Most governments are eager to nurture promising startups with lots of growth potential. Such startups can generate new jobs, spur innovation and new patenting, and, in the best of cases, bolster an entire local economy.
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It’s no surprise, then, that local politicians are often willing to offer up financial support. For instance, some cities and states have extended loans and grants to the startups they deem most promising. Yet this strategy requires that governments choose the right startups, which is a difficult task even for experienced investors, let alone for government agencies.
Partially for that reason, another approach to propping up startups has gained popularity in the U.S.: tax credits that go not to startups themselves, but to the individuals who invest in them during their very early stages. Investors who take stakes in startups during this early stage are commonly known as angel investors, and tax credits for angel investors are meant to encourage them to open their wallets.
“This program is very simple for governments to run and implement, because it does not require the government to select winners, but instead the market essentially allocates the money,” explains Filippo Mezzanotti, an associate professor of finance at the Kellogg School.
But do tax credits for angel investors actually produce the kind of broader economic boom that politicians expect?
Mezzanotti examined the real economic impacts of angel-investor tax credits in collaboration with Matthew Denes, an assistant professor of finance at Carnegie Mellon University, Sabrina Howell, an assistant professor of finance at New York University, Xinxin Wang, an assistant professor of finance at the University of California at Los Angeles (UCLA), and Ting Xu, an assistant professor of business administration at the University of Virginia.
The researchers’ findings cast some doubts about the success of these programs—at least according to the broader economic goals touted by political leaders.
Although the angel-investor tax credit did indeed induce more investment by angel investors, the researchers found no associated benefits to the economy. Their analysis finds that the credits do next to nothing to increase employment, the number of startups in a given region, or innovation.
What explains this paradox? The researchers think it may be due to the type of investors that are taking advantage of the tax credits. In particular, they discovered that less experienced angels were much more likely to take advantage of the credit than more experienced professional angel investors. Through a survey of investors, the researchers try to shed light on why this latter group was not especially interested in the credits: these individuals are looking for “home runs”—that is, the types of investment returns that an early investor in Google or Facebook would have seen—rather than slightly reduced tax bills.
Building a Database of Angel Activity
The question of whether angel-investor tax credits actually produce the intended results is an important one, given that governments have dedicated enormous amounts of money to them.
In the U.S., angel investors received $8.1 billion in credits from the 31 states that introduced them between 1988 and 2018. And that total fails to capture the global spread of the idea. Other countries that offer angel tax credits include Canada, England, France, Germany, Ireland, Portugal, Spain, Sweden, China, Japan, Brazil, and Australia.
Yet the phenomenon is not well understood, in part because angel investing isn’t easily tracked. “When you’re thinking about very early stage investment, there’s a generalized lack of standardized data,” Mezzanotti says, with no comprehensive dataset capturing who is investing, which startups are receiving funding, or the value of deals being made.
“When we talk about angels, we’re talking about a very heterogeneous group of people.”
— Filippo Mezzanotti
So he and his collaborators pulled together data on angel activity from startup databases Crunchbase, VentureXpert, VentureSource, and AngelList, as well as from filings with the Securities and Exchange Commission. Combining these investment data with the public information on the identities of investors involved with the tax-credit programs, the researchers created an unprecedentedly detailed database on angel investment.
“What we tried to do is create the most comprehensive dataset available,” Mezzanotti says.
They then compared this new dataset with the information on the introductions and terminations of angel tax-credit programs across 31 states between 1988 and 2018. The researchers found that the tax incentives did indeed drive up angel activity by about 18 percent on average. The credits also boosted the number of individual angel investors by approximately 27 percent.
But did that jump in overall angel investment translate into broader economic benefit? To find out, they next took a close look at state-wide economic outcomes, including employment across industries, young firms’ entry and exit and job-creation rates, the number of small businesses established in manufacturing and high-tech industries, the number of successful exits through IPO or acquisition, and patent activity.
Across all of these outcomes, the impact of the tax-incentive policy was negligible.
“We couldn’t find any evidence that these programs significantly impacted the local economy,” Mezzanotti says. “We wondered: ‘What could explain this?’”
Two Classes of Angels, Two Very Different Investment Patterns
Answering that question required the researchers to dive into the thinking and behavior of angel investors themselves.
