is likely that the earliest and

strongest transitional development will occur in

such areas and that public policy should be

focused on encouraging that development. We

believe that encouraging this clustering process

is a policy issue, which is central to the eco-

nomic transition of rural communities.

Success in transitional economic develop-

ment is more likely for clusters within rural

communities or regions if they organize to

engage in systematic pursuit of opportunities to

discover comparative advantage based upon

competitive innovation, rather than waiting

passively for the great breakthrough or deliver-

ance by government policy. Within an individ-

ual company, opportunities can be found in

unexpected occurrences, incongruities of vari-

ous kinds, process needs, or changes in an

industry or market (Drucker 1985). Within a

community or region, opportunities arise from

demographic changes, changes in perception,

or new knowledge. These company and com-

munity sources overlap and the potential for

innovation may lie in more than one source at a

time. While innovation based on new knowl-

edge tends to have the greatest effect on the mar-

ketplace, the translation of the ideas into actual

products, processes, and services often takes

decades. Drucker emphasizes that in seeking

opportunities, innovators need to look for sim-

ple, focused solutions to real problems. Grandi-

ose ideas designed to revolutionize an industry

rarely work. Innovation, like any other

endeavor, takes talent, ingenuity, and knowl-

edge. If diligence, persistence, and commitment

are lacking, companies and communities are

unlikely to succeed at the business of innova-

tion. These insights from Drucker are useful

guides to rural developmental policy design and

implementation.

Furthermore, the venture capital and private

equity finance communities—along with the

institutional investors which provide their capi-

tal and the investment banking firms which pro-

vide their liquidity through harvest—are more

likely to be judgmental than developmental.

These funds typically have ten-year lives and


face pressure from their investors to deliver

exceptionally high portfolio returns (25 percent

to 40 percent compounded) within this period.

Along with looking for good management

teams, good ideas, and good business plans,

equity investors are looking fundamentally for

good industries and good business models in

which to invest, i.e., industries that are more

competitively forgiving than the market as a

whole and business models which are focused

upon creating value for investors. These charac-

teristics pose great challenges for rural commu-

nities, two of which are discussed below.

The first challenge concerns the willingness

and ability of rural Americans to adapt their

business models and structures to a free market

orientation and the extent to which existing

organizational arrangements, some of them

government-linked, may impede that adapta-

tion. An example of this is the use of the coop-

erative structure as a business model for

participation in the value-added activities con-

nected with the agriculture industry (Hays

1999). Farmers' co-ops have been useful in

bringing purchasing, production, marketing,

and distribution strength to smaller independent

farmers over the years. Perhaps more impor-

tantly, co-ops play a central role in the value-

added developments of the post-commodity era

of agriculture. Examples of these co-ops and the

brands they produce are shown in Table 8.

While these brands are household words in the

United States, the co-op structure reflects part of

the effective demand aspect of the access to

equity capital problem in rural America.

Because they represent a large part of the food-

processing market, i.e., the non-commodity

source of added value in agriculture, these enti-

ties are economically significant and have open

access to Wall Street equity investment firms.

However, in a period when capital investment

for competitive expansion is important to their

survival, these entities find it difficult to raise

equity capital and are almost entirely dependent

on debt financing.

Co-ops have difficulty building an equity

base from internal sources because they distrib-

ute their proceeds to members each year.

Because of their legal and tax structure, they

cannot sell stock to nonmember purchasers or

use it to pay for acquisitions. They have diffi-

culty in financing major expansion unless they

borrow or merge with other co-ops, as many

have done recently. The co-ops, “with their

roots in 19th century agrarian socialism,” play a

huge role in U.S. agriculture and in rural com-

munities, yet due to their structural characteris-

tics are seen as “quaint counterpoints to the

unbridled capitalism energizing most of the

economy” (Hays 1999)—the very system into

which they must fit if equity flows to rural com-

munities are to be increased.

Their direct competitors are firms such as

Pepsico, Coca-Cola, Cadbury-Schweppes, and

Nestle—large, multinational corporations with

the ability to raise virtually unlimited amounts

of capital as needed. The ability to borrow at

low interest rates from the $19 billion National

Cooperative Bank—a federal government facil-

ity which lends exclusively to them—because

of its convenience, may reduce the likelihood

that the co-op structure will be replaced by a

structure which would enable access to national

equity markets. Research should be devoted to

the question of the extent to which dedicated

government-subsidized agriculture-linked

credit facilities (e.g., the Federal Farm Credit

System) acts as a deterrent to the adoption of

market-based equity financing programs in

rural communities and regions.

The second challenge concerns the institu-

tional orientation of venture capital and private

equity financing and the early-stage equity gap


described above. Our data show that this type of

investment will flow from state to state in pur-

suit of credible opportunities for wealth crea-

tion, and in that sense rural communities have

open access to it. The point is that it flows in

response to effective demand, i.e., the opportu-

nity to earn economic rent, and to areas in which

there exist professional investment entities with

which to partner in such investments. Rural

communities and regions must encourage the

organization of such entities which can supply

developmental venture capital in order to

finance the new firms which carry their hopes

for economic transition and to ultimately attract

the investment-partnering interest of the “judg-

mental” national equity system participants. A

start to this entity-formation process is available

through the emerging economic development

industry. This is a set of grass-roots organiza-

tions often formed as not-for-profit entities

funded by foundations and focused upon

improving the local use of federal government

programs like the Small Business Innovation

Research grant program, SBA loans through

bank and nonbank intermediaries, Small Busi-

ness Investment Companies equity finance, and

networks of angel equity investment pools

formed through ACE-Net.

We propose a general framework that can be

adapted to local conditions in order to stimulate

entrepreneurial activity and improved access to

equity finance.

