Tax Incentives and Informal Venture Capital
The Small Business Equity Gap
Of the 500 fastest growing companies in the United States
(the “Inc. 500”) in 2002 (measured by revenue
growth over five years), 41 percent started business with
$10,000 or less and 14 percent started with less than
$1,000. In contrast, only 22 percent started with more
than $100,000. Only 2 percent of the 2002 Inc. 500 list
received seed capital from venture capitalists.
The formal venture capital industry, comprised of professionally
managed venture capital funds, tends to reject small deals
because they are simply not worth the costs associated
with their assessment and monitoring. Furthermore, as
the size of private venture capital funds has increased,
the size of the average investment per round of financing
and, perhaps more important, the size of the average first-round
investment, has increased significantly. Table 1.1 shows
the size of first-round financing by industry group and
overall in the formal venture capital industry over the
period 1980 to 2003.
While there has been some softening in recent years,
the average first-round investment in the formal venture
capital industry remains significant and has exacerbated
the equity gap at the earliest stages of a business’s
development. As a consequence, government venture capital
policy and programs often focus on angel financing generally
as well as seed and start-up financing because early-stage
financing has the potential to generate the greatest social
returns through job creation and product innovation and
because financing at these stages is not adequately addressed
by the formal venture capital industry.
In formulating government incentives for angel financing,
it is essential to appreciate that not all small and medium-sized
businesses (SMEs) are the same and not all informal venture
capital investors are the same. Government policy should
target investment by the right angel investors in the
right businesses.
Given the fact that the vast majority of love and angel
capitalists are taxable individuals, it is only natural
that both federal and state governments have focused on
tax measures affecting individuals as a means of addressing
the financing difficulties faced by SMEs. In fact, tax
measures have tended to be the predominant means of government
intervention (and expenditure) in the area of informal
venture capital. Too often, however, these tax measures
have been poorly targeted with respect to the businesses
and/or the investors that benefit from the measures.
SMEs are often touted, particularly by their own lobby
groups, as the key to economic growth. Statistics—for
example, that SMEs account for over 99.7 percent of all
employers, employ over half of all employees, are responsible
for over half of research and development, and account
for most of the job growth in the past few decades—are
often bandied about, giving the impression that SMEs should
be viewed as a homogenous group to be imbued with government
support. However, the term, SME, includes a broad range
of businesses. In the context of government policy targeting
investment in SMEs, an important distinction must be drawn
between small businesses that plan to grow rapidly and
other small businesses that provide a livelihood to a
relatively small and stable (in terms of number, though
not in terms of employee longevity) group of people.
A rapid growth SME, as the name implies, is a business
that intends to expand quickly (generally in order to
capture a large market share by capitalizing on new technology)
and requires significant capital to achieve its objectives.
The vast majority of small businesses (over 90 percent),
sometimes referred to as lifestyle businesses, are generally
not businesses that venture capitalists consider for investment
because there is little likelihood of growth and exiting
the investment is significantly more difficult.
Moreover, from a government policy perspective, these
lifestyle businesses are not job creators, but job churners
and the jobs that they churn are not “good”
jobs; generally, they are low-paying jobs with few benefits,
little security, and few prospects for advancement. What
create good jobs are not small businesses, per se, but
small businesses that grow large. These rapid growth SMEs
represent only four to eight percent of all small businesses,
yet since 1979 they have accounted for 70 to 75 percent
of net new jobs. Moreover, one-fifth of the rapid growth
SMEs accounted for almost one-half of all jobs generated
by autonomous new firms.
Government incentives for venture capital formation should
target only rapid growth SMEs.
Just like the businesses in which they invest, business
angels are not a homogeneous group. They range from the
once in a lifetime investor helping out a family member
or friend to the professional angel who is continually
evaluating and monitoring investment opportunities. When
developing government policy affecting investment in rapid
growth businesses at their earliest stages of development,
it is important to consider the factors that influence
angel capital investment, particularly the factors that
influence the decision to invest (and how much). Studies
of angel investors tend to suggest that tax incentives
will not make angel investors out of non-angels. At best,
tax incentives may increase the amount of venture capital
that existing angels are willing to invest (or reinvest).
Accordingly, the incentives should target repeat investors.
