Tax Change Can Re-ignite Venture Investing by: Roman Kikta
Like the rest of the economy the venture capital industry is struggling. Even the best of VC firms are finding it difficult to raise new money and even collect on prior commitments.
Venture Capitalists are responding in several ways. Nearly all are pruning their portfolios. This means some cutting some inevitable losses a bit early. But it also means that some very promising companies with innovative ideas, viable products and strong management are also going to die too. Each VC firm has its own criteria but in many cases the test will simply be the time estimated to becoming cash -flow positive.
If a company looks great but is several years off it may get pruned while a less promising company a year away from revenues may be maintained. In other cases it will be thumbs down simply because a company requires more immediate funding than the investor can produce.
Another effect is that many VC firms are cutting back on new investments especially at the seed and early stage rounds and are looking only at later round investments in companies that are already cash-flow positive or near to it. Some might question whether investing in companies that are making money is really venture investing. It is certainly a far cry from backing three smart gutsy entrepreneurs with a PowerPoint.
Yet the entrepreneurs with a PowerPoint and the venture capitalists who took a risk on them have powered the US economy for decades. In 2006 fully one tenth of all US jobs were to be found in companies originally funded by venture capital. Over the period from 1998 to year end 2008, VC firms invested an average of $35.8 Billion per year in an economy that averaged $12 trillion per year in GDP over the same period. That is a big return for the US economy on a relatively minor investment. When you consider that the ranks of the venture funded include such brand names as Google, PayPal, Apple, Ebay, Yahoo! and Amazon, it also becomes clear that VC funded firms are the leaders in innovation.
Clearly investors willing to make high-risk investment are a critical part of America’s innovation economy. Yet, the Venture Capital industry whether located in Silicon Valley, Silicon Hills (Austin), Silicon Alley (New York) or the Route 128 Corridor (Boston) is being forced to change in ways that threaten that innovation economy.
Happily no government bailout is required to encourage a robust venture investment industry. There is a role for the Federal government to play with one or two changes to its tax code. Several years ago former Colorado Senator Gary Hart proposed the creation of a special class of stock he called “enterprise” or “e-stock.” His idea was that stock used to fund a start-up company or to fund new US based plants would be exempt from capital gains taxes the first time they were sold. The idea was to encourage risk taking by increasing the potential rewards. There was no cost to the treasury because these new companies would be creating tax paying jobs that might not otherwise exist and if they were successful in the long-run they would be corporate tax payers. And of course subsequent owners of the stock would pay capital gains taxes.
I believe Sen. Hart’s idea is the seed of an idea that could create a new era in venture investing. There is one significant change I would advocate: instead of being tax exempt on its first resale the stock would carry a one-time-only tax exemption that could be sold with the stock should the seller choose to do so. The problem with a one-time sale is that the buyer will want the price reduced to reflect the tax savings the seller will enjoy. In other words, the buyer will want to share in the tax savings. However, it is the initial investor who took the biggest risk and it is the initial investment that most needs to be encouraged.
By allowing the seller of E-stock to essentially sell the tax exemption you have created a market for the exemption. If the buyer is a private equity firm the buyer obviously expects to resell the company at a later date for a substantial profit. Therefore, the tax exemption will be worth more to the buyer than the initial seller and the seller can demand a premium for the exemption. If the buyer is a corporation the exemption will almost certainly be worth more to the buyer than the seller and may again command a premium. What if the buyer is the public through an IPO? Again the public buyers of the stock anticipate the stock will significantly increase in value and would especially treasure a tax break on resale.
Angel investors are another consideration. These generally represent either the so-called “friends and family” funding source, or professional angel investors who make relatively small investment of $25,000 to $100,000. Even in the best investment environment angels play a vital role. Many times the would-be entrepreneurs cannot even get to the PowerPoint stage without a year off from regular employment to develop a viable business plan. Angels are going to play a critical role in the future and the tax exempt status of their stock would be a strong encouragement.
There are questions to be thought through. Would E-stock be exempt from the inheritance tax as well as the capital gains tax? How long would an owner be required to hold the stock before allowing a sale that was tax exempt? Startups are typically funded in multiple rounds as cash needs grow. How may rounds of E-stock could a start up issue? Sen. Hart’s proposal went beyond startup companies. He included stock used to create US based plants as a way to create US jobs. It would seem at a time many companies in the US are struggling with outmoded noncompetitive plants in a capital constrained economy providing an incentive for investors to take a US based risk to retool American industry would also make sense. It isn’t often that a tax exemption can actually create more tax revenue than it costs but done right the Enterprise Stock concept can do just that.
President Obama tells us our nation may be looking down the barrel of trillion dollar deficits for years. Enterprise stock represents an opportunity to cut that deficit by generating tax paying jobs on US soil and by stoking the entrepreneurial innovation engines needed to keep the US as the number one economy in the world.
Written by Roman Kikta