Justin Field

by & filed under NVCA Blog, Tax Reform, Venture Investment.

At NVCA we are committed to helping policymakers craft pro-growth policies that help startups continue to drive the U.S. economy and encourage job creation.  So when we see articles that fail to understand how innovation and entrepreneurship work, it is our responsibility to correct the record.  This recent article in Politico makes just this mistake and threatens to undermine public support for an important provision of the tax code that encourages investment in early stage startups.

Let us start with a couple of facts that we should all keep in mind.  Twenty-five years ago, more than 90 percent of global venture capital was invested in U.S. entrepreneurs.  Last year, U.S. startups attracted 54 percent of global venture capital investment as other countries continue to reform their policies to build their ecosystems and compete with our long-held leadership in the space.  In addition, smaller C corporations have been vanishing.  As a result, the total number of U.S. public companies have been reduced by half in only 20 years.

There’s a reason why innovative entrepreneurship has become a global competition.  New businesses are the engine of job creation in the United States, creating an average of about 3 million new jobs each year and accounting for virtually all net new job creation, according to data from the U.S. Department of Labor and the U.S. Census Bureau.  According to a Stanford study on U.S. public companies, those that were venture-backed account for 85 percent of total research & development spending.  Qualified Small Business Stock (QSBS) encourages investment into the companies which produce this high level of innovation and economic growth. Given these facts, it’s easy to see why new company formation is the best answer to the bipartisan goals of raising our economic growth and job creation rates.

None of these important facts that support the value of startup activity to our economy were included in the piece.

By focusing only on the investor side of successful startup investing, the author misses the point that the goal of QSBS is to encourage more investment into early stage startups, fueling more companies to grow and scale.  And as noted in the article, investing in startups that are eligible for QSBS is a highly risky activity, where one success has to balance out multiple failures in order for the economics to work.  Unfortunately, you don’t know which entrepreneur will make it or not.  QSBS simply lowers that hurdle rate for the successful investment to be worth the risk of investing in the entrepreneurial ecosystem.

The Politico article states that QSBS is really for Silicon Valley startups and the investors who finance them.  The reality is that QSBS is more important to entrepreneurial ecosystems outside of Silicon Valley.  Smaller and regional venture capital funds tend to have more problems fundraising and are more dependent on taxable investors to raise capital.  Big VC funds can raise capital from the large institutional investors (pension plans, foundations etc.) for which this provision does nothing, but smaller ones have more difficulty doing that.  We need more venture capital investment in this country, particularly in non-coastal states, and QSBS, now that it’s permanent, will be one of the best policies for encouraging these VC funds to form and vital capital to reach underserved regions.

Many would agree with the Politico article’s characterization that historically QSBS has had challenges, but that’s because despite what it looked like on paper, for most of its existence QSBS actually provided virtually no benefit.  That started to change in 2010 when significant improvements were made in the Small Business Jobs Act.  QSBS still had structural challenges though because the improvements were extended annually while investors have to hold the startup stock for at least five years.  In December of 2015, lawmakers wisely made these improvements permanent, thus providing certainty that investors need to make long-term decisions.  We would encourage policymakers to continue their good work and modernize the documentation and eligibility requirements, something NVCA is interested in working with lawmakers to fix.

The article states that QSBS is not about small business, but there’s a strict asset test of $50 million dollars, which hasn’t changed in 24 years and is not indexed to inflation.  So by definition, at the time of investment the company is still quite small relative to the average C corporation.  If it grows past the threshold in subsequent years, that’s good for the country because it provides more jobs, capital spending and opportunities to produce the innovations that improve our lives.  This is the intent of the provision, and something that should be celebrated, not condemned.

QSBS may not be explicitly for all small businesses such as bars and law firms, but as noted above startups are the source of almost all net new jobs in the U.S. economy in the last forty years.  The U.S. entrepreneurial ecosystem has been a key differentiator between the U.S. and Europe or Asia that has allowed our economy to be much more resilient in the face of difficult times.  In short, there are many powerful reasons to seek to encourage investment in startups.

The article also questions whether QSBS has any impact on an investor’s decision-making, but that flies in the face of nearly every economists view of how tax policy affects the economy.  If we want less of something such as tobacco use, we put a tax on it or increase taxes on it.  If we want to encourage something, such as work or investment, we decrease the taxes on it.  Now that QSBS is finally making a real impact (for 18 years it had essentially no value), it’s difficult to believe that in this one instance, the basic rules of tax economics suddenly cease to work.

Investing in entrepreneurship comes with extraordinary risk and investors in the sector lose money on these investments far more often than they have gains. In fact, it’s so risky that federal policy has discouraged anybody but large institutions and wealthy investors from investing in startups.  So, once Congress decided to encourage capital to fund startups, it should be no surprise that the majority of the benefits flow to wealthy investors.  In fact, we should celebrate the concept of Americans doing well when they create real value for the economy by making high-risk investments for long periods of time into building the next generation of American companies, and that is just the intent of QSBS.