Federal Tax Policy and Angels
Federal tax policy affecting angels has focused on four
areas: the general capital gains tax rate; a preferential
tax rate for gains realized on small business securities;
a “rollover” or tax deferral when proceeds
from the sale of small business securities are reinvested
in other small business investments; and the preferential
treatment of capital losses from small business securities.
Unfortunately, government policy in recent years has
focused almost exclusively on a general capital gains
tax preference. An abundance of economic literature has
considered the impact of a general capital gains tax preference
on risk-taking and the conclusions are, at best, mixed.
At the very least, it is difficult to refute the argument
that an across-the-board reduction of capital gains taxation
is a very blunt instrument for encouraging investment
in new technology firms. In fact, it can have the opposite
effect. Given the relative difficulty of exiting venture
capital investments, a general capital gains tax preference
is more likely to increase investment in property for
which there is a large secondary market, including publicly-traded
securities and real estate.
Furthermore, a reduced capital gains tax rate applicable
to all capital property undermines more appropriately
targeted incentives. For example, when the long-term capital
gains tax rate was reduced to 15 percent in 2003, the
capital gains tax preference for qualified small business
stock (QSBS) was essentially eliminated. In the absence
of alternative minimum tax (AMT), the effective tax rate
for QSBS gains is only one percent below the long-term
capital gains tax rate; and if the gain is subject to
AMT, the preference over long-term capital gains is only
2/100ths of one percent.
The angel capital rollover is certainly a more targeted
measure, although it too has its deficiencies. First,
as in the case of the tax preference attached to QSBS,
any reduction in the general capital gains tax preference
undermines the more targeted preference.
Second, the angel capital rollover is limited to individual
investors and is therefore of no benefit to corporate
venture capital investors. While most angel investors
are individuals, small businesses, particularly at the
seed or start-up stage, often receive financing from key
suppliers or customers. A rollover would provide a greater
incentive to these corporate investors to reinvest proceeds
from a successful small business investment in other small
businesses because the gain would otherwise be subject
to tax at the general corporate tax rate.
Third, the 60-day time period in which a replacement
QSBS investment must be found is extremely short and may
lead to rash investment decisions in order to secure the
deferral. Canada, which recently introduced an angel capital
rollover modeled on the US provision, gives individuals
the remainder of the calendar year in which the disposition
occurs plus a further 120 days to find a replacement investment.
Given the difficulties in matching angel investors with
potential investments, a more generous time period to
find a replacement investment would be appropriate.
Not surprisingly, the first relief measure targeting
angel capital investment was not the preferential treatment
of capital gains from dispositions of small business stock.
Rather, it was enhanced relief for capital losses from
small business investments, which would otherwise be deductible
only to the extent of realized capital gains. For angel
capitalists, more relaxed loss limitation provisions are
a more direct and effective way to increase venture capital
investment than a capital gains tax preference, even a
targeted tax preference such as the capital gains exemption
for QSBS. As No?l Cunningham and Deborah Schenk note,
a capital gains tax preference is “a very poor second-best
solution” to full loss relief. Consider the following
example.
An individual (Ms. X) has a choice of two investments:
the first is a riskless investment with an annual rate
of return of 10 percent. The second is a risky investment,
in which there is a 40 percent chance that Ms. X’s
investment will triple in one year and a 60 percent chance
that the investment will fail completely within one year.
The expected rate of return on the second investment is
therefore 20 percent. All individuals are risk-adverse
to some extent and would therefore limit the amount invested
in the second investment despite the fact that the expected
return is double that of the riskless investment. Suppose
that in the absence of tax, Ms. X is unwilling to invest
more than $1,000 in the second investment (i.e., Ms. X
will not risk losing more than $1,000). Suppose now that
a 40 percent proportionate tax is introduced with full
loss offset. This tax would reduce the after-tax rate
of return on the first investment to 6 percent and on
the second investment to 12 percent. Although the relative
attractiveness of the two investments remains the same,
Ms. X should be willing to invest more money in the second
investment because the government has in effect assumed
40 percent of the risk. On the other hand, if the utility
of losses is restricted and Ms. X has no other capital
investments, she would not invest in the second investment
at all.
If losses remain restricted but a capital gains tax preference
is introduced—for example, 50 percent of the gain
is excluded from tax, as is the case with the QSBS exemption—the
expected return on the second investment is 4 percent,
still less than the after-tax return on the riskless investment.