A proposed community-centeredentrepreneurial development frameworkand its action components

Because population clusters in rural America

may differ significantly among themselves

according to the set of resources they possess

and opportunities they face, we argue that devel-

opment and financing of entrepreneurial activity

can best be accomplished and sustained over

time through a community-centered public-sec-

tor/private-sector interactive partnership, adapted

to the resources and opportunities which exist at

the community level. This partnership should

include the integrated efforts of the residents,

businesses, institutions, and financial market


Table 8

AGRICULTURAL COOPERATIVES AND BRANDED PRODUCTS

Cooperative Examples of brands

Dairy Farmers of America Borden cheese, regional dairy brands

Farmland Industries Farmland meats

Land O’ Lakes Land O’ Lakes butter

Gold Kist Gold Kist poultry, peanuts

Ocean Spray Ocean Spray juices and fruit

Sunkist Growers Sunkist citrus fruit

Tri-Valley Growers S&W, Libby’s, Sacramento

Riceland Foods Riceland rice, Chefway rice, oil

Pro-Fac Cooperative Bird’s Eye, Comstock, Snyder’s

American Crystal Sugar Crystal, Pillsbury sugar

National Grape Cooperative Welch’s juices, jellies

Blue Diamond Growers Blue Diamond and Smokehouse almonds

participants at all levels which have interests in

the solution to the problems involved, on the one

hand, and federal, state, and local governments

on the other. While the organizational methods

and styles may differ among communities, we

believe the elements of this general framework

are central to the needs of particular locations in

which it might be applied.

These community cluster participants provide

the connective tissue between federal govern-

ment policy and programs, the national private

equity finance system, the rural communities

and regions, and the states in which they are

located. The core of the cluster consists of those

people who wish to live and work in the commu-

nity. The local and regional universities, com-

munity colleges, public utilities, and financial

institutions all have a stake in community and

regional development and must play a catalytic

and supportive role in the application of public

policy and the development of appropriate proj-

ects. Under such a system, appropriate relation-

ships may be developed between the local area,

the various levels of government, and the pri-

vate-sector corporate world and financial mar-

kets. The major action components of this

policy framework are presented in Table 9 and

each component is discussed below.

To improve the realized flow of equity capital

to rural America in order to assist its transition

to full participation in the U.S. economy, the

local development system must seek to achieve

the following objectives at local, state, and

national levels (Table 9).

1. Stronger effective demand for capital in

rural areas must be developed through the effec-

tive operation of local entrepreneurial initiatives.

2. An increased flow of local equity finance

must be made available for local entrepreneurial

investment projects. Local sources of individual

and institutional capital must be focused on

local investment opportunities.

3. Local financial market intermediation

mechanisms must be developed and upgraded,

and these must include bankers, nonbank lend-

ers, attorneys, successful business people, indi-

vidual, institutional, and corporate investors.

4. Participation by local people and entities in

government programs of finance (SBA credit,

SBIR grants, SBIC capital programs, ACE-Net

network for angel investors) and assistance to

entrepreneurial business (SBDC) must be

developed and improved.

5. Through the political process, local com-

munities should press for the expansion of the

role of federal government developmental

finance institutions to provide the equity

capital-orientation, private-sector partnering,

and operating characteristics of similar institu-

tions serving international development

needs—e.g., the World Bank, International

Finance Corporation, and the Overseas Private

Investment Corporation—thereby increasing

the availability and accessibility of an increased

volume of equity capital and debt financing for

growing businesses.

6. Through the political process, local com-

munities should press for the direction of fed-

eral, state, and local government policy toward

changes in regulation and taxation designed to

remove barriers and provide incentives for the

development of entrepreneurial activity

through initiation of new companies and revi-

talization of existing firms.

The successful development of the framework

and its equity investment network depends on

three private-sector prerequisites. First, the entre-

preneurial culture of the rural communities, his-

torically focused on traditional industries, e.g.,



Table 9

A COMMUNITY-CENTERED ENTREPRENEURIAL CLUSTERDEVELOPMENT FRAMEWORK AND ITS ACTION COMPONENTS

Component Objective

1 Encourage and support entrepreneurship

as the cultural core of the community

economic system.

Build upon the tradition of self-reliance and indepen-

dence in rural America to focus attention on the opportu-

nity to influence the nature and shape of the community’s

economic and social future.

2 Facilitate the discovery of entrepreneurial

opportunity.

Stimulate the interaction among community economic,

political, and social entities and between community,

national, and international entities toward the systematic

and continuous search for entrepreneurial opportunity,

and the follow-through and encouragement of start-up

entrepreneurial initiatives which result .

3 Adopt business models which facilitate the

acquisition of equity capital.

In commercializing entrepreneurial initiatives, utilize

business models which focus on wealth creation for

equity capital providers (private rate of return), including

employee incentive options, as well as return for other

stakeholders and the community (social rate of return).

4 Provide technical and business training

for entrepreneurs, arrange for professional

advisory and service providers and incuba-

tion services for entrepreneurial

companies.

Organize the availability of facilities and services

designed to improve the quality and strength of entrepre-

neurial initiatives within the community to create a sus-

tained deal flow worthy of local and national equity

investment.

5 Organize local and regional equity

capital and debt-financing network.

Stimulate local investment interaction among local, state

and regional wealth owners, including individuals, pri-

vate and public nonfinancial operating companies, institu-

tional public and private investment pools, and the system

of financial intermediaries currently or potentially resi-

dent in the community.

6 Provide access to harvesting vehicles and

provide vehicles for recycling of capital

gains.

Create interaction between community system compo-

nents and the local, national, and international system of

brokerage and investment banking firms capable of pro-

viding buyout, merger and acquisition, initial public

offering and other “investment harvesting” services for

the community deal flow, and the system of private and

public investment vehicles capable of reinvesting the pro-

ceeds of gain through the creation of new investment

vehicles.

agriculture, energy, and fisheries, must be

expanded to include commercial activity and

innovative, fast growth-oriented businesses as

part of the economic base so that a flow of entre-

preneurial initiative and activity, i.e., a deal

flow, is produced. Second, the political culture

of the communities, traditionally focused on

agriculture and energy at the federal and state

level, must engage parts of government (e.g.,

the banking regulators, the S.E.C., and the SBA)

and private-sector “corporate America” which

are tied to broader economic development pol-

icy and business opportunity. Third, local and

regional savers and investors—individual,

institutional, and corporate—must be willing to

commit their energy, capital, and resources to

building rural America by participating in the

process of evaluating local and regional entre-

preneurial projects and considering them for

risk capital investment as well as coinvestment

with the sources of financing described above.