“When we talk about angels, we’re talking about a very heterogeneous group of people,” Mezzanotti says. “There’s one group of people who do a deal or two in their lifetime, and then there is the smaller but very active group of people whom we call ‘professional.’ They have a lot of experience; they’re very good at figuring out where to collect information and screening companies.”
By also using the state-provided data on recipients of the angel tax incentive, the researchers found that the boost in angel activity following the introduction of a program was largely driven by a surge of investment from less-experienced, in-state, younger investors—with little uptake by professional angels, who were more likely to be older, more experienced, and from another state. If anything, professional angels appeared to be largely unresponsive.
This fact, combined with the lack of overall economic impact the researchers found, suggested two potential stories.
It was possible that less-experienced investors just aren’t as good at funneling their money into startups primed to eventually make a big economic splash.
Alternatively, or additionally, Mezzanotti says, maybe the tax incentives led people to relabel investment that was already happening—for instance, in one’s own business. That is, many so-called “angels” may have in fact been self-financing entrepreneurs, who simply began taking advantage of the tax credit once it was made available.
Lending credence to this possibility: the researchers found that 35 percent of companies receiving funding under the angel tax credit had at least one investor who was a company executive or a family member of an executive—dwarfing the typical 8 percent of angel-backed firms nationwide, according to AngelList.
A Survey of the Angels Investors Themselves
Another unanswered question was nagging at the researchers: the more experienced group of angel investors didn’t appear to be taking advantage of the credit. In other words, they seemed to be leaving money on the table. Why?
“We felt that there was pretty much no observational data we could collect that could answer that,” Mezzanotti says. “So the most natural thing to do was ask.”
He and his collaborators decided to conduct a survey of investors. They asked about the factors that weigh most heavily in their investment decision-making, the reasons angel tax credits are or are not important to that process, and their history of taking advantage of the credits.
Out of nearly 1,500 survey respondents, only 7 percent of them said that tax credits are very important when deciding to invest, consistent with the previous findings. Furthermore, over half rated the tax credit not at all important in their investment decision-making. This number increased to 71 percent among the most experienced investors. Indeed, many of the more experienced respondents told the researchers that they didn’t even register the presence of a tax credit because it presented too incremental of a gain; they were out to hit a home run.
“The way these professional investors are thinking is, ‘I’m trying to select the next Google,’” Mezzanotti explains. “‘And If I’m trying to select the next Google, it will be the next Google whether there’s a tax credit or not.’”
As a result, the presence of tax credits does not necessarily lead them to change their investment behavior. This concept is well summarized by one of the respondents to the survey, who said: “If I believe in the business model, then a tax credit is largely irrelevant. Conversely, if I do not believe in the model then the tax credit is also irrelevant.”
They also note that the credits come with headaches like paperwork and other transaction costs that could render them not quite worth the savings.
Shifting Support to Startups
One of the central selling points for the angel-investor tax-credit program is that public officials can shift the responsibility of vetting and selecting startups to private investors. However, Mezzanotti concludes that this may also be one of its weaknesses.
“You don’t end up attracting the investors you’re planning to attract,” he explains, but rather a less experienced group that may be more concerned with minimizing losses and harvesting the tax benefit.
If policymakers’ goal in instituting the tax credits is stimulating the creation of new jobs, high-growth businesses, and industries in their regions, Mezzanotti argues, then the policy may benefit from having more requirements regarding the type of investor that can seek the tax credit. For instance, the policy could be designed to target only professional investors, with a solid knowledge of investing in early stage companies. This is similar to what Israel did in the 1990s with a program that provided tax incentives to venture-capital firms with proven experience in investing in tech companies.
Alternatively, policymakers could also focus on using the public funds to increase the local supply of high-quality startups. For example, Mezzanotti points to research suggesting that a high-quality university can help to build a local supply of innovators, without requiring the government to try to pick “winners” directly. Other research indicates that R&D tax credits given to large, traditional companies appear to have spillover effects that can lead to the creation of related startups, too.
“In my personal opinion, trying to figure out how to increase the supply of high-quality startups could be more effective than providing incentives to investors,” says Mezzanotti. “Without the promising companies, the angel tax credit may simply result in a transfer from the state to the investor, and you’re not necessarily getting anything back.”
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