Is it as risky as it seems? a short note on how tax policy impacts informal venture capital investing.

White, Eve P. ; White, John B. ; Miles, Morgan P. 等

ABSTRACT

The purpose of this study is to answer the question, "are informal venture capital investors rational?" If angel investing is rational, then it should have a competitive rate of return (adjusted for risk, liquidity, and investment efforts) compared to more passive market-based investments such as index fund investing. If these adjusted rates of return are not competitive and do not compensate for the additional costs of informal venture investing, then the nonfinancial motives must be the most important criteria driving informal venture capital investments. The following analysis illustrates how tax policy can be used to make seemingly economically irrational informal venture investments an economically rational decision.

 Capitalism expands wealth primarily through creative
 destruction- the process by which the cash flow from obsolescent,
 low-return capital is invested in high-return, cutting-edge
 technologies (Greenspan, 2002).

INTRODUCTION

Informal venture investment has recently become a topic of great interest for entrepreneurial finance. Research by Wetzel (1983), Duxbury, Haines, and Riding (1996), Van Osnabrugge and Robinson (2000), and Mason and Harrison (2002, 1993), among many others, suggests that informal venture capital (or angel investing) is becoming an increasingly important financing mechanism for small and medium-sized enterprises (SMEs). The reasons that informal venture investing has become more important are many, including the recent decline in formal venture investing, lower returns in traditional equity markets, lower returns in the traditional debt markets, and the ability in some instances for informal venture capital to overcome the capital constraints that SMEs often face (Mason & Harrison, 1995).

Currently, many investors invest through intermediaries, such as mutual funds, and feel that they have almost no control over the outcomes of their investment decisions. Needless to say, some of these investors with extensive management experience prefer an alternative investment mechanism that allow them to take a more active role. Heard and Siebert (2000) succinctly characterize the process of angel investing:

 A typical angel investor is a high-net worth individual with an
 interest and knowledge in a particular business sector, often
 because that is where he or she gained personal wealth. Angels
 can help a startup company with their considerable experience.
 This can also cause considerable harm if they are naive about
 the needs of the business. An angel will frequently become an
 active advisor to the company and often take a seat on its board
 of directors.

Investors considering investing in the informal equity market then must answer this question: Is informal venture investing an economically rational decision, given tax effects, risk, liquidity, cost of capital, etc.? In other words, could informal venture investors do as well by simply investing in an S&P 500 index mutual fund, which would have higher liquidity and lower transactions costs?

Governments have also become keenly interested in the economic development benefits of encouraging entrepreneurship. For example, many states use tax dollars to support entrepreneurship as a tool of competitiveness, economic development, and job creation. (See the Directory of State Business Development Incentives, 2002 and Kayne, 1999.) These tax expenditures are sometimes politically justified because the benefits to the state may include: (1) enhanced tax bases; (2) income growth; and (3) growth in employment; however, one constraint to entrepreneurship is the availability of risk capital to develop, assess, and exploit entrepreneurial opportunities during the earliest stages of business creation.

INFORMAL VENTURE INVESTING: PROS AND CONS

During the bull market of the 1990's, informal venture investment did not appear to be as an attractive investment on a risk-adjusted basis as equity market alternatives, such as low-cost mutual funds indexed to the market. Publicly-traded equity market rates of returns exceeded 12.5% from 1992 to 2002 (Vanguard, 2005). With this high return available from more traditional investments, it seems difficult to justify the added risk, costs, and effort associated with the informal venture alternative. However, investing by business angels continued during the 1990's and in the post dot-com era of the 2000's, informal venture capital investing continues to be a popular alternative for investors. Are business angels seeking ever higher rates of financial returns for their time, talent, and treasure or some other type of compensation (Amit, Glosten, & Muller 1990)?

From the individual investor's perspective, passive investments in an indexed mutual fund have several distinct advantages over the active investment of informal venture capital: (1) much lower due diligence costs; (2) lower transactions costs; (3) inherently much greater diversification when investing in a market-fund similar to Vanguard's Index 500, which tracks the S&P 500 Index; and (4) much more liquidity (Wright & Robbie, 1998). The lower levels of liquidity and diversification and higher due diligence and transaction costs should require investors to demand higher rates of return for informal venture capital investments than for the alternative index mutual fund investments. Table 1 is a comparison of recent returns to the S&P 500 and a venture capital investments. The expected risk premium for venture investing does not seem to be apparent from this data.