These factors are conditionally interdepen-

dent. The development of the entrepreneurial

culture in rural America depends fundamentally

upon the discovery and successful development

of local and regional comparative advantages

capable of producing economic rents for those

who organize to exploit them—including equity

investors. Credibility is the key to gaining

investor participation and is ultimately earned

by achieving and sustaining results. Investors,

both institutional and individual, are suspicious

of economically targeted investment because of

the politically based rather than market-based

motivation often associated with such invest-

ment. In some cases, investors effectively

redline investment in their home community as

a diversification policy and a defense against

what they view as politically complicated

investment. These rural equity investment

opportunities must be judged by investors to

credibly promise to earn the private-sector

opportunity cost of capital on a risk-adjusted

basis after overcoming the frictional cost of

being at some distance from financial centers.

To successfully develop the network, local

investors must commit to fairly evaluate local

investments against market criteria.

The initiative for this activity should come

from the private sector, public and private insti-

tutions, and local government and it should be

considered as an economic opportunity to be

seized rather than as a social problem to be ame-

liorated. Federal and state government involve-

ment, programs, and resources should be utilized

to a maximum, however. The branches and

agencies of government are politically moti-

vated to assist rural America, the resources are

in place, and the best guidance for proper use of

that assistance will come from the residents of

rural communities and regions. Government

resources should be viewed as stepping stones to

permanent private-sector institutionalized

solutions in finance and all other aspects of the

initiative.

Entrepreneurs and investors must share

responsibility and blend their efforts to achieve

success within this local development system.

In order to improve their ability to attract capital

and to create wealth through their businesses,

entrepreneurs must face a set of relevant priori-

ties. They must become professional entrepre-

neurs, motivated to create wealth for investors

along with full participation by all other stake-

holders. To do this, they must manage entrepre-

neurial ventures to a higher standard of market

expectations which extend regionally, nation-

ally, and globally. This implies adopting effec-

tive business models that are market-driven and

competitively-based. To be successful in these

pursuits, entrepreneurs must build solid busi-

ness teams, utilize boards of directors and advi-

sors, and motivate participants by sharing equity

ownership with them. In order to achieve per-

sonal success and success of this development


system, entrepreneurs must take responsibility

to give back to the community through partici-

pation and by becoming politically involved.

In order to deal effectively with entrepreneu-

rial initiatives in rural America to achieve the

best risk-adjusted return for their invested capi-

tal and to improve the sustainable growth of

acceptable deal flow from those communities,

local and nonlocal financial market participants

should focus on a number of priorities. Most

importantly, they should accept a share of the

responsibility to lead in developing the local

financial market system and its connectivity to

national and international systems. This

requires being developmental, which may seem

to clash with the usual judgmental characteris-

tics of financial intermediaries. As many inves-

tors and intermediaries have found, the market-

share benefits from developmental activity can

be substantial.

Financiers, especially local banks, investment

pools, and intermediaries, should adapt to

opportunities, whether from regulatory

changes, e.g., securitization of equity and debt

contracts for pooling in secondary markets or

market changes. The latter includes recognition

and adaptation to the changing sources of

investment value in niche opportunities and

new industries (e.g., mass customization, sell-

ing electrons). These financiers should learn to

invest equity and extend debt on the basis of

negotiated valuation, structure, pricing con-

tracts, and relationships, not just on the basis of

collateral. This involves recognition of the fact

that location and transportation costs are reced-

ing as critically important limiting factors.

Discussion of action components,linkages, and expected results

The community system discussed here must

exist within a broader framework, with major

contributions required from federal, state, and

local government, the private-sector financial

markets participants, as well as the set of people

and entities interested in entrepreneurial activ-

ity at the rural community and regional level. In

the remainder of this section, we discuss the

action components in detail.

Action Component 1: Encourage and support

entrepreneurship as the cultural core of the

community economic system. The fundamental

point in this framework is the affirmation of

entrepreneurship as the cultural core of the com-

munity's economic system. While this may dif-

fer among communities, rural America has

traditionally been an enterprise-based econ-

omy, centered around independent farms, oil

exploration, and drilling companies, fishing

boats or fleets, and similar businesses. This tra-

dition should be sustained and used as the main

building block of the economic transition. As

structural change in these basic industries ren-

der unprofitable small enterprises in their tradi-

tional form, adjustment to new economic

realities should be based as much on the core

competencies of enterprise management as on

switching to wage earning-based employment.

People who have successfully run an indepen-

dent business in one of the basic industries may

have managerial skills which can be adapted to

higher margin niche markets in those industries

or to entirely new business opportunities which

present themselves.

For many of these rural residents, the struc-

tural transition is well under way. Small farms

report that 40 percent of total income is from

“off the farm” sources, reflecting not only the

experience of managing an independent entre-

preneurial business in a very complex and

declining-margin industry, but also the ability to

maintain associative connections and business

interactivity with existing and new companies.

The important point of this action component is


to encourage a balance between enterprise for-

mation and wage employment within the transi-

tional economy and in encouraging wage

employment in firms based on entrepreneurial

initiatives in the community and companies

which are their suppliers.

Sustaining the enterprise tradition and encour-

aging entrepreneurship can be approached

through associative activity and interaction

among existing and incipient individual business

owners many of whom are potential entrepre-

neurs. For example, youth entrepreneurship pro-

grams such as National Institute for Teaching

Entrepreneurship (NIFTE) and Junior Achieve-

ment can be offered in the same way that 4-H

Club and Future Farmers of America programs

are offered and perhaps jointly with them. These

would involve not only the community youth

but also the business, financial, and entrepre-

neurial leaders thereby providing a point of

associative interaction as well as building the

cultural core. These programs can be offered

through the community and regional education

system at all levels in high schools and trade

schools. Marketing and financing linkages can

be extended through local and regional associa-

tive activity, venture fairs, and trade shows

which highlight local companies.

Action Component 2: Facilitate the discovery

of entrepreneurial opportunity. The combined

efforts of government, large business corpora-

tions, and the local communities and regions

should be directed to the search for new sources

of economic growth which can be developed in

rural areas. Interaction must be facilitated

among community economic, political, and

social entities and between community,

national, and international entities toward the

systematic and continuous search for entrepre-

neurial opportunity, and the follow-through and

encouragement of start-up entrepreneurial ini-

tiatives which result.

Entrepreneurial opportunity may be found in

providing a service or product for the local com-

munity, the region, the nation, or for interna-

tional markets. The opportunity may be based

on any level of technology and may be discov-

ered by companies in any of the stages of its life.

