Is It as Risky as It Seems? a Short Note on How Tax Policy Impacts Informal Venture Capital Investing

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ABSTRACT

The purpose of this study is to answer the question, "are informal venture capital investors rational?" If angel investing is rational, then it should have a competitive rate of return (adjusted for risk, liquidity, and investment efforts) compared to more passive market-based investments such as index fund investing. If these adjusted rates of return are not competitive and do not compensate for the additional costs of informal venture investing, then the nonfinancial motives must be the most important criteria driving informal venture capital investments. The following analysis illustrates how tax policy can be used to make seemingly economically irrational informal venture investments an economically rational decision.

Capitalism expands wealth primarily through creative destruction- the process by which the cashflow from obsolescent, low-return capital is invested in high-return, cutting-edge technologies (Greenspan, 2002).

INTRODUCTION

Informal venture investment has recently become a topic of great interest for entrepreneurial finance. Research by Wetzel (1983), Duxbury, Haines, and Riding (1996), Van Osnabrugge and Robinson (2000), and Mason andHarrison (2002,1993), among many others, suggests that informal venture capital (or angel investing) is becoming an increasingly important financing mechanism for small and medium-sized enterprises (SMEs). The reasons that informal venture investing has become more important are many, including the recent decline in formal venture investing, lower returns in traditional equity markets, lower returns in the traditional debt markets, and the ability in some instances for informal venture capital to overcome the capital constraints that SMEs often face (Mason & Harrison, 1995).

Currently, many investors invest through intermediaries, such as mutual funds, and feel that they have almost no control over the outcomes of their investment decisions. Needless to say, some of these investors with extensive management experience prefer an alternative investment mechanism that allow them to take a more active role. Heard and Siebert (2000) succinctly characterize the process of angel investing:

A typical angel investor is a high-net worth individual with an interest and knowledge in a particular business sector, often because that is where he or she gained personal wealth. Angels can help a startup company with their considerable experience. This can also cause considerable harm if they are naive about the needs of the business. An angel will frequently become an active advisor to the company and often take a seat on its board of directors.

Investors considering investing in the informal equity market then must answer this question: Is informal venture investing an economically rational decision, given tax effects, risk, liquidity, cost of capital, etc.? In other words, could informal venture investors do as well by simply investing in an S&P 500 index mutual fund, which would have higher liquidity and lower transactions costs?

Governments have also become keenly interested in the economic development benefits of encouraging entrepreneurship. For example, many states use tax dollars to support entrepreneurship as a tool of competitiveness, economic development, and job creation. (see the Directory of State Business Development Incentives, 2002 and Kayne, 1999.) These tax expenditures are sometimes politically justified because the benefits to the state may include: (1) enhanced tax bases; (2) income growth; and (3) growth in employment; however, one constraint to entrepreneurship is the availability of risk capital to develop, assess, and exploit entrepreneurial opportunities during the earliest stages of business creation.

INFORMAL VENTURE INVESTING: PROS AND CONS

During the bull market of the 1990's, informal venture investment did not appear to be as an attractive investment on a risk-adjusted basis as equity market alternatives, such as low-cost mutual funds indexed to the market. …