Investing in Start-up Puerto Rico

Investing in Start-up Puerto Rico

Ernesto Villarini Baquero evillarini@cdvca.org

I was happy to read about Parallel 18’s latest group of startups and listen to each company pitch during their recent virtual kickoff event. Generation 8 is the accelerator’s first all Puerto Rican cohort and it surfaces as a hopeful sign amidst a sea of small businesses that have shut down due to the COVID-19 pandemic. Half of the Gen 8 companies stem from parallel 18’s pre-acceleration program, which speaks to their strategic approach to nurturing business growth at an early stage.

Parallel 18 is one of a handful of business incubators and accelerators on the Island. It is a program of the Puerto Rico Science, Technology and Research Trust. Similar programs are offered by Grupo Guayacan, PRTEC, and Startup.pr, to name a few. As tax-exempt entities these organizations receive both governmental and philanthropic support to finance the grants, services and support they provide to participating startups. This activity should prompt some questions from taxpayers and investors alike: What role do startups have in economic development? How are they financed? What else do they need to grow? And do start-ups have a place in an investment portfolio? The Kauffman Foundation reports that because of their high-growth nature, successful startups account for up to 50% of new jobs created in the U.S. They also expand the commercial base by adding new business locations and encourage direct and indirect employment growth. For most startups, immediate financing needs arise as they try to prove their concept (product or service) and test their target market. At the so-called pre-seed stage, capital is sourced mostly from FFF (Family, Friends, and Fools), business angels and the accelerators themselves.

Startups able to raise this initial financing look to grow a product that can start generating “traction”; a company’s first purchasing commitments or sales. Simultaneously they look to consolidate their core team, the members who will then be referred to as the founders. The right team and getting traction are key in obtaining additional capital from angels with deeper pockets and early-stage venture capital (VC) firms. Reaching the seed stage does not guarantee that the

busines will have success, but growth will not occur if risk capital is not secured early on.

Many startups will be unable to find a profitable product-market fit and fail to meet growth expectations. Forbes magazine reported a few years ago that up to 90% of startups fail to meet their market potential or promise for financial returns. Those that fail to grow exponentially will sometimes evolve into lifestyle companies or keep operating “under the radar” waiting for market conditions to improve. An entrepreneur that fails at this stage usually goes back to the drawing board to figure out how the market opportunity can be better addressed.

The few survivors of the seed stage pass on to series A and B financing rounds where founders usually give up a significant stake in their company in exchange for the capital needed to scale. VC funds are the main source of financing at this stage, and investors will fund start-ups through these funds to gain exposure to a high-risk / high-reward asset class unmatched by the public markets. Capital is not all that matters at this stage. The top VC firms standout because of their ability to add value to the companies they invest in in the form of market access, technological know-how or operational prowess and efficiency. While the founders’ stake in the business decreases through this process, they are usually compensated by the growth in market value of their stock.

Does this startup investment scenario play out in Puerto Rico? The truth is that venture activity has been scant at best in our jurisdiction over the past 30 years. With the exception of Advent-Morro Equity Partners, it wasn’t until 2014’s Act 185 – Puerto Rico Private Equity Funds law – that other private investing options popped up. By 2017 the Office of Puerto Rico’s Commissioner for Financial Institutions had reported 14 funds registered under this law, and other options have risen since. Currently, there is a much wider spectrum of funds providing alternative financing throughout the capital stack.

Some of these funds were created to target individual investors mostly interested in the tax advantages of Act 185 (now part of Act 60). The jury is still out on the impact of these tax incentives, but it is nice to know that this financing space is not as empty as it once was. Local tax-exempt institutional investors have also invested in Act 185 funds to increase diversification in their portfolios. Many of them have also recognized the potential for these investment portfolios to contribute to the

local economy by providing jobs, innovative products, and additional commerce and contributions to the local tax base.

So, what businesses do these funds invest in? That is the piece of the puzzle business incubators and accelerators seek to address. Today there are many young sophisticated entrepreneurs, that first learned about entrepreneurship in their school, thanks to multisectoral efforts, such as Banco Popular de Puerto Rico’s Echar Pa’ Lante initiative. Puerto Rico has quietly been investing in the next generation of entrepreneurs over the last two decades and they are now creating profitable businesses hungry for investment dollars that can fuel their growth. Parallel 18 200+ international business graduates prove this, as do the alumni from Guayacan’s EnterPRize Business Competition, and the many startups moving into new co-working spaces on their own.

So, if there are startups in Puerto Rico doing business internationally and ready to grow, and we have local risk capital funds with investment management experience, where are the investors for these high risk / high reward opportunities? They are out there, but still quite shy about investing in Puerto Rico. Our economy has been taking a beating since 2006, and hurricane María stretched out our recovery even further. Local investors are still going through a toxic experience with the Puerto Rico bonds, while U.S. investors have focused on “safer” investments in public markets. However, we have seen some exceptions which we can tap into and hopefully build on. For example, the Calvert Foundation (now Calvert Impact Capital) investing in the Lift Puerto Rico Business Impact Fund, managed by Acrecent Financial, to provide alternative financing to local businesses.

Before the pandemic, we had witnessed close to $200 million raised in commitments to private equity and venture capital in Puerto Rico between 2015 and 2019. The Puerto Rico Fund for Growth, which the Community Development Venture Capital Alliance (CDVCA) manages, is almost a quarter of that amount. However, this is a far cry from the total investment dollars in Puerto Rico pension funds, insurance reserves, corporate reserves, foundations and endowments which surpass the $30 billion mark, but, it is a good start for investments with a mandate towards our jurisdiction. If our recovery continues to provide opportunities to our courageous entrepreneurs and savvy investment managers, investors will continue to have options to make market-rate financial returns while providing much-needed financing for businesses in our economy.

While relatively new to Puerto Rico, the placed-based investing phenomenon is quite common elsewhere. Pacific Community Ventures, which is also part of the CDVCA investment portfolio, recently published a Catalog of Economically Targeted Investments by Pension Funds showing that 30% of the 118 investments made in the private equity space were also meant to finance growing innovative businesses and create jobs. KPMG, one of the world’s “big 4” accounting firms, recently reported how the private equity industry is increasingly raising funds designed to “marry” financial returns and positive societal outcomes. These investors are key for growing startups and essential in moving towards an economy that can rely on innovation for value creation, growth, and employment.

Under our current circumstances, investors might think that a responsible approach obligates them to invest all their assets abroad, and they would be 95% right. Through hundreds of lawsuits, we have learned the hard way the importance of diversification in mitigating risk. However, it could also be argued that it is our responsibility to allocate investment dollars locally, where jobs are created, income generated, and taxes paid to the local treasury to support government services, infrastructure development, and public works. A 5% allocation could provide $1.5 billion to finance local businesses and help us continue to build Puerto Rico’s wealth. If investors are key in supporting our burgeoning startup ecosystem, shouldn’t we be our own first investors? I hope you agree with me that we must.

The author is Vice President of the Community Development Venture Capital Alliance and member of the Puerto Rico Fund for Growth investment management team. Questions or comments can be sent to evillarini@cdvca.org.