Entrepreneurial opportunities may be found in

the existing community industry base, they may

be based on community or regional compara-

tive advantage or on currently unmet needs.

Industrialized and integrated agriculture con-

tains many opportunities for niche market

entrepreneurial developments that would be

open to rural entrepreneurs.

The key to this discovery of opportunity is

open interaction among local entities and

between local and nonlocal entities. Joint ven-

tures and partnerships should be permitted and

encouraged to occur, along with “seconding” of

employees among entities. These can be initi-

ated and stimulated by not-for-profit facilitative

organizations and by associative activity link-

ing local and nonlocal interest groups. An

important source of such activity is university

Small Business Innovation Research projects

involving university joint ventures with local

companies as codevelopers of technological

innovations. An important part of this interac-

tion is supplier relationships among established

firms and between established firms and newer,

smaller companies.

Action Component 3: Adopt Business models

which facilitate the acquisition of equity capi-

tal. When equity investors assess an investment

opportunity, they look for a combination of a

competent entrepreneurial team capable of

providing a breakthrough product or service in

a market with superior growth potential capable

of sustaining significant economic rents. To

attract equity capital, entrepreneurs must utilize

business models which focus on wealth crea-

tion for equity capital providers (private rate of


return), including employee incentive options,

as well as return for other stakeholders and the

community (social rate of return).

The earlier example of the co-op is relevant to

this point. As useful and mutually supportive as

the cooperative organization has been for rural

America, it suffers in competition for equity

capital with its corporate competitors. Though

uncomfortable, acceptance of new business

models may well be necessary in order to gain

effective access to competitive equity capital

markets.

Entrepreneurial activity in rural areas may

adopt many types of business models. With

respect to companies in the existing industrial

base, internal ventures may be initiated within

existing companies to develop specialty niche

manufacturing and service entities that can be

incubated and capitalized within the company.

Similarly, ventures can be spun off from existing

companies as free-standing firms, with funding

provided by the parent and other investors. Start-

ups independent of existing community-based

companies may be predicated on local, regional,

national, or international opportunities regard-

less of level of technology—based solely on

comparative advantages discovered to be pos-

sessed by the community. Also, acquisition,

restructuring, and redirecting companies exist-

ing in the community offers community

expansion and wealth creation through entre-

preneurial growth.

Action Component 4: Provide technical and

business training for entrepreneurs, arrange for

professional advisory and service providers and

incubation services for entrepreneurial compa-

nies. Rural entrepreneurs must have access to

relevant know-how and access to information

and networking appropriate to the business.

Access to providers of legal, tax, accounting, and

consulting services is vital to the development

of clusters of entrepreneurial companies. These

companies must also have access to skilled

employees with appropriately supportive skill

sets. For each of these, technical and business

training is important and should be provided by

the local educational system: university, com-

munity college, industrial school, and high

school.

Local and regional social conditions—the

quality of education, housing, and health ser-

vices—are vital to the recruiting and retention

of such individuals. As well, the business must

have access to companies that supply industry-

standard skilled support services on a contract

basis and supplies at a reasonable cost. These

are not only generators of entrepreneurial activ-

ity but also provide sources of employment,

income, and wealth creation.

The community must organize the availabil-

ity of facilities and services designed to improve

the quality and strength of entrepreneurial ini-

tiatives to create a sustained deal flow worthy of

local and national equity investment. Incentives

must be established to provide technical and

business training for entrepreneurs, and to

arrange for professional advisory and service

providers and incubation services for entrepre-

neurial companies. Universities and commu-

nity colleges must be encouraged to operate

SBDC and incubators, offer curriculum and

executive education courses and special semi-

nars enhanced by distance learning.

Action Component 5: Organize local and

regional equity capital and debt financing net-

work. Perhaps the main payoff from building

the entrepreneurial development framework is

the stimulation of investment interaction among

local, state, regional, and national wealth own-

ers and intermediaries. These include individu-

als, private and public nonfinancial operating

companies, institutional public and private


investment pools, and the system of financial

intermediaries currently or potentially resident

in the community.

Many of these (e.g., public and private institu-

tional investment pools) automatically red line

local areas for investment—some on policy

grounds, some to avoid political entanglements,

and others simply believe that there are no attrac-

tive investment opportunities in these areas. In

other cases (e.g., banks, brokers, other interme-

diaries), risk considerations and the existence of

superior alternatives cause them to shun local

investments. For individual angel investors and

dedicated equity investment funds, deal flow

may be difficult to generate and transactions

costs (e.g., costs of search, due diligence, and

monitoring) are considered excessive.

The great potential of this proposed frame-

work is the opportunity to overcome these

impediments by the exchange of information

among interested and capable parties and the

generation of joint investment projects among

them. Creating associative activity and net-

working systems fuses the combined talents and

resources of these people with self-interest – the

driver of most investment. Many participants

either wish to live and work in the community or

region, or cannot leave the region without incur-

ring substantial costs.

In some cases, legal or regulatory changes

may be needed in order to open access to certain

types of capital. Political involvement of com-

munity members at the federal, state, and local

levels may be effective in bringing about such

change. In cases such as public and private pen-

sion funds, university endowment funds, and

foundations, portions of the fund corpus may be

set aside for local investment. With respect to

bank consolidation, community pressure can be

brought to bear through the Community Rein-

vestment Act (CRA) to require heightened lev-

els of banking service, especially through SBA

credit, the use of SBIC funding, private equity

finance through Section 20 bank subsidiaries

pools, and other services linked to small busi-

ness and entrepreneurial firms. For those with

an aversion to the use of CRA, there is the

option of encouraging competition through

nonbank financial institutions in instances

where bank are slow to participate.

As argued by RUPRI, there is potential bene-

fit in expanding the charters of various Govern-

ment Service Enterprise (GSE)-financing

agencies to include business and economic

development financing and to create pools for

the securitization and open market resale of

such loans. In most cases, this involves adding a

regional aspect to what was principally a secto-

rial area of specialization, with attendant uncer-

tainty about the efficiency and effectiveness

which might result. A more radical but impor-

tant dimension of such change is expanding the

charters to do equity investment, as the World

Bank did over the past decade. The equity

investment approach and record of the World

Bank's International Finance Corporation (IFC)

and the U.S. Treasury's Overseas Private Invest-

ment Corporation (OPIC) in transitional and

developing economies would serve as a useful

point of reference and role model for GSE

activities within the United States. The Clinton

Administration “New Markets” recommenda-

tions evoke the image of funding international

transitional economies, but are much more

restricted and limited in the change suggested.

