19 Feb Will economy, tax hikes dry up venture capital?
Madison, Wis. – By venture capital standards, 2007 was a good year to be an entrepreneur, but with economic storm clouds on the horizon, how long can the good times last?
WTN Media put that question to Wisconsin investors following the release of the annual PricewaterhouseCoopers and National Venture Capital Association’s venture capital report. They have reported that U.S. venture capitalists poured $29.4 billion into 3,813 deals in 2007, the highest annual investment since nearly $110 billion in 2000 and a 10.8 percent total dollar increase over 2006.
While they project another active year in 2008, what impact will the flat economy, having slowed to 0.6 percent growth in the fourth quarter of 2007, have on venture capital deployment in 2008? Moreover, what about the impact of higher marginal tax rates on the wealthiest members of the investment class if either Hillary Clinton or Barack Obama is elected president?
Those two factors should not have much of an impact on venture capital fund-raising and deployment, according to John Neis, founder and managing director of Venture Investors, but Charlie Goff, general partner of the Appleton-based NEW Capital Fund, believes tax law changes would have a negative impact.
There is, however, plenty of opportunity for ill-conceived legislation to impact venture capital deployment, they added.
Thus far, the conventional economic wisdom suggests a slowing of the economy in the first six months of 2008, followed by moderate growth in the final two quarters. If a prolonged recession develops, all bets are off, but Neis said a brief economic slowdown that occurs in a single calendar year isn’t likely to impact capital formation.
He noted that venture capitalists typically raise money for a 10-year fund, and they select companies to invest in over a five-year period, so a short-term blip isn’t going to make much of a dent. Venture Investors announced a new $115 million investment fund in 2007, and has made several commitments since.
“A change in the economic environment isn’t going to have an enormous impact overall,” he said. “Money that will be invested in 2008 was largely raised in the 2003-2007 time frame.”
A multi-year slowdown, however, could impact commitments to new funds “as it did in 2001-2004,” he added.
Goff concurred, suggesting that the markets of early-stage investment targets would provide some cushion. “I don’t see a slowdown [in venture capital] because of the perceived direction of the economy,” he said. “The markets that early-stage companies address are, in theory, so large that a small change in the economy is not going to affect their viability.”
As for the prospect of increasing the top federal income tax rate, which now stands at 35 percent, that may not have the dampening affect some people predict. Clinton has promised to return to the income tax rate for upper income Americans that was in effect during her husband’s administration – 39.6 percent – a period of robust economic growth linked to the information technology revolution. Obama has not pinpointed a particular tax rate, but has been critical of the Bush tax rate cuts, saying they have benefited those who earn more than $1 million about 160 times more than they have benefited the middle class.
In addition to rolling back the Bush tax cuts for the wealthiest Americans, both Democrats have called for greater tax relief for the middle class.
Neis does not believe raising the top rate would have a large impact on venture investment because most investment dollars come from pension funds, endowment funds, and foundations, which are tax-exempt.
Whenever policymakers change the rules of the game, Goff said capital would naturally flow to the new highest prospective area of return. “If that means going off shore or setting up funds off shore, then I would not be surprised to see that happen as a result of tax policy changes,” he said.
The real threat?
The greater threat to venture capital deployment, Neis said, is ill-considered legislation, especially at the national level. At the moment, venture capitalists are treated like other investors and receive a capital gains tax rate on any return on investment – it is not taxed as normal income – and their share of the investment gain is called carried interest.
Members of the House Ways and Means Committee have introduced a bill that, in Neis’ view, targets investors who enjoy this tax benefit. Neis said the bill would impact the venture capital industry by targeting carried interest across the board, resulting in a tax hike of as much as 130 percent on venture investors, thereby placing a damper on their job-creating activity.
Neis said that existing capital gains tax policy was developed to encourage risk-taking and investment in long-term economic growth, but the proposed change would “alter the attractiveness for people in this [venture capital] business.”
Given that increased venture dollars are going to areas where Wisconsin is strong, life sciences and medical devices, the impact of a drop in venture capital deployment could be damaging to the state. Nationally, medical devices and biotechnology set a record $9.1 billion on 862 deals in 2007, up from $7.6 billion and 786 deals the year before, according to the National Venture Capital Association.
Mark Heesen, president to the NVCA, characterized the overall increase as “extremely rational” because the industry now is investing in a mix of sectors – life sciences, information technology, and clean energy – that are more capital intensive than they have in the past.
In addition, 2007 was a year that saw 86 initial public offering exits totaling $10.3 billion and averaging $120.1 million. This includes the TomoTherapy IPO, which netted about $180 million for the Madison-based medical device manufacturer.
The contributions of venture capital to job creation in Wisconsin were measured in a recent study by Global Insight. The economic, financial, and political analysis firm looked at venture capital deployed from 1970 to 2006 and found that $1 billion was invested in 154 Wisconsin companies. Those commitments created nearly 66,000 jobs and now generate $12.5 billion in revenue.
In addition to TomoTherapy, the Wisconsin high-tech companies that have received venture capital include Promega Corp., NimbleGen Systems, which was acquired as its exit strategy after initially filing for an IPO, and the clean-tech energy producer Virent Energy Systems.
Still, Wisconsin companies attracted just $60 million of venture capital in 2006, which represents just one quarter of one percent of the $25.9 billion total invested in the United States that year.
To boost investment, Gov. Jim Doyle has proposed a series of steps under his Accelerate Wisconsin initiative. The program, which seeks to build on angel and venture tax credits established as part of Act 255, would establish a capital-gains exclusion to promote re-investment in start-up companies. It allows individuals a 100 percent capital gains exclusion of up to $10 million for long-term capital gains reinvested in qualifying Wisconsin businesses.
Accelerate Wisconsin also would expand existing tax credits, including raising the current cap of $1 million in tax-creditable investment up to $4 million, and sets of goal of $100 million in angel and venture capital tax credits available to state businesses by 2015.
In addition to providing the matching funds required for federal research grant applications, the proposal also doubles funding for current technology grants and loans, and allocates $5 million annually for seed money to start-up companies and small businesses.
Goff said incentive extension announced by Doyle clearly helps mitigate the risk for early-stage investments. He does not see that changing based upon the direction of the economy or national tax policy.
While Doyle’s proposals have received strong support in the Republican-controlled State Assembly, support has been soft in the Democrat-controlled State Senate. Neis, however, senses growing support for the governor’s proposals, and said there is no talk of scaling back the angel incentives already in place.
“Should Doyle’s changes not occur, it’s a status quo situation,” he said.
• State of the State: Doyle touts high-tech proposals
• Republicans introduce economic development package
• Wisconsin Technology Council endorses Doyle investment plan
• Accelerate Wisconsin seeks to improve early-stage, venture capital performance
• Matt Storms: New rules would expand the definition of “accredited investors”