What State Evaluators Should Consider When Reviewing Early-Stage Investment Incentives

Many states use tax incentives to encourage early-stage investment in high-growth industries, but to determine whether those incentives can effectively achieve the many goals that policymakers often set them — for example, job creation, investment, and the overall economy of the Boosting the state – brings with it many challenges.

Last fall, The Pew Charitable Trusts co-hosted a “virtual office hour” event Ellen HarpelFounder and Chief Executive Officer of the consulting firm Smart Incentives, and Andy BrienzChief examiner for the Kansas Legislative Division of Post Audit. The speakers discussed best practices, strategies and questions to ask when evaluating early-stage venture capital tax credits for new businesses. These may include “angel investor” tax credits, which some states refer to as start-up investment incentives.

States use these loans to catalyze startup funding, but the benefits accrue to the investor, not the company receiving the support. This presents an additional hurdle for reviewers when lawmakers ask whether a program improves business outcomes, since corporations are not the primary beneficiaries.

Harpel presented findings from her company’s most recent report entrepreneurial incentives. Brienzo shared his team’s approach, as well as the results and recommendations of his most recent Angel Investor Tax Credit Review. The couple also asked questions.

Here are five takeaways:

1. There is no single definition of “early-stage investment” across all incentive programs.

Although many states encourage investment in early-stage companies, program rules can define early-stage companies in different ways, making it difficult for evaluators to compare programs across states. For example, company age parameters – how long a company operates before it is deemed ineligible for angel funding under the program – may vary. Kansas Angel Investor Tax Credit Program requires funding to go to companies that are not older than five yearswhile in Minnesota certain companies can be up to 10 years old and still qualify under the state version of the loan.

“What was called early stage or even seed or pre-seed in one state was completely different than what those terms called in another state,” Harpel said, referring to the more than 200 enterprise-related state programs she is a part of checked your company’s 2021 report. Early-stage business, she explained, “means something very specific in terms of venture capital, [but] it means nothing in particular politically.”

Why this matters: If lawmakers want to ensure that a program encourages investment in specific types of businesses, they should clearly define the eligible types so that the program can achieve its stated goal. Additionally, when assessing the impact of early-stage funding incentives, evaluators should examine the Enabling Act to determine whether specific investments believed to be encouraged by the provisions reflect the legislature’s objectives.

2. Providing investors with incentives does not guarantee quality investment decisions.

Unlike loans, grants, and small business job creation incentives, investor tax credits do not provide direct incentives for new businesses, but rather for individuals or companies making the investment. This means that policymakers intend to use the loans to encourage investments that might not otherwise be made. However, there is evidence that these programs may unintentionally lead to lower quality investment decisions, e.g. B. to projects that may not find support on their own and are more likely to fail than those that do not require investment incentives. There is no guarantee that these companies will achieve the returns that states want to encourage with such programs.

Brienzo named a possible problem. “The literature in our review supports this [investors] tend not to be professional angels. … [The investors who claim this incentive] tend to have lower screening ability,” he said, which can lead to investments that could simply “help lower-quality companies survive a little longer.”

Harpel’s work reflects a similar concern. “The good thing about angel investing is that you have experienced investors helping growing businesses,” she warned, though inexperienced investors can also qualify for the loan.

Why this matters: If policymakers want to support companies with high growth potential that are making positive economic impacts, 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 benefit young companies more directly, may better serve a state’s economic development goals. Literature reviews, which include academic studies and assessments of similar programs, can help provide the evidence that policymakers need to inform their decisions.

3. Some angels may invest independently of any incentive.

Many states allow owners, family members, or affiliated companies associated with the beneficiary company to obtain credit under their angel investment programs. For example, the Maine Office of Program Evaluation and Government Accountability found last year that two companies in the state were wholly invested by their founders. Investors were granted nearly $1.4 million in tax credits under the Maine seed capital tax credit and “no outside investment was sought.”

Harpel’s research shows that this is not uncommon. “Tax credits often go to entrepreneurs’ insiders, friends and family,” she said, raising questions about whether some of the surge in early-stage investment would have happened without government support. This problem is known as the “but for” factor.

Why this matters: Assessing the extent to which tax incentive programs affect business decisions is an important factor in determining the impact of the programs. Although states employ a variety of strategies to help key decision-makers understand this “but-for” factor, common sense assumptions can often be just as instructive: Policy-makers can easily conclude that an angel investment program is unlikely to create new ones will stimulate investment when it does Angels are closely associated with the companies they support because they would likely have provided financial support regardless. Evaluators can identify these cases through case studies, company surveys, and reviews of program bylaws.

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

New startups have many priorities besides attracting capital investment. Executives may value partnership and networking opportunities with local businesses, regulatory compliance assistance, and help in developing a marketing or hiring strategy more than an inflow of investment. “Most entrepreneurs don’t think about state and local government policies, programs, or even the environment…when they start their businesses,” Harpel said. “They focus on their business mission and their customers.”

Why this matters: Countries with angel investment programs should consider whether corporate investment is the primary need for new and emerging businesses, or whether other resources—such as human resource development, regulatory and compliance support, or corporate training programs—may be more valuable to target 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 governments improve program design and management to achieve desired impacts. This could mean determining whether funds are going to the intended industries, locations, companies or individuals, or whether certain target beneficiaries are receiving an outsized benefit at the expense of others. Brienzo pointed out that his office “couldn’t help but observe the lack of [equitable distribution] in investment” statewide. Johnson County, Kansas, for example, is one of the wealthiest in the state. “It received by far the most investment” and had “outsized benefits at the expense of rural areas and some other urban districts,” he said.

Harpel highlighted strategies that can help encourage the use of incentives to the benefit of a wide range of companies. “There is a lot that can be done in terms of raising awareness, promoting and expanding our economic development network[s] making sure people are familiar with the program… and redesigning some of the existing procedures and application forms. … That alone could make a big difference in terms of justice.”

Why this matters: Policymakers create incentive programs to encourage a wide range of outcomes. One way evaluators can determine whether such programs are well designed is by analyzing who benefits from them. This can also identify the downside – who is not Benefits that can be just as important – and alert to potential policy reforms or changes in the way programs are managed.

Early-stage investment tax credits are a common economic development tool, but implementing them successfully can be challenging. The increasing availability of program analysis will greatly benefit policy makers in deciding whether to create, modify or terminate these programmes.

Shane Benz explores tax incentives with The Pew Charitable Trusts’ State Tax Health Project.

Leave a Comment