As you know, at VentureSouth we are fans of the South Carolina angel investor tax credit. Over the course of 2020, we have learned more about the credit, its renewal, its use, and its impact, and so we wanted to share some of these learnings through a few additional posts.
Why now?
Late in each year, we like to remind anyone that owns a South Carolina angel investor tax credit that the “transfer window” is now open at its widest. This is because buyers can use the purchased credit on their tax returns for the year in which they purchased the credit – so the buyer could use a credit purchased today (November 2020) on her 2020 tax return, which will be filed in the next few months, and is a quicker payoff than for purchases made in January.
So, if you have any credits for sale, now’s the time! But the window is closing soon.
OK, pitch over. To start this series, here are some questions from a skeptic!
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1) The angel investor tax credit renewal process.
Back in June, we celebrated when the credit was extended for another five years. Passage of the renewal was uncertain, right up until it was passed! Legislative process is not our area of expertise, but during the process a number of questions were posed about the credit and its impact, and so we thought it would be interesting to record those questions, and our responses, here. (All are edited slightly for clarity.)
1 – Some of the lobbying material says the credit needs reauthorization or the companies may not survive. Who are “these companies” specifically?
The Secretary of State provides a listing of Qualified Businesses. Many early stage companies are structured to require outside private capital, sometimes over several rounds, before they reach a sustainable cash flow position. This is precarious position even before the revenue shortfalls many companies are facing from the pandemic. We can only attest to the companies VentureSouth supports directly, but there are several SC-based companies in our portfolio that would likely not survive without additional angel investment.
2 – Of the total amount invested that qualified for the tax credit since 2013, what percentage was invested in companies that have not survived?
At VentureSouth, we do not know the outcomes for all the approved companies or companies that received investment that received a credit, because we are only involved in a fraction and there is not currently a mechanism to capture that data. We would expect a non-trivial failure rate, as startups are inherently risky and over half are expected to fail. The angel investment incentive gives more of them a better chance to survive the “valley of death” before they have sustainable cash flow.
3 – Compared to the total amount invested that qualified for the tax credit, how many angel investor dollars were invested that did NOT qualify or did not even apply for the tax credit?
There is no current mechanism to capture that data, so we do not have a way to report that broadly. We can however report that roughly one third of VentureSouth investments in South Carolina since 2013 have been in companies that qualified for the credit.
4 – What evidence is there that angel investments would happen anyway without this tax credit? Angel investors drop millions into new, innovative, risky startups in exchange for ownership and in hopes of scoring an outrageous profit—not a tax credit.
While it is true that angels invest in risky startups in exchange for equity in hopes of significant returns, the track record of those “outrageous profits” is limited in South Carolina (unlike venture hotbeds elsewhere). This makes it more difficult to get outside angels who use the “outrageous profits” target to invest here.
However, not all angels invest under that thesis. Angels that invest outside of venture hotbeds, including VentureSouth members, are generally not aiming at the “life-changing” results. Those are nice, but actually strong returns are possible just from build a diversified portfolio of companies that go fairly well. In that investment scenario, the tax credit provides a meaningful marginal incentive to invest.
Whatever the investment strategy, young companies that grow fast create nearly all net job growth – so we need that risk capital available from individual investors to give those companies a chance to survive and ultimately thrive.
While many startups will ultimately fail, the potential for strong returns helps investors to take the risk – and the angel tax credit mitigates the risk. As for data, a survey of angel investors in South Carolina found that 84% indicated the angel tax credit was a significant or deciding factor in their investment decision and on average, investors indicated they invested 2 3x as much in companies eligible for the credit vs companies not eligible for the credit.
5 – If this tax credit does indeed work as well as you say and is so necessary in revitalizing our economy, why the $5m cap? Shouldn’t we in that case double down and remove the cap?
We would agree that the cap should be raised based on the evidence of effectiveness to date, but for now we simply want to make sure the bill is extended.
6 – Per the fiscal impact statement, the bill doesn’t directly benefit startups. It benefits investors who invest, not startups which receive investment.
The fiscal impact statement considers the “cost” to the budget, but ignores all of the benefits of the credit.
The credit itself is for the investors taking the risk of investment, and so yes they benefit from a tax credit initially. Some of that benefit is “recaptured” (i.e. surrendered by the investor) if the investment produces a significant positive return.
The benefit of the credit, though, is much wider than just to the investor. First the startups most certainly benefit from the capital provided by the investors, as they would otherwise not have the funding needed to sustain or grow their business. Second, the people employed by the jobs created and sustained by the recipient companies benefit; the accompanying payroll taxes and downstream sales taxes generated by those salaries benefit the local economy (and the tax base) in many ways.
7 – Tech entrepreneurs are frequently encouraged to take as little angel investor money as they can and to put it off as long as they can to avoid diluting their ownership, so I’m skeptical that they will turn to angel investors rather than banks or government when they need capital due to the economic situation.
Certainly entrepreneurs attempt to raise as little dilutive capital as is needed to make their company successful. However, banks do not lend to startups – especially technology driven ones with little in the way of tangible assets – because there are no consistent cash flows or collateral. And especially they cannot lend to founders who do not have personal collateral to support personal guarantees. Government grant programs for most startups are very limited and not applicable for most companies.
Angel investors therefore fill a very significant gap in the “valley of death” for entrepreneurs. No-one forces entrepreneurs to take angel funding, but VentureSouth sees a constant stream of entrepreneurs seeking angel investment. In a market like South Carolina with limited venture capital, those entrepreneurs have very limited access to forms of risk capital to help them get started and grow.