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$8.1 billion in state angel tax credits: Creating investors or more successful entrepreneurs?

September 17, 2020
By: Mark Skinner

Many of the most successful technology, life science and advanced companies in the country received financing in the form of an equity investment during their rapid growth and scaling stages of development.  Whether viewed as valiant, villains or vultures, the presence of individuals and firms willing to provide capital to companies when they have few physical assets or revenues is strongly associated with healthy regional innovation economies. As a result, considerable policy attention has been focused by states on increasing the amount of risk capital flowing to local startups.

The objective is simple: high wage, innovation-driven economic development. State policy makers want those entrepreneurial companies to grow jobs and wealth within their boundaries. Approaches vary – and achieve considerable variation in their degrees of success – but one of the most widely implemented are angel investment tax credits, found in 31 states in the study discussed below.

Findings published in a new academic working paper included in a recent National Bureau of Economic Researchers newsletter suggest state policymakers should have considered alternate uses of the collective $8.1 billion in state tax revenues conceded to angel investors through these tax credits since 1988, if the public’s goal is to spur more successful entrepreneurial activity.

Investor Tax Credits and Entrepreneurship: Evidence from U.S. States, an August 2020 NBER working paper by Matthew R. Denes, Sabrina T. Howell, Filippo Mezzanotti, Xinxing and Ting Xu reports the authors’ findings that angel investor tax credits may help to increase the number of local investors within a state by as much as 31 percent, but that increase has “no significant effect on entrepreneurial activity.”  In essence, their findings suggest investment tax incentives may reward people for spending money without achieving the results the founders, the investors and the state economic developers want: profitable, growing companies. The authors estimated the total angel investment activity supported over their sample period to be in excess of $23 billion.

The authors go a step further and claim, based on a survey of 1,400 angel investors, the types of investors using these tax incentives fall into two buckets. The first group are insiders (investors within a company’s founders, executives or the team’s family members) or angels who are already active in the local or regional risk capital market and would have made some or all of the investments anyway. [Note: anecdotally, this could explain those times when a new investor tax credit is quickly maxed out. This research could indicate that it is not pent up risk intolerance finally being relaxed by overly cautious investors, but rewarding an existing equity market of high net-worth individuals already supporting the local innovation economy.]

The second type of investor the working paper authors identify as being attracted to state investment tax credits are more numerous and are characterized as being younger, inexperienced and selecting lower-growth opportunities than counterparts in the authors’ research who did not take advantage of the credits. Important for readers to note, low growth is assessed not by venture capital measures of valuation but by two important economic development measures of pre-investment employment and employment growth. The authors also considered founder experience in measuring growth of startups.

Exploring data from AngelList, Crunchbase, Form D filings, VentureSource, VentureXpert and, when available state government reports on the tax credits, the authors found the “growth characteristics of angel-backed firms also deteriorate after the implementation of the angel tax credits, which may be expected if relaxing financial constraints reduces the quality of firms financed at the margin.”

The criticism of angel tax credits does not stop there, however. The authors compared the results of the credits against the goals of the credits as defined in the states’ enabling legislation for the credits.  They conclude:

“We find that the policies have no significant effect on a plethora of entrepreneurial activity metrics, including young-firm employment, job creation, startup entry, successful exits, and patenting. Across many specifications, subsamples, and measures, we consistently find that the angel tax credits have an economically small and statistically insignificant effect on local entrepreneurship.”

The authors suggest the presence of tax credits changes investor behavior resulting in an increase in inferior investments, investors and results.

The survey findings also suggest the majority of investors do not consider the presence of a credit as important. Of the 1,411 angel investor responses received, 51 percent rated the credits as “not at all important (the lowest of five options).” Among the most experienced investors responding to the survey, the percentage increases to 71 percent. The most common reason given for scoring the credits so low related to investors seeking to invest in profitable companies, not in trying to offset losses. The administrative hassle of taking the credits was given as a reason by 15 percent of investors who had never taken a state investment tax credit.

While problematic regarding the policy goal of encouraging successful local entrepreneurial activity, some percentage of the inexperienced investors attracted to angel tax credits may become better investors over time through training, mentoring and collaboration. Organizations like the Angel Capital Association and Venture Forward provide structured training programs, for example.  Additionally, from a longer term regional innovation policy perspective, encouraging these angel investors to partner with well-constructed venture development organizations in their regions would couple high quality entrepreneurial support, R&D assets, and smart capital committed to the public goal of building sustained innovation-driven economic opportunity.

Investor Tax Credits and Entrepreneurship: Evidence from U.S. States is available for purchase ($5) from SSRN here.  Table A1 provides a summary of details regarding the individual tax credit programs included in the study.

angel capital, tax credits, entrepreneurship, recent research