The Federal Reserve System could play an

important role in this activity through the direct

and dedicated involvement of each of the 12

regional banks in its own region.

Action Component 6: Provide access to har-

vesting vehicles and provide vehicles for recy-

cling of capital gains. Perhaps more than any

other type of financial intermediary, investment


banking firms, buyout funds, and late-stage pri-

vate equity investment funds are willing and

able to execute harvesting transactions regard-

less of geographic location or need for a local

partnering institution. The local entrepreneurial

cluster can easily create interaction between

community system components and the local,

national, and international system of brokerage

and investment banking firms capable of pro-

viding buyout, merger and acquisition, initial

public offering, and other investment harvesting

services for the community deal flow. The local

cluster can serve as a pooling mechanism to the

extent that harvesting individuals or entities

wish to recycle proceeds into further entrepre-

neurial investment through the creation of new

investment vehicles, e.g., venture capital funds,

SBICs, and angel networks, capable of reinvest-

ing the proceeds.

CONCLUSIONS

We have shown in this paper that entrepre-

neurial firms within rural America have cap-

tured a very small cumulative share of the U.S.

market for the private and public equity portions

of finance in the years between year-end 1985

and year-end 1998. Our analysis shows that within

subregions of rural America important differ-

ences in equity capital investment have existed

since 1985, suggesting that the core problem in

the area as a whole may be lack of well-organ-

ized effective demand for capital as well as poor

access through available financial service facili-

ties to the national equity market system.

We have shown that, consistent with findings

of our previous research, Primary Metropolitan

Statistical Areas (PMSA) had the greatest par-

ticipation in equity markets over this period, fol-

lowed closely by Metropolitan Statistical Areas

(MSA). Nonmetropolitan areas were a distant

third in this respect. We also showed that the

greater the “degree of urbanization” of these

small areas of the country and the more proxi-

mate those areas are to metropolitan areas, the

greater was their participation in equity markets

over the period from 1985 to the present.

The incidence of direct business financing

intervention by the U.S. federal government

through its Small Business Administration-

guaranteed business loan program was higher

on a per capita basis over the study period in the

“lowest degree of urbanizat ion, non-

metropolitan” areas, i.e., the “pure rural areas,”

than in the “highest degree of urbanization,

PMSA or MSA” areas, i.e., the “pure urban

areas”, and the “higher degree of urbanization,

PMSA or MSA” areas in between. The propor-

tion of total financing represented by SBA was

much higher in pure rural areas, with the differ-

ence being considerably greater than the differ-

ence in SBA credit volume per capita relative to

the pure urban areas.

SBA credit appears to have been allocated on

the basis of distribution of population, while

private equity capital seems more driven by

forces of market opportunity. This results both

in greater flows of private equity to urban areas

with more concentrated population clustering

as well as significant flows of SBA funding,

much of which may be directed to the urban

core areas in which the need for subsidized gov-

ernment financing is similar to that in rural

America.

While SBA finance was the dominant source

of business finance in “pure rural” areas over

the study period, those areas did attract at least

minimal levels of venture capital, IPO, and SEO.

Future research may be profitably directed to

studying the characteristics of those SBA-

financed companies and to determine whether

those firms were at any point effective candidates

for venture capital, private equity, and public

offerings of equity securities. Policymakers


must note the “chain event” relationship through

which higher absolute and per capita levels of

venture capital and private equity were associ-

ated over the study period with subsequent

higher levels of initial public offering (IPO) and

seasoned equity (SEO), suggesting the presence

of firms which convinced investors of their

national and international market potential.

Investment to fund entrepreneurial ventures is

a scarce resource, not so much because of a lack

of capital as because of the difficulty of proving

the worth of the intended investment. Individual

and institutional investors fund venture capital

investment because it promises risk-adjusted

rates of return well above the norm. To attract

such investment to an area or industry where it

does not currently exist requires not just a need

for the fruits of economic development but also

proof of a productive effective demand for the

capital. This demand reflects a comparative

advantage in the provision of goods and services

for which there is a demonstrably large and

growing market. The result is economic rent

earned by those who exploit and finance the

opportunity. It involves the hard work of bind-

ing the entrepreneur to the task of the venture,

harvesting the proceeds through sale of the entity

or its shares privately or to the public, and the shar-

ing of the risk and financial return between entre-

preneur and venture-financing partner.

Because of the significant role of the U.S. fed-

eral government in rural economic life in past

decades through involvement in agriculture,

energy, and other aspects of public policy, there

is an inclination to look toward public policy for

the answers to the problem of rural economic

development and its financing. Our data, which

show that SBA credit is the dominant form of

business finance, may indeed reflect that incli-

nation. However, the direct involvement of the

federal government in the nation's economic life

is shrinking in volume and becoming more indi-

rect. Much more local, entrepreneurial eco-

nomic initiative is needed and state and local

government must be counted upon to play an

increasing role as a complement to the federal

government.

Aresulting argument is that public policy may

be most effective if, instead of being directly

interventionist, it is applied to the stimulus of

private-sector entrepreneurial activity in the

areas to be developed. Support for a “bottom-

up” business model, based upon a combination

of public policy change, at federal, state, and

local government levels, and private-sector ini-

tiative as a strategy for change and new eco-

nomic growth is reflected in evidence from

many of the world's transitional and emerging

economies. In these economies, a much greater

portion of economic recovery and expansion is

emanating from the entrepreneurial sector than

from the “top down” forced privatization of

state-owned entities.

An entrepreneurship-based strategy centers

upon the discovery and development of new

means of creating economic value and sustain-

able growth in that value. The strategy may

include the restructuring and reinvigoration of

existing companies as well as the start-up of

new companies. It may incorporate the supply

of local needs and it may include finding oppor-

tunities in developing knowledge-based compa-

nies of the new economy. It depends importantly

although not exclusively upon the role of entre-

preneurial finance, especially the role of equity

capital as a base upon which to reinvigorate

existing businesses, build new businesses, and

nfrastructure. While the U.S. financial system is

renowned for its well-developed system of

growth capital finance and its sophisticated,

broad, deep, and resilient equity markets, exten-

sion of its service to firms located in rural areas

is both challenging and problematic.