For many investors, however, informal venture investments are still attractive. Van Osnabrugge and Robinson (2000) suggest that business angels seek both financial and nonfinancial rewards. For example, some business angels are retired, and they enjoy creating employment opportunities for themselves. They feel that they are contributing to society by sharing their experience and working with new start-ups. Duxbury et al. (1996: 44) suggest that business angels tend to have an internal locus of control, very high needs for achievement and dominance, and moderately high needs for affiliation and autonomy. These personality characteristics suggest that business angels prefer investments in which they can participate and contribute; however, typically, the most important reward remains obtaining a superior financial return. Van Osnabrugge and Robinson (2000) note that "most angels hope to quintuple their money in five years, although few actually do." Table 2 offers a comparison of the rewards that investors may receive by angel investing and index mutual fund investing.

Miles, Isley, and Munilla (2001) and Duxbury et al. (1996) in separate studies found that informal venture capital investors tended to invest in start-ups that were somehow related to their current or previous business interests, which reduces the costs associated with due diligence. This suggests that venture capitalists have an opportunity to legally exploit insider knowledge (analogous to insider information in the publicly-traded equity market). In some situations, the start-up may be strategically related to the investor's ongoing business and the new venture might contribute to the existing firm's product or marketing efforts. In other instances, the possibility, albeit slight, to make an extremely high return was the incentive to invest at least some portion of the investor's portfolio in the informal venture capital market. As Miles et al. (2001) found, typically informal venture capital investors were also active investors in an array of more passive market-based investments such as mutual funds. The capital allocation between investing in a highly liquid, highly diversified index fund or a much less liquid start-up is the heart of the question pertaining to the economic rationality of informal venture investing.

PURPOSE

The purpose of this study is to answer the question, "are informal venture capital investors rational?" If angel investing is rational, then it should have a competitive rate of return (adjusted for risk, liquidity, and investment efforts) compared to more passive market-based investments such as index fund investing. If these adjusted rates of return are not competitive and do not compensate for the additional costs of informal venture investing, then the nonfinancial motives must be the most important criteria driving informal venture capital investments. The following analysis illustrates how tax policy can be used to make seemingly economically irrational informal venture investments an economically rational decision.

RATES OF RETURN TO INFORMAL VENTURE INVESTMENTS

Consider a project that requires an angel investor to commit $1 million dollars with a 10 percent probability of a maximum upside return of $20 million in five years. The expected value of the investment is $2 million. In the absence of any special tax treatment for angel investments, the investment has an expected return of 14.8 percent. This investment is shown in Timeline 1.

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Although the preceding analysis assumes no special tax treatment on the initial investment, many states use investment tax credits to encourage the job creation that results from angel investing. For illustration purposes, assume a 10 percent investment tax credit. This would produce an immediate tax credit of $100,000, which lowers the investment at risk to $900,000. The new timeline is shown in Timeline 2.

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The 10 percent investment tax credit caused the expected internal rate of return on the investment to rise 2.5 percentage points, an increase of 16.9 percent. An investment tax credit greater than 10 percent would cause the IRR to increase even more.

TAX VALUE OF LOSSES

The previous analysis is the standard treatment of investment cash flows, which centers on the cash flows from earnings, but for angel investors, the venture investment is only a portion of their investment portfolio. Therefore, losses in one portion of the portfolio have value in that losses can offset gains from taxes. Long-term capital gains are generally taxed at 20 percent. Losses can be used to offset gains, essentially making those gains tax-free. Long-term losses are first applied against long-term gains, with remaining losses then applied to short-term gains. If losses are greater than total gains, then $3,000 of the remaining loss may be deducted from income. If more than $3,000 of loss remains, then this loss may be carried forward against future income. (See www.irs.gov/taxtopics for further information.)

