Recent Research: Researchers find investment tax credits drive out successful investors

“The Achilles Heel of Reputable VCs,” a recent paper by Nuri Ersahin et al., finds that the most successful venture capital (VC) funds make fewer and smaller investments in states after investment tax credits go into effect. These VCs also co-invest with fewer firms, are less likely to invest in “serial” entrepreneurs and experience fewer positive exits after the introduction of the tax credit.

The paper specifically speaks to the investment activity of VC firms that have previously garnered the top one-third of initial public offering (IPO) shares, which the authors call “reputable VCs.” The authors examine this group because they recognize that many investment tax credit studies have found marginal overall effects on investment activity and are attempting to build on this research. The contribution of this paper is showing that, within static topline numbers, the credits are trading activity from successful VCs for activity from new or previously-unsuccessful investors.

While the authors’ decision to study this subset of VC firms makes sense within the context of the existing literature, readers are cautioned that these results do not address the impact of investment tax credits on the overall investment in the state, or how startups within the state are affected.

The authors found that the introduction of a state investment tax credit reduces the number of investments by reputable VCs. In fact, many of these firms depart the state altogether, as the credit is followed by a nearly 30 percent reduction in the number of these firms making any investments in the state. In their place, states attract more participation from investors with a weaker IPO track record.

The deals made by the reputable VCs that do remain look different than they did before the credit went into place. Specifically, the deals are smaller and are more likely to be followed sooner by another round. The authors’ findings suggest that the investment tax credit is forcing at least some startups to spend more time raising funds, as they are seeing less investment per round than they might without the credits.

Two factors assessed in the paper likely contribute to these smaller rounds:

• Reputable VCs co-invest with fewer other VC funds following the introduction of a state investment tax credit. With this being the case, even if each VC invested the same amount, the overall deal would be smaller.
• Reputable VCs appear more likely to invest in inexperienced founders in states with a credit. It would not be surprising if these VCs prefer to make smaller initial investments in these founders.

The finding about experienced entrepreneurs (those who previously founded at least one other company) is worth assessing in more detail. The authors find a larger reduction in the number of investments by reputable VCs in companies with experienced founders than in their overall number of investments. This suggests that experienced entrepreneurs may prefer to work with less-established investors and choose to do so as the credit attracts new investors to the state.

Given these findings about the changing investment patterns of reputable VCs in states with a credit, it is not surprising that the authors also find that reputable VCs experience fewer positive exits (including both IPOs and mergers/acquisitions) post-credit. However, the paper does not entirely clarify whether the rate of positive exits declines, or just the number of exits declines, which would be expected to occur alongside the lower number of investments.

Policy implications

“The Achilles Heel of Reputable VCs” finds that state investment tax credits serve to crowd experienced, financially-successful VCs out of the state market in favor of newer or less-successful investors. While the reputation of participating VCs is not a directly-important factor in assessing the value of investment tax credits — job and sales growth, for example, are more central considerations — there could be negative impacts to the trade-off from more- to less-established VCs. States should look at the startups in their regions to determine if established VCs are more likely to generate positive results for their portfolio companies, or if newer investors achieve equally-robust results. If the former, then the trade-offs in VC reputation the authors identify as an outcome of investor tax credits is a net-negative for the state’s economic development goals.

More broadly, these findings add to the large body of research that questions the value of investment tax credits, identifying many cases of insiders benefiting from credits and few measurable, positive impacts for the state’s economy.