Such a strategy has both a “real” and “finan-

cial” side. On the real side, the strategy requires

the development of effective demand for goods

and services produced in rural America, based

upon observable economic activity which has

wealth-creating potential with a sustainable

comparative advantage capable of producing

employment, income, and wealth. The economic

output involved may include the provision of

goods and services with proven demand else-

where, the provision of import-substitute items

or the creation of goods and services for export.

Definition of such output types is beyond the

scope of this paper, but its development is a nec-

essary complement and pre-condition to our

topic, the attraction of equity capital to rural

America. There are demand problems as well as

supply problems that must be recognized and

overcome if the flow of equity capital to rural

areas is to increase. Individuals and institutions

interested in such a strategy must discover, initi-

ate, and develop the comparative competitive

advantages upon which the renaissance of rural

America may be based.

In a world of relatively efficient financial mar-

kets, capital continuously seeks and moves to

acquire acceptable ratios of risk and return. Any

proposed rural America equity strategy must

answer the questions: “how can the equity

investor make money from this investment,

what risks are involved, and how long will it

take to generate acceptable returns?” In con-

junction with this, a local entrepreneurial

finance system linked to regional and national

financial market systems is required, capable of

both marshaling local savings for local invest-

ment and attracting risk capital to the local com-

munity or region.

Lack of effective access to equity capital has

been recognized as a limiting factor in economic

development in rural America for some time. It

has also been recognized as a limiting factor in

inner-city America and in the transitional and

emerging economies of the world. In that sense,

while the specific circumstances may differ

from place to place, it is a universal problem that

has attracted attention in recent years from pol-

icymakers, economists, and financiers. Those

concerned with the problem faced by rural

America should avail themselves of the cumu-

lative learning and insight derived from efforts

to resolve this universal problem and bring it to

bear on local conditions.

To the extent that population units (i.e., zip

codes) categorized as “rural” contain “urban

places”—defined by population concentra-

tion—such units may have current “clustering

potential” which is closer to that of urban areas

than to “pure” rural areas. Also, the extent to

which rural areas are proximate to PMSAs,

MSAs, or NMSAs may influence the generation

of demand for equity funds and access to equity

markets among rural areas. By combining de-

gree of urbanization and proximity to size cate-

gory of metropolitan area and forming a new

categorization scheme, public policy analysts

may be able to direct their research and their

programs for development or intervention in a

more targeted and productive way. This may

conserve resources and improve development

results by focusing public policy efforts, avoid-

ing misdirected programs and leveraging the

indigenous strengths and opportunities existing

within the rural areas involved.

Based upon these findings, we suggest that a

public policy framework based jointly upon a

“degree of urbanization” definition of rural

areas and proximity to metropolitan areas of dif-

ferent sizes, i.e., PMSAs, MSAs and NMSAs

will better target public policy than one which

treats all rural areas as essentially the same and

homogeneous within. This approach may be

especially important in an era in which public

resources are limited and in which political


preference seems to be for more local, market-

driven solutions to economic problems rather

than solutions based upon direct federal govern-

ment intervention.

This “urban advantage” reflects industrial

location factors associated with the clustering of

entrepreneurial, knowledge-based, fast growth-

oriented economic activity such as is observed

in particular parts of the United States (e.g., Sili-

con Valley, Route 128, Austin, Minneapolis,

and other predominantly urban areas). These

include the agglomeration of economic activity,

key human resources, educational and social

support systems, and financial services provid-

ers, all more likely to be found in urban rather

than rural areas. While such companies may

show up almost randomly in rural areas, the sys-

tematic lack of the factors cited above renders

difficult the spontaneous development of this

kind of economic activity in those parts of rural

America in which such clustering is currently

absent and difficult to generate. Even more

important for future development, it also

reflects the “clustering” of the very input factors

which are considered important to the

knowledge-based entrepreneurial firms of the

“new economy,” suggesting that spontaneous

development of this kind will be urban rather

than rural in the years ahead.

For the communities of rural America to build

diversified economic value upon a declining

base of agriculture and energy, they must

develop local clusters of the critical inputs cited

above and must create interactive economic

networks within, among, and outside their com-

munities. Comparative economic advantage

must be identified and developed by local peo-

ple willing to commit time, energy, and capital

to initiating and working to grow business enti-

ties dedicated to the pursuit of that advantage.

This advantage can be found relative to local

product and service needs, import substitutes,

or exports. It may be stimulated by efforts of

local state universities, trade and service organi-

zations, local companies, and financial institu-

tions. When local entrepreneurs discover and

act upon wealth-creating local comparative

advantage, they will make the first equity

investments and will do so more willingly if

they see the opportunity to gain access to

sources of equity capital beyond local resources

for growth of the equity base.

Because not all rural communities are con-

centrated in particular states but are spread

across the nation, and because the Bureau of the

Census employs population as the primary cri-

terion in the definition of “rural,” the dichoto-

mous “urban/rural” categorization may mask

subtle differences among rural areas which may

be important for public policy decisions and pri-

vate sector initiatives. We believe that this

“binary” categorization of urban/rural misses

the subtle effects of the degree of urbanization

of rural areas and that, in fact, a great many rural

areas contain “urban places,” clusters of popu-

lation which may offer potential for market-

driven, entrepreneurial economic development.



