Good ideas may be scarce, capital to fund them is not
Many state governments, hoping to stimulate entrepreneurship and create jobs, offer tax credits to angel investors, the wealthy individuals who invest in early stage startups. Proponents of the program argue that incentivizing seasoned investors will boost early stage investments in high-growth startups.
But a working paper by Carnegie Mellon’s Matthew Denes, New York University’s Sabrina T. Howell, Northwestern’s Filippo Mezzanotti, UCLA Anderson’s Xinxin Wang and University of Virginia’s Ting Xu suggests the tax credits are ineffective in promoting entrepreneurship. The paper offers a comprehensive analysis of little-studied U.S. angel tax credit programs and suggests that while these tax credits significantly increase state-level angel investment, the increase in investment is driven by a surge in inexperienced, new and local investors, many of whom are already firm insiders.
What’s more, the research, analyzing 30 years of data, suggests credits have the unintended consequence, by funding relative laggards, of lowering the average growth metrics of a state’s funded startups. Consistent with this, the authors find that the programs have no effect on larger outcomes, such as the entry of new firms or high-tech job creation.
Thirty-one states have introduced angel tax credits from 1988 to 2018. Notable exceptions are nine states without state income taxes and states with a plentiful supply of angel investors already (California and Massachusetts).
The first angel tax credit is Maine’s Seed Capital Tax Credit Program, which began in 1988, while North Dakota and Tennessee offer the most recent credits, as illustrated in the chart below, which displays the staggered adoption and termination of angel tax programs.
To compile data on angel investments, the authors combined information from Crunchbase, Thomson VentureXpert, Dow Jones VentureSource, and Form D filings available through the Securities and Exchange Commission, eliminating duplicates to get 123,399 investments from 1985 to 2017. They combine this information with investor identities, locations and experience from AngelList and LinkedIn.
The researchers recorded the startup entrepreneurs’ prior founder experience and the employment growth for the year before any angel investment as a measure of startup potential. Finally, data on state-level real outcomes from the U.S. Census Bureau’s Business Dynamics Statistics, Quarterly Workforce Indicators and County Business Patterns was used to measure job creation (and destruction) by the startups and to record their entry and exit rates. Patent applications were reviewed, as well, and the number of successful exits (being acquired, going public in a stock offering) by the startups.
Despite a lukewarm reception from experienced angel investors, over the researchers’ sample period 88% of the offered tax credits, or a total of $8.1 billion, was handed out. With an average tax credit of 34%, $23.8 billion in angel investment is supported over the sample period, a large sum relative to both existing entrepreneurial support programs and angel investing in these states, the authors note. A tax credit of $1 reduces one’s taxes owed by $1, making it far more attractive than a simple tax deduction, which reduces taxable income.
The Experience Gap
While anyone with money can fashion themself an angel investor and take advantage of a tax credit, that doesn’t necessarily mean they will be good at it.
Using past studies on characteristics of angel investors for comparison and a subset of the data from seven states that publicly release the names of the investors, the researchers determined that investors utilizing the tax credits are mostly “younger, more local and less experienced than the average angel investor.”
Those taking the tax credits had an average age of 42 versus 58 for angel investors. Only 6.2% of the tax credit investors had prior entrepreneurial experience while 55% of angels have entrepreneurial experience. And while the number of in-state angel investors rose by about 31%, there was no change in out-of-state investors.
The researchers’ findings suggest that new investments mostly ended up at firms with lower growth potential. This growth potential is estimated using pre-investment employment, employment growth and founder experience. Overall, these growth characteristics for angel-funded firms deteriorate from their average pre-investment levels when investor tax credits are introduced. The findings suggest that the angel tax credits have little positive effect on local entrepreneurship.
Failing to Attract the Right Audience
The researchers set out to understand why professional angel investors don’t respond to investor tax credits. A survey of 1,411 angel investors suggests that these investors approach the investment looking for a “home run,” or big win. Professional investors are more interested in a startup’s management team and their business strategy or technology than in receiving subsidies (see chart below). In fact, the more experience an investor had, the less interested they were in investor tax credits. Additionally, the survey revealed that 15% of professional angel investors found applying for the tax credits to be too much of an administrative burden.
If state governments align tax credits with the interests of sophisticated angel investors and potentially screen out the inexperienced investors and, in particular, firm insiders, the outcome of tax credits might improve. Or states could invest directly in startups. Research and development grant programs, accelerators and new venture competitions are methods that have shown promise in multiple past studies.
But tax policy that merely seeks to draw more capital to the startup world seems naïve at best. U.S. startups raised a record $69 billion in 2021’s first quarter, 41% higher than the previous record for a quarter. What’s scarce is a good business idea and talent to execute it.
Assistant Professor of Finance
About the Research
Denes, M. R., Howell, S. T., Mezzanotti, F., Wang, X., & Xu, T. (2020). Investor Tax Credits and Entrepreneurship: Evidence from US States (No. w27751). National Bureau of Economic Research.