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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


Reprinted under the Fair Use doctrine of international copyright law. Full copyright retained by the original publication. In accordance with Title 17 U.S.C. Section 107, this material is distributed without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes.


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