Sanjay Parekh — Posts by Sanjay Parekh on business, technology, policy, and other miscellaneous subjects.

Georgia HB 1069, Part 2

June 21, 2010

My last post on HB 1069 has elicited a bunch of comments (more were sent privately than publicly on my post), a post over on TechDrawl, and news through the grapevine that people were either agreeing with what I wrote or very upset by what I wrote. To address all of that, this follow up post is even longer than I originally intended.

Some Clarifications

First, let me clarify some things. I have no issue with the work and efforts that folks put into passing HB 1069. In fact, I applaud it. For way too long we (and by we, I mean those involved with startups as a whole – entrepreneurs, investors, and others) have been disconnected from the legislative process. Even if this particular bill isn’t what I/you/we wanted, at least it’s a start. That’s a good thing and I hope bodes well for more efforts like this in the future.

I also recognize that the bill to take away the low income tax credit and implement the angel tax credit were originally separate issues. They were and they should have been when the bill passed. As I’ve said to some of you privately, I know that the proponents of the angel tax credit were likely not in favor of taking away a tax credit from the poor. If there are any folks like that, they’re pretty mean spirited and not worthy of debate within this context. I have heard that these two bills were merged in order to “save” the angel tax credit – and I totally get that. But the fact is that with these two bills shoved together, the news will report that one is saving the state $21 million while the other is costing $10 million. I think that’s harmful to what we’re trying to do – this isn’t just about passing legislation but it’s also a PR campaign of sorts if we’re going to be successful in getting additional legislation passed in the future.

Finally, it appears that my calculations around the 6.48 times required return on investment may have caused some confusion. This is the rate of return required for the state of Georgia to be made whole on their tax credit to angels. Angels need a much lower rate of return to be made whole – in fact, a negative return could make them whole given the tax credit. If an angel’s investment lost up to 35% of the initial investment, the angel would still be whole or better given this tax credit. I’m not sure if the tax credit adjusts the basis of the investment for federal purposes, but if not this scenario could open up a can of worms for potential tax fraud (this topic is best suited for another day or another blog post).

The Comments

The comments on the past post were pretty interesting. Issues such as passing flawed legislation and correcting it later to the Hope Scholarship to not calculating the NPV of the credit. These are all issues I’m going to punt on because it’s my blog and my prerogative.

That said, keep the insightful comments coming. They definitely help me shape and think through the issues that may or may not be relevant. Just don’t be surprised if I don’t address all the issues raised. There just isn’t enough time in the day!

The Need – It’s Not Angel Financing

Perhaps the biggest issue I have with the angel tax credit is not who is paying for it (we are all paying for it even though it seems like the poor were hit directly) or the rate of return needed to make the state whole (I ignored many issues on generating tax receipts although directionally, I think the number shows that this is a hand out not a hand up). No, my biggest issue is that this isn’t going to fix anything. That’s right, I don’t think this fixes the funding climate or root causes that we have in Georgia for startups.

Honestly, there are plenty of angels in Georgia – that is, if you have a fundable startup. Many startups that look for funding and complain about the lack of funding are frankly, unfundable. They are generally missing a critical business component and are reluctant to fix this for whatever reason. The team is wrong, the market is wrong, or the product is wrong. Or more often than not, more than one of these is wrong.

Angels are in the business to invest and win big on risky ventures. But angels also understand risk mitigation and if an entrepreneur is unable, or unwilling, to execute some steps to mitigate this risk both for themselves and the potential angel, what does that say?

The other side of the coin that angels are acutely aware of is the lack of follow on financing after they fund startups initially. This lack of financing (local or otherwise) increases the risk that angels face when making an investment. Instead of being able to know that if a startup is successful there will be investors coming in after them, angels must consider what to do with even the most successful startups. And given that the game of angels (and VCs honestly) is risk mitigation through diversified investments, doubling down on a startup isn’t always the best approach as an investor.

So this all leads to my point. The need in Georgia isn’t more angel investing. It’s more post-angel/VC-level funding. If you think of how many VC funds we have in Georgia, you can probably count them on one hand. You’ll need two hands if you include the bio-tech focused funds. That’s not a lot of investors for a city the size of Atlanta.

Granted the $10 million per year being spent on the angel tax credit isn’t that large but over the three year period, this amounts to more than what the Georgia Firefighters’ Pension Fund will invest in all private equity (not just venture capital) now that they’re allowed to do these investments. The GFPF amounts to about $500m in total assets and they can invest at most 5% ($25m) in private equity. Oh yeah, any fund they invest in has to have $100m in assets before they invest their money. So don’t look at the passage of HB 249 as something that will change the local funding landscape. That said, I’m happy that Georgia firefighters now have the ability to diversify their pension fund and increase their overall returns. We should (and I will) support any venture fund they invest in so as to show other funds (pension or not) what a mistake they’ve been making by not investing in private equity.

Back to the topic at hand. If we took this $10m in tax credits and instead had the state of Georgia become an LP in new Georgia based venture funds, imagine what an impact that could make. Perhaps 1-3 new venture funds each year created in Georgia over a 3 year life cycle (this assumes that the state isn’t the only LP in these funds since I think that would be a huge mistake). These funds would be motivated to find and fund some great startups so as to show positive returns and then raise a second fund a few years later. Local angels would want to fund startups that these venture funds could then take and provide further funding to. That is something I could get behind in terms of impact and change to the local landscape.

Finding the Money

The other issue I’ve had since the beginning was where the money came from to pay for this tax credit. I’ve already said I know that the cut of the tax credit for the poor and this angel tax credit were originally different issues. But why not just get the rich to pay for this tax credit in the first place? Let’s look at the numbers.

According to this chart (which may be inaccurate but is probably right in terms of size) there are 155,537 households in Georgia that make $200,000 or more annually. This number is important because that is the line that defines an accredited angel investor – presumably only these people will be taking advantage of the angel tax credit in the first place.

As a side note, this chart shows there are 587,435 households who earn less than $20,000/year. These are the folks that just lost their tax credit as a part of HB 1069. 587,435 poor households lost a tax credit so that 155,537 rich household could get a tax credit. I’ll quit harping on this issue, I promise.

So if these 155,537 households could potentially gain from this tax credit, why not tax them some small amount so as to fund the tax credit. Raising $10m from these households would take at most an increase in their tax rate of 0.021% and realistically it would be much less. So their top tax rate in Georgia would go from 6% to maybe 6.021%.

Yes, that seems like you’re just taking money from people to just give it back to them later. But honestly there aren’t 155k+