Appendix 1

COMPREHENSIVE FINANCING DATA

Area

Degree

of

urbani-

zation

Dollar volume Count

Nonmetro MSA PMSA

Total by

degree

Non-

metro MSA PMSA

Total by

degree

SBA

1 5,956,858,831 1,629,427,958 633,229,404 8,219,516,193 39,530 10,505 3,597 53,632

2 56,132,564 124,571,497 106,933,236 287,637,297 308 725 589 1,622

3 321,822,401 261,021,283 186,679,008 769,522,692 1,760 1,495 1,073 4,328

4 657,615,268 414,147,163 173,342,711 1,245,105,142 3,856 2,378 1,071 7,305

5 1,330,018,894 770,887,153 194,355,974 2,295,262,021 7,690 4,399 1,249 13,338

6 1,483,419,994 754,014,903 421,168,782 2,658,603,679 9,073 4,408 2,260 15,741

7 2,047,306,793 1,280,425,520 498,541,034 3,826,273,347 12,824 7,627 2,504 22,955

8 2,284,713,301 1,605,389,004 610,655,222 4,500,757,527 15,698 9,586 3,184 28,468

9 1,802,103,253 3,247,220,904 1,180,144,618 6,229,468,775 12,239 19,911 6,142 38,292

10 755,828,883 18,833,771,944 20,937,618,473 40,527,219,300 5,204 118,062 106,778 230,044

Total

by area 16,695,820,182 28,920,877,329 24,942,668,462 70,559,365,973 108,182 179,096 128,447 415,725

VC

1 209,320,000 189,755,000 127,345,000 526,420,000 111 61 83 255

2 69,571,000 73,516,000 33,298,000 176,385,000 23 39 15 77

3 19,963,000 41,395,000 75,741,000 137,099,000 14 22 51 87

4 112,163,000 63,767,000 97,681,000 273,611,000 37 42 39 118

5 52,011,000 106,612,000 202,104,000 360,727,000 28 67 76 171

6 34,110,000 110,577,000 348,313,000 493,000,000 33 38 113 184

7 72,761,000 497,747,000 554,284,000 1,124,792,000 47 66 270 383

8 116,331,000 330,501,000 604,930,000 1,051,762,000 53 137 219 409

9 191,439,000 769,895,000 1,391,293,000 2,352,627,000 86 286 560 932

10 103,105,000 11,775,975,000 45,178,340,000 57,057,420,000 56 4,189 14,032 18,277

Total

by area 980,774,000 13,959,740,000 48,613,329,000 63,553,843,000 488 4,947 15,458 20,893


Appendix 1 � Continued

COMPREHENSIVE FINANCING DATA

Area

Degree

of

urbani-

zation

Dollar volume Count

Nonmetro MSA PMSA

Total by

degree

Non-

metro MSA PMSA

Total by

degree

IPO

1 823,070,000 1,785,846,000 12,430,961,000 15,039,877,000 32 32 88 152

2 16,221,000 196,151,000 15,959,000 228,331,000 2 8 3 13

3 243,975,000 466,332,000 161,074,000 871,381,000 5 5 6 16

4 421,096,000 215,674,000 704,464,000 1,341,234,000 18 7 12 37

5 716,242,000 1,049,975,000 852,176,000 2,618,393,000 22 24 19 65

6 860,906,000 664,155,000 963,909,000 2,488,970,000 18 12 21 51

7 528,183,000 966,180,000 2,587,991,000 4,082,354,000 17 32 52 101

8 686,425,000 2,636,459,000 2,385,147,000 5,708,031,000 32 57 48 137

9 938,008,000 4,044,996,000 3,663,000,000 8,646,004,000 26 100 95 221

10 432,796,000 70,381,141,000 238,766,722,000 309,580,659,000 16 1,424 3,527 4,967

Total

by area 5,666,922,000 82,406,909,000 262,531,403,000 350,605,234,000 188 1,701 3,871 5,760

SEO

1 851,020,000 825,958,000 1,098,013,000 2,774,991,000 30 18 25 73

2 14,278,000 163,513,000 741,321,000 919,112,000 3 3 6 12

3 859,704,000 967,315,000 167,084,000 1,994,103,000 4 12 4 20

4 837,123,000 352,087,000 907,341,000 2,096,551,000 17 5 14 36

5 496,849,000 1,351,949,000 2,699,251,000 4,548,049,000 9 25 24 58

6 1,212,375,000 1,088,402,000 2,340,868,000 4,641,645,000 24 16 18 58

7 512,704,000 966,152,000 6,810,976,000 8,289,832,000 19 29 54 102

8 1,573,670,000 3,281,065,000 4,352,260,000 9,206,995,000 36 52 52 140

9 1,011,054,000 6,318,892,000 5,613,453,000 12,943,399,000 19 119 96 234

10 302,726,000 107,429,023,000 261,829,236,000 369,560,985,000 8 1,456 3,029 4,493

Total

by area 7,671,503,000 122,744,356,000 286,559,803,000 16,975,662,000 169 1,735 3,322 5,226

Source: Securities Data Company, U.S. Census Bureau, OSPEF Analysis.