This suggests that the expected cash flows from angel investing come not only from successful projects that produce positive returns but also from those projects that yield no return or even lose the principle invested. Consider, for example, the previous investment situation in which the investment is a total loss: $1 million dollars invested with a 10 percent chance of a $20 million payoff in five years. Also, assume that the angel investor has other investments in his portfolio and has realized $400,000 in long-term gains and $300,000 in short-term gains this year. By offsetting the long-term gains with the long-term loss (from the informal venture investment), $80,000 (from 20% x $400,000 gain) is saved in taxes. An additional $118,800 is saved by offsetting the short-term gain. (Short-term capital gains are taxed as ordinary income. Assuming the angel investor is in the maximum tax bracket of 39.6 percent, the tax on an additional $300,000 of income is $118,800.) Finally, an additional $3,000 may be deducted from income, since $200,000 of the $900,000 loss has not been used. This will reduce the angel's tax liability an additional $1,188 for this year. The $197,000 loss that remains can be used to offset future long-term or short-term gains. The loss may also be used to deduct the $3,000 per year from income to save $1,188 per year in taxes for the next 65 years, with the final $2,000 loss yielding a $792 tax savings in year 66. While carrying a loss this far into the future is unlikely, it does illustrate how the tax effect minimizes the value of the loss. The investment in the case described above corresponds to the Timeline 3.

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This 2.3 percentage point increase in the internal rate of return shown in Timeline 3 represents an additional 13.3 percent increase over the return when the tax value of the losses are ignored in Timeline 2. As Timeline 3 clearly shows, the tax value to those losses is significant and the astute investor will certainly include that value in the investment decision.

The results shown in Timeline 3 were driven by the manner in which the losses were distributed. As more of the losses are used to offset gains taxable at the higher tax rates, the higher the expected IRR will be. For instance, if the angel investor had $500,000 in long-term gains and $400,000 in short-term gains, the entire loss would be exhausted in a single year. Tax gains would be $100,000 in long-term capital gains and $158,400 in short-term capital gains. A $900,000 investment with expected cash flows in five years totaling $2,258,400 produces an internal rate of return of 20.2 percent. This is slightly higher than the previous example in which the tax value of $197,000 of the loss was deferred. These cash flows are shown in Timeline 4.

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State income tax liability will produce additional cash flows to the business angel from savings on any state and local income taxes, depending on the state of residence. For instance, Rhode Island income tax liability is 25 percent of the federal tax liability. This would increase the cash flows from tax savings $64,600 (25% x ($100,000 + $158,400)). This increases the IRR from 20.2 percent to 20.9 percent. If any city or county income taxes are in the angel's taxable address, then these tax savings would represent additional cash flows, raising the project's IRR even further. State income taxes vary with each state, making it impossible to specify the tax savings generated by this source. At the present time, only nine states do not tax the income of their residents. With the exception of these states, however, it is safe to say that the existence of state income taxes will make the returns from a project that loses the entire investment even higher than the examples have shown.

CONCLUSION

This study illustrates that the economic attractiveness of informal venture investing is increased considerably by the inclusion of the tax effects on gains and losses. Therefore, it should come as no surprise that investing by business angels continued through the bull market. Angel investing is even more attractive today with alternative returns in equity and credit markets so low. The implications for government policy makers interested in encouraging entrepreneurial activity are obvious. The investment tax credit enhances the project's return by reducing the initial net cash invested and increases the expected return. In addition, the economic activity stimulated by the business angel's response to the investment tax credit will enhance employment, income and tax revenue, resulting in positive social outcomes by helping reduce the capital gap that small businesses and start-ups often face (Mason & Harrison, 1995).

A 2005 study by Preston found that 19 states offered some type of tax credit to angel investors. These tax credits can be placed into three categories: direct tax credits at any investment stage; tax credits for seed capital; and contingent tax credits if actual returns fell short of expected returns. While the possibility of over-subscription in any tax credit plan always exists, Preston (2005) maintains that "developing tax credit programs is an iterative process." The tax credit program can be adjusted as it achieves its goal of creating jobs by directing capital to specific industries and/or geographic areas of the state.

Is informal venture capital investing as risky as it seems? No, appropriate tax policy can create positive incentives to enhance participation in informal venture investing. Because of the federal tax savings generated by losses, state tax credits need not be as high as federal investment tax credits to encourage venture investing.

REFERENCES

Amit, R., Glosten, L., & Muller, E. (1990). Entrepreneurial ability, venture investment, and risk sharing, Management Science, 36(10), 1232-1245.

Directory of state business development incentives. (2002). National Association of State Development Agencies, Washington, D.C.

