25% Angel Tax Credits

Governments know that they are in trouble.  Fiscally, they are stretched to the limit with unfunded liabilities.  The politicians are unable to make the tough choices to cut spending-and they are limited to how much they can raise taxes.  That’s why Obama kept touting taxes on people that make $250k or more.  It’s a small slice of the American public and easy to demogogue.

Mitt Romney - The 1 Percent

Mitt Romney – The 1 Percent (Photo credit: Cory M. Grenier)

Around the country, states are experimenting with different tax policy as well. For example, Illinois, Wisconsin, Nebraska and Minnesota all have programs designed to stimulate investment in start up companies.  Each state has a slightly different twist on it, but a lot of them have settled on a 25% Angel tax credit.

The way it works is a business registers for the credit.  It receives approval from the state.  Then investors in the company receive a 25% reduction on state income taxes for the amount they invest in the company.   Each individual entity is limited to a $2M cap for the credit.  States also routinely run out of funds allocated for angel tax credit investment.

Data shows that states with the credit have stimulated more investment in start up companies.  Because these kinds of investments are only open to wealthy individuals, the tax credit isn’t available to anyone that is not an accredited investor.   In political parlance, that’s the wealthy.  Advocates of the tax credit like to tout job creation.  While start ups do create jobs, they don’t create them at a pace like a hotel or restaurant.

In my mind, that angel tax credit isn’t economically efficient.  It may stimulate investment, but does that stimulate growth?  Here is some data that we know.  Bob Okabe from RPX Group does a lot of work for the Angel Capital Association.  I have heard him speak several times and he always drills down into this data.  Each year, roughly 600,000 companies are formed in the US.  Of that 600,000 roughly only 60,000 will get funding from angels.  Of that 60,000, roughly only 1000 will see any money from a Venture Capitalist.  Or .0016 of all the companies started each year get VC investment.  That’s a small fraction.

Here are some other rule of thumb statistics.  If you invest in 10 start ups, roughly 3 will pay for your entire portfolio and the rest will lose money.  Of course, you might have to invest in more than 10 to find those three!  VC’s have roughly the same risk/reward ratios.  Remember, they are getting into the game at a later level.  Angels typically invest at a valuation of less than $5M.  VCs typically invest at a valuation of $10M or more.  They need that business to roll up to a $100M business or more to make a decent return.  Given the high failure rate, even for VC funded businesses, the angel tax credit is nice but not a deciding factor on investment.

When analyzing a company, no one ever looks at the end valuation and says, “I am investing in a company with a 5M valuation, but because of the angel tax credit, it’s really a 1.25M valuation.”  No one ever figures the tax credit in when making an investment decision either.  Business analysis in start ups is done on the basis of the idea, and the investors perceived chance of success.  Peter Thiel didn’t look at tax structure when he plunked down $400,000 to start up Facebook.

If we wanted a tax credit to make a difference, we’d end capital gains taxes on successful exits.  Successful exits would create more money to be available for more investments to be made.  Suppose that I made a $50,000 investment in an early stage company.  The company was wildly successful and that investment was worth $15M on exit.  A 300x return!  Under current tax law, that investment is going to owe a massive amount of tax to the federal government.  Starting with a 15% capital gains tax, but extending into many other taxes as well.    Just like the 100M lotto winner that only realizes around 45% of the actual pot, the investor that gets a big score doesn’t realize the entire gain.  Additionally, because investors don’t invest in just one company, they have many losers to take away from that gain.  In my 10 company example, there are $450,000 in losers to siphon off a little of the profit from the one winner.

But what if there were no capital gains on the one win?  The odds are really good that the investor would plow a lot of that money back into start up companies looking for the next big score.  That would change the metrics around how many companies actually get funded.  The more companies that get funded, the more chance for growth.  If politicians really wanted to stimulate growth on the federal and state level, maybe they should persuade the IRS to amend the tax code. If you invest in a seed stage company’s first two rounds, you get 0% capital gains tax on successful exits.

Zero capital gains tax on an exit is a much stronger incentive than a 25% angel tax credit on initial investment.

 

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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