Since 1958, individual taxpayers have been entitled to
deduct from all income a certain amount of capital losses
from “section 1244 stock” (rather that restricting
the deduction to capital gains). Since 1978, the amount
of capital losses from section 1244 stock that can be
offset against ordinary income has been $50,000 ($100,000
for a married person filing a joint return) and the maximum
amount of section 1244 stock that a small business corporation
can issue has been $1,000,000. Neither limit has increased
since 1978.
There are two major problems with the section 1244 stock
provisions. The first is that the limits—both the
limit affecting each investor’s loss and the limit
on section 1244 stock that each SME can issue—are
too low, particularly given the increasing size of the
equity gap that angel investors are supposed to fill.
The second problem is that the tax preference is poorly
targeted, in that there are no restrictions on the types
of small businesses for which relief is provided. Given
the fact that the vast majority of small businesses and
small business failures are lifestyle businesses, the
vast majority of individuals benefiting from section 1244
are not angel investors, but love capital investors in
lifestyle business. The provision could be more appropriately
targeted—for example, by excluding from the benefit
a “black list” of businesses, similar to that
applicable to the QSBS provisions. By better targeting
the measure, the relief provided in individual cases could
be increased, say to $200,000 ($400,000 for a married
person filing a joint return), and the amount of section
1244 stock that each corporation can issue could also
be increased.
State Tax Policy and Angels
A number of states—for example, Indiana, Iowa,
Maine, and Missouri—have introduced income tax credits
for seed capital investment in small businesses. These
tax credits act as a front-end incentive targeting primarily
angel capitalists. By reducing the after-tax cost of the
investment, the state government essentially assumes some
of the risk of investment. In this respect, the tax credit
acts in a manner similar to increased loss relief for
venture capital investments. However, the tax credit is
provided regardless of an investment’s success whereas
loss relief is available only if the investment fails.
While the state tax credit programs tend to target the
right SMEs (generally through a “white list”
of permitted investments), they do not necessarily target
the right investors. Angel capitalists must rely on their
own ability to choose and monitor appropriate investments
because there is no professional intermediary that assists
in these functions, in contrast with formal venture capital
market intermediaries. An angel capital tax credit does
not distinguish between sophisticated and unsophisticated
angels. Securities legislation has acted as a safeguard
in this respect to some extent; however, some jurisdictions
have relaxed their securities regulations affecting private
placements in order to promote small business investment
to the point that this safety feature has been eliminated.
Sophisticated angels provide more than capital to a fledgling
business; their expertise may assist the business in developing
its products and perhaps in accessing additional capital.
Less sophisticated angels can act as impediments when
additional capital is sought.
It is difficult for a tax credit program to target only
those angel investors who will add value (other than capital)
to the qualified business and it is perhaps inappropriate
for governments to engage in such paternalistic behavior.
Where, however, the government introduces a tax credit
(or other tax or financial incentives) to induce investment
in SMEs and at the same time provides little if any protection
in the form of information disclosure requirements to
investors in the securities legislation or the tax credit
program, it opens up the potential for unscrupulous behavior
that can undermine investor confidence.
Generally speaking, there are minimal requirements that
a small business must meet before receiving government
certification for the tax credit and unsophisticated angels
may be inclined to view state certification of a small
business as a “stamp of approval,” despite
express statements by the government to the contrary.
Unless the government is prepared to assume the role of
financial intermediary and undertake a full evaluation
of the small businesses applying for the tax credit in
an attempt to select “winners”—a role
for which the government is ill-equipped—government
programs should target more seasoned angel capitalists
or specialized investment vehicles, such as professionally
managed small business investment funds, that can better
evaluate potential investments and nurture the businesses
in which they invest. The various state angel capital
tax credit programs do none of these things. An angel
capital tax credit combined with the recent tendency to
relax securities regulation affecting private financings
is, in may view, a recipe for disaster. Informal venture
capital investment is better served by an expanded angel
capital rollover and greater loss relief for appropriately-targeted
small business investments. In my view, state government
incentives for early-stage venture investing should focus
on non-tax measures, such as developing angel capital
networks or incubator programs, which more directly address
the information asymmetries particularly prevalent at
the earliest states of a business’s development.
July 15, 2004
By: Daniel Sandler, Faculty at Law University of
Western Ontario
http://www.nasvf.org/web/allpress.nsf/pages/9255
Reprinted under the Fair Use doctrine of international
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