Duxbury, L., Haines, G., & Riding, A. (1996). A personality profile of Canadian informal investors. Journal of Small Business Management, 34(4), 44-55.

Greenspan, A. (2002). Stock options and related matters: Remarks before the 2002 financial markets conference of the Federal Reserve Bank of Atlanta, Sea Island, Georgia

Heard, R.G. & Sibert, J. (2000). Growing new businesses with seed and venture capital: State experiences and options, National Governors' Association: Washington, DC.

Kayne, J. (1999). State entrepreneurship policies and programs, Kauffman Center for Entrepreneurial Leadership: Kansas City, MO.

Mason, C. M. & Harrison, R. T. (1993). Strategies for expanding the informal venture capital market. International Small Business Journal, 11(4), 23-38.

Mason, C. M. & Harrison, R. T. (1995). Closing the regional equity capital gap: The role of informal venture capital. Small Business Economics, 7, 153-172.

Mason, C. M. & Harrison, R. T. (2002). Is it worth it? The rates of return from informal venture capital investments. Journal of Business Venturing, 17, 211-236.

Mason, C. M. & Harrison, R.T. (2004). Does investing in technology-based firms involve higher risk? An exploratory study of the performance of technology and non-technology investments by business angels. Venture Capital, 6(4, October), 313-332.

Miles, M. P., Isley, P., & Munilla, L. B. (2001). Marketing a university by supporting a business angel forum, presented at the University of Illinois at Chicago and George Washington University Marketing and Entrepreneurship Research Forum, Washington, DC, August.

Preston, S. (2004). State tax credits for equity investments: A survey of current practices. Angel Capital Association Study Newsletter, September 21, [On-line]. Retrieved December 13, 2005, from http://www.angelcapitalassociation.org/dir_about/news_detail.aspx?id=74.

Van Osnabrugge, M. & Robinson, R. J. (2000), Angel investing: Matching start-up funds with start-up companies: The guide for entrepreneurs, individual investors, and venture capitalists, Jossey-Bass: San Francisco.

Vanguard Group. (2005). S&P 500 index fund. [On-line]. Retrieved December 15, 2005, from http://flagship3.vanguard.com/VGApp/hnw/FundsHistoricalReturns?FundId=0040 &FundIntExt=INT.

Wetzel, W. E. (1983). Angles and informal risk capital. Sloan Management Review, 24, 23-33.

Wright, M. & Robbie, K. (1998). Venture capital and private equity: A review and synthesis. Journal of Business Finance and Accounting, 25(5and6), 521-566.

Eve P. White, Georgia Southern University

John B. White, Georgia Southern University

Morgan P. Miles, Georgia Southern University

Table 1: A Comparison of the Returns of the S&P 500 Index and Business
Angel Investing

YEAR S&P 500 INDEX (1) BUSINESS ANGEL RETURNS (2)

1997 33.36% 14.0%
1998 28.68% 14.9%
1999 21.04% 15.9%
2000 -9.10% 16.4%
2001 -11.89% 16.2%
2002 -22.10% 14.6%
2003 28.68% 13.6%

 1) Vanguard (2005)

 2) Mason and Harrison (2004)

Table 2: A Comparison of the Rewards of Informal Venture Investing and
Index Mutual Funds

INVESTMENT REWARDS INFORMAL VENTURE CAPITAL

FINANCIAL Expectation to out-perform the
 market

CONTRIBUTING TO AN Source of reward for venture
ENTREPRENEURIAL ACTIVITY capitalist

POTENTIAL TO CREATE JOB & Could be a significant motive
INCOME FOR INVESTOR

SENSE OF SOCIAL Feeling of Agiving back@
RESPONSIBILITY

TAX EFFECT ON LOSSES Capital loss and investment tax
 credits (in some states)

INVESTMENT REWARDS INDEX FUNDS

FINANCIAL Expectation to perform like the
 market

CONTRIBUTING TO AN N.A.
ENTREPRENEURIAL ACTIVITY

POTENTIAL TO CREATE JOB & N.A.
INCOME FOR INVESTOR

SENSE OF SOCIAL Typically N.A., but would be
RESPONSIBILITY similar to Asocial screening@
 index funds

TAX EFFECT ON LOSSES Capital loss

 Adapted from van Osnabrugge & Robinson (2000)