What State Assessors Should Consider When Reviewing Early Stage Investment Incentives

Many states use tax incentives to encourage early-stage investment in high-growth industries, but determining whether these incentives can actually achieve the many goals that policymakers often set for them – for example, spurring job creation , investment and the overall state economy – comes with many challenges.

Last fall, The Pew Charitable Trusts held a “virtual office hours” event with Ellen Harpelfounder and managing director of the consulting firm Smart Incentives, and Andy Brienzolead auditor for the Kansas Post-Audit Legislative Division. Speakers discussed best practices, strategies and questions to ask when evaluating early-stage venture capital tax credits for new businesses. These can include “angel investor” tax credits, which some states call seed investment incentives.

States use these credits to catalyze funding for startups, but the profits go to the investor, not the company receiving the support. This adds an additional hurdle for evaluators when lawmakers ask whether a program improves business outcomes, because businesses are not primary beneficiaries.

Harpel presented the findings of his firm’s recent report on entrepreneurial incentives. Brienzo shared his team’s approach, as well as the findings and recommendations of his recent Angel Investor Tax Credit Review. The pair also answered questions.

Here are five takeaways:

1. There is no standard definition for “seed investment” in incentive programs.

Although many states encourage investment in start-up companies, program rules can define the early stage in different ways, making it difficult for evaluators to compare programs across states. For example, metrics related to business age, that is, how long a business has been in business before it was deemed ineligible for angel funding under the program, can vary. The Kansas Angel Investor Tax Credit Program requires funding to go to businesses that are no more than five yearswhile in Minnesota, some businesses may be up to 10 years old and still qualify under the credit status version.

“What was called an early stage or even seed or pre-seed in one state was entirely different than what those terms referred to in another state,” Harpel said, referring to the more than 200 programs of related to entrepreneurship that she examined in the context of his cabinet’s 2021 report. Early-stage business activity, she explained, “means something very specific in terms of venture capital, [but] it does not mean anything specific in political terms.

Why it matters: If legislators want to ensure that a program encourages investment in certain types of businesses, they must clearly define the eligible types so that the program can achieve its stated objective. Additionally, when assessing the impact of seed funding incentives, evaluators should examine the enabling law to determine whether specific investments intended to be encouraged by the provisions reflect the legislator’s objectives.

2. Offering incentives to investors does not guarantee high quality investment choices.

Unlike small business loans, grants, and job creation incentives, investor tax credits do not provide incentives directly to new businesses, but rather to the individuals or businesses that make the investment. . This means that policy makers want the credits to encourage investments that might not otherwise take place. But evidence suggests that these programs can unintentionally lead to lower quality investment choices, such as projects that might not attract support on their own and are more likely to fail than those that don’t require investment. incentive investments. There is no guarantee that these companies will produce the returns that states aim to encourage with such programs.

Brienzo cited a potential problem. “The literature in our review supports that [investors] tend not to be professional angels. … [The investors who claim this incentive] tend to have weaker picking ability,” he said, which can lead to investments that might just “help lower-quality companies survive a bit longer.”

Harpel’s work reflects a similar concern. “The good thing about angel investing is that you have experienced investors helping growing businesses,” but she cautioned that inexperienced investors can also benefit from credit.

why it matters: If policymakers want to support high-growth-potential companies that generate positive economic impact, they should consider whether programs such as angel investment tax credits are an effective way to achieve this outcome. Other programs, such as incentives that more directly benefit start-ups, may better serve a state’s economic development goals. Literature reviews that include academic studies and evaluations of similar programs can help provide the evidence policymakers need to inform their decisions.

3. Some angels can invest independently of an incentive.

Many states allow owners, family members, or affiliates related to the recipient business to claim credits under their angel investment programs. For example, the Maine Office of Program Evaluation and Government Accountability found last year that two state enterprises had received investments entirely from their founders. Investors got nearly $1.4 million in tax credits under Maine’s Seed Capital Tax Credit, and “no outside investment was sought.”

Harpel’s research shows that this is not uncommon. “Tax credits often go to insiders, friends and family of business owners,” she said, raising the question of whether some of the increased start-up investment is would be produced without state aid. This problem is known as the “but for” factor.

Why it matters: Assessing the extent to which tax incentive programs influence business decisions is an important factor in determining program impact. Although states employ a variety of strategies to help key decision-makers understand this “without” factor, common-sense assumptions can often be just as illuminating: decision-makers can easily infer that an angel investment program is unlikely to spur new investment if the angels are closely tied to the companies they support, as they likely would have provided financial assistance anyway. Evaluators can identify these cases through case studies, company surveys, and reviews of program statutes.

4. Early investment is one of many factors that can affect the success of a business.

New startups have many priorities besides attracting capital investment. Business leaders can value partnerships and networking opportunities with local businesses, assistance in complying with regulations, and assistance in developing a marketing or hiring strategy more than an influx of investments. “Most entrepreneurs don’t think about national and local government policies, programs and even the environment…when they start their business,” Harpel said. “They are focused on their business mission and their customers.”

Why it matters: States with angel investment programs should consider whether business investment is the most relevant need for new and emerging businesses, or whether other resources, such as workforce development, regulatory process and compliance assistance, or business training programs, may be more useful to targeted industries. .

5. Analysis of program beneficiaries can provide important data on the inequitable distribution of funds.

Understanding who benefits from economic development incentives can help states improve program design and administration to produce desired impacts. This could mean identifying whether funds are going to intended industries, locations, businesses, or individuals, or whether certain target recipients receive an outsized benefit at the expense of others. Brienzo pointed out that his office “couldn’t help but notice the lack of [equitable distribution] in investing” across the state. Johnson County, Kansas, for example, is one of the wealthiest in the state. “It received by far the most investment” and had “an outsized advantage at the expense of rural areas and some of the other urban counties,” he said.

Harpel has highlighted strategies that can help encourage the use of incentives to benefit a wide range of businesses. “There is a lot to do in terms of raising awareness, promoting, expanding our economic development network[s] to make sure people know about the program…and to rethink some of the procedures and application forms in place. … That alone could make a big difference in terms of fairness.

Why it matters: Policy makers create incentive programs to encourage a wide range of outcomes. One of the ways that evaluators can determine whether these programs are well designed is to analyze who benefits from them. It can also identify the other side of the coin—which is do not benefit, which can be just as important – and draw attention to possible policy reforms or changes in the way programs are administered.

Start-up investment tax credits are a common economic development tool, but they can be difficult to implement successfully. The increasing availability of program analyzes will greatly benefit decision-makers when deciding whether to create, modify or terminate these programs.

Shane Benz is researching tax incentives with The Pew Charitable Trusts State Fiscal Health Project.

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