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Point of View : Jun 15, 2010 (Vol. 30, No. 12)

Tax Breaks Would Lure Investors

Revamping Capital Gains and Focusing on Incentives Could Increase Angel Investing
  • J. Leslie Glick, Ph.D.

Early last year (February 1, 2009) in this column, I suggested that since venture capital (VC) has a proven impact on job creation and the economy, and because VC firms were then experiencing much difficulty in raising funds for investing not only in start-ups and early-stage ventures but even in late-stage ventures, that the federal government invest as a limited partner in VC firms.

As I subsequently documented in a proposal sent to key government leaders, historical data indicated that if over a 20-year period the U.S. government invested $15 billion annually as a limited partner in VC firms, an estimated 1.3 million jobs would be created in 5 years and 6.8 million jobs in 20 years. Key technologies benefiting society would be developed and commercialized, and the government would ultimately record a positive return on its investment capital.

Indeed, based on VC returns achieved from 1988 through 2007, if the government had made 20 annual investments of $15 billion in U.S. VC firms, the $300 billion total investment would have yielded a total return of around $2.2 trillion.

For this scheme to work, three things need to happen. First, the government has to place its investment capital in a fund of funds managed by an independent investment manager. Second, all VC firms above a minimum size and operating history must be eligible for such funds, which would be disbursed in proportion to the magnitude of the private-sector funds each VC firm managed. Third, all investment decisions regarding which companies the VC firms should fund must be left exclusively to the general partners of the VC firms.

While this concept was subsequently advocated by columnists in The New York Times, The Washington Post, and The Wall Street Journal, it was not warmly received by U.S. government leaders. One member of Congress explained that, for political reasons, legislators would feel obliged to direct funds to particular investments, which in all likelihood, would lose money, thereby embarrassing themselves.

There were adherents, however, and last year, the state of Florida and the U.K. government created such funds for investing in VC firms. Moreover, in December 2009, a World Economic Forum study that analyzed over 28,000 companies in 128 nations that received VC funding between 2000 and 2008 found that companies that received up to 50% of their VC from government funds outperformed companies that were backed either entirely by private funds or mostly by government funds.

Tax Incentives

My latest proposal might be more palatable to the U.S. government; it recommends stimulating the economy by partnering indirectly with angel investors (high net worth individuals making venture investments). According to the National Science Board, for the four-year period ending in 2006, total U.S. angel investments, averaging $22.5 billion annually, were only 3.3% smaller than total U.S. VC investments. Most importantly, though, almost 90% of angel investment funds, in contrast to only about 20% of VC funds, were placed in start-ups and early-stage companies.

I believe that the federal government could stimulate the placement of start-up and early-stage investments by creating tax incentives for angel investors, whereby both the investors and the government reap gains if the investments grow. Currently, if an angel invests in a company, long-term capital gains are subject to a 15% tax and long-term capital losses offset long-term capital gains.

Suppose, however, that angel investors were able to receive an immediate 25% tax credit on all investments made in privately held companies whose common stock and additional paid-in capital were less than $10 million prior to such investments, with the tax credit even being applied against payment of estimated income taxes. The quid pro quo would be that the government would reap 25% of any resulting capital gains.

It turns out that both the investor’s and the government’s net return, to net risk ratios are identical when the proposed tax treatment is compared with the conventional long-term capital gains treatment. However, under the proposed system, the investor would likely be more willing to invest and even invest larger sums, and the government’s net return as compared to capital gains taxes recovered under current law, would be considerably higher.

For example, suppose an investor were to invest $100,000 today. The investor’s maximum risk equals 85% of the investment or $85,000, if a 100% loss reduces long-term capital gains taxes by 15%. The government’s maximum risk is $15,000 of less tax collected. However, if in the long run, the investor’s return to investment ratio reaches 2.5, the gross return would total $250,000, of which $150,000 would equal the capital gain. The government would receive 15% of the gain or $22,500 as capital gains tax, so the investor’s net return after taxes would equal $127,500.

Under the proposed system, since the investor receives a tax credit equal to 25% of the $100,000 investment or $25,000, the investor’s maximum risk equals $75,000. The government’s maximum risk is $25,000 less tax collected.

However, if the investor’s return to investment ratio reaches 2.5, the net return of $150,000 would be shared as follows: 25% or $37,500 would go to the government, and the investor would keep $112,500. While the investor receives a smaller net return from a gross investment of $100,000, when comparing the proposed system to the current system, the net investment is only $75,000 due to the tax credit, $25,000 less than under the current system.

Under the current system, if the investor invests $75,000 and in the long run achieves a return to investment ratio of 2.5, the gross return of $187,500 causes a long-term gain of $112,500. This gain is subject to a 15% capital gains tax equaling $16,875, which results in a net return of $95,625 or 15% less than the net return of $112,500 resulting from the same net investment under the proposed system.

Indeed, for the same level of net investment and for any positive long-term return to investment ratio, for both the government and the investor the net return under the proposed system exceeds that under the current system, by almost 18% for the investor and over 122% for the government.

Implementation of the proposed system would likely stimulate more and/or greater angel investments in start-ups and early-stage companies, not only because of a higher net return to the investor, but also because the investor would essentially be reimbursed for 25% of the amount invested.

If the resulting net investments remained unchanged, gross investments would be 33% higher, so that at the historical levels mentioned previously in this article angels would invest $7.5 billion more per year. Employing the methodologies described in the proposal that was submitted to the government last year, I have calculated that over 650,000 new jobs would be created over five years.

In addition, the National Venture Capital Association previously reported that for the 20-year period ending December 31, 2007 (the year before the onset of the recent recession), U.S. VC firms earned an average annualized return on investment of 16.7%, even though this period included the dot-com bubble. If over the next 20 years angel investors earn only half of that return, the government’s 25% share in an annual average of $30 billion invested would yield around $350 billion. The angels would end up with $1.4 trillion, and many more high-risk start-ups exploiting state-of-the-art technologies would be funded.

Cutting-edge biotechnology companies, in particular, would benefit, thereby fostering the development of breakthrough products in areas as diverse as personalized medicine, nanobiotechnology, biofuels, and agricultural and industrial biotechnology.