Appendix 2

COMPREHENSIVE FINANCING DATA, EXPRESSED PER CAPITA

Area

Degree of

urbanization


Nonmetro MSA PMSA

Total by

degree Nonmetro MSA PMSA

Total by

degree

SBA

1 289 185 207 253 1,916.05 1,192.56 1,178.03 1,650.56

2 133 207 229 193 727.42 1,204.46 1,261.08 1,086.84

3 275 169 257 224 1,505.94 969.54 1,479.80 1,259.69

4 247 199 199 222 1,446.77 1,144.58 1,230.46 1,301.38

5 321 229 208 272 1,855.78 1,305.44 1,334.05 1,578.50

6 310 236 265 277 1,893.07 1,377.52 1,422.20 1,642.80

7 384 254 305 319 2,407.42 1,513.27 1,534.06 1,913.04

8 444 251 267 325 3,052.06 1,496.61 1,394.22 2,058.08

9 490 298 278 331 3,328.17 1,827.68 1,444.63 2,034.31

10 428 334 263 294 2,944.17 2,095.43 1,339.05 1,668.78

Total

by area 336 294 261 290 2,174.94 1,822.27 1,344.28 1,706.78

VC

1 10 22 42 16 5.38 6.92 27.18 7.85

2 164 122 71 118 54.32 64.79 32.12 51.59

3 17 27 104 40 11.98 14.27 70.34 25.32

4 42 31 112 49 13.88 20.22 44.81 21.02

5 13 32 216 43 6.76 19.88 81.18 20.24

6 7 35 219 51 6.89 11.88 71.11 19.20

7 14 99 340 94 8.82 13.10 165.41 31.92

8 23 52 265 76 10.30 21.39 95.90 29.57

9 52 71 327 125 23.39 26.25 131.71 49.51

10 58 209 567 414 31.68 74.35 175.97 132.58

Total

by area 20 142 509 261 9.81 50.33 161.78 85.78


Appendix 2 - Continued

COMPREHENSIVE FINANCING DATA, EXPRESSED PER CAPITA

Area

Degree of

urbanization


Nonmetro MSA PMSA

Total by

degree Nonmetro MSA PMSA

Total by

degree

IPO

1 40 203 4,071 463 1.55 3.63 28.82 4.68

2 38 326 34 153 4.72 13.29 6.42 8.71

3 209 302 222 254 4.28 3.24 8.27 4.66

4 158 104 809 239 6.75 3.37 13.79 6.59

5 173 312 910 310 5.31 7.12 20.29 7.69

6 180 208 607 260 3.76 3.75 13.22 5.32

7 99 192 1,586 340 3.19 6.35 31.86 8.42

8 133 412 1,044 413 6.22 8.90 21.02 9.90

9 255 371 862 459 7.07 9.18 22.34 11.74

10 245 1,249 2,994 2,246 9.05 25.27 44.23 36.03

Total

by area 114 838 2,748 1,439 3.78 17.31 40.51 23.65

SEO

1 41 94 360 85 1.45 2.04 8.19 2.25

2 34 272 1,587 616 7.09 4.98 12.85 8.04

3 736 627 230 580 3.42 7.78 5.52 5.82

4 314 169 1,042 373 6.38 2.41 16.08 6.41

5 120 401 2,883 538 2.17 7.42 25.63 6.86

6 253 340 1,473 484 5.01 5.00 11.33 6.05

7 96 192 4,173 691 3.57 5.75 33.08 8.50

8 306 512 1,906 666 7.00 8.12 22.77 10.12

9 275 580 1,320 688 5.17 10.92 22.58 12.43

10 171 1,907 3,283 2,681 4.53 25.84 37.99 32.59

Total

by area 154 1,249 2,999 1,712 3.40 17.65 34.77 21.46



Appendix 3

COMPREHENSIVE FINANCING DATA, EXPRESSED PER CAPITASTANDARDIZED FOR NONMETRO, DEGREE 1

Area


Degree of


(percent) (percent) (percent) (percent) (percent) (percent)

SBA

1 100 64 72 100 62 61

2 46 72 79 38 63 66

3 95 59 89 79 51 77

4 85 69 69 76 60 64

5 111 79 72 97 68 70

6 107 82 92 99 72 74

7 133 88 106 126 79 80

8 154 87 93 159 78 73

9 170 103 96 174 95 75

10 148 116 91 154 109 70

VC

1 100 212 411 100 129 505

2 1,619 1,204 703 1,010 1,204 597

3 168 265 1,030 223 265 1,307

4 415 303 1,106 258 376 833

5 124 312 2,128 126 370 1,509

6 70 341 2,160 128 221 1,322

7 135 973 3,347 164 243 3,074

8 223 509 2,611 192 398 1,782

9 513 697 3,225 435 488 2,448

10 575 2,060 5,584 589 1,382 3,271

IPO

1 100 508 10,205 100 234 1,858

2 96 817 86 305 857 414

3 523 758 557 276 209 533

4 396 260 2,029 435 217 889

5 433 781 2,282 342 459 1,308

6 450 520 1,520 242 242 852

7 249 481 3,974 206 409 2,054

8 335 1,032 2,618 401 574 1,355

9 639 931 2,160 456 592 1,441

10 614 3,131 7,505 584 1,629 2,852

SEO

1 100 227 872 100 204 819

2 82 659 3,848 709 498 1,285

3 1,783 1,521 559 342 778 552

4 761 411 2,527 638 241 1,608

5 291 973 6,989 217 742 2,563

6 613 825 3,571 501 500 1,133

7 233 465 10,116 357 575 3,308

8 742 1,242 4,620 700 812 2,277

9 667 1,406 3,201 517 1,092 2,258

10 415 4,622 7,960 453 2,584 3,799


1Data used in this study includes venture capital financing,

initial public offerings and seasoned public offerings from

January 1, 1986 throughDecember 31, 1998. Data used for

Small Business Administration loans approved as from

October 1, 1976 through February 28, 1997.

2 The U.S. Census Bureau defines �urban� for the 1990

census as comprising all territory, population and housing

units in places of 2,500 or more persons incorporated as

cities, villages, boroughs (except Alaska and New York)

and towns (except New England states, New York and

Wisconsin), but excluding the rural portions of �extended

cities.� Further, urban also comprises census designated

places of 2,500 or more persons as well as other territory,

incorporated or unincorporated, included in urbanized

areas. Territory, population and housing units not

classified as �urban� constitute �rural.� These are �places

of less than 2,500 persons� or �not in places.� �Not in

places� comprises �rural� outside incorporated and census

designated places as well as the rural portions of extended

cities.

3 The U.S. Office of Management and Budget defines

Metropolitan Statistical Areas for the 1990 census. The

current standards provide that each newly qualifyingMSA

must include at least:

· one city with 50,000 or more inhabitants, or

· a Census Bureau-defined urbanized area (of at least

50,000 inhabitants) and a total metropolitan population

of at least 100,000 (75,000 in New England).

Under the standards, the county (or counties) that

contains the largest city becomes the �central county�

(counties), along with any adjacent counties that have at

least 50 percent of their population in the urbanized area

surrounding the largest city. Additional �outlying

counties� are included in the MSA if they meet specified

requirements of commuting to the central counties and

other selected requirements of metropolitan character

(such as population density and percent urban). In New

England, theMSAs are defined in terms of cities and towns

rather than counties.

An area thatmeets these requirements for recognition as an

MSAand also has a population of onemillion ormoremay

be recognized as a CMSA if:

· separate component areas can be identified within the

entire area bymeeting statistical criteria specified in the

standards, and

· local opinion indicates there is support for the

component areas.

If recognized, the component areas are designated

PMSAs, and the entire area becomes a CMSA. PMSAs,

like the CMSAs that contain them, are composed of one or

more counties, except in New England where they are

composed of cities and towns. If no PMSAs are

recognized, the entire area is designated as a MSA. As of

the June 30, 1996 OMB announcement, there were 255

MSAs, and 18 CMSAs comprising 73 PMSAs in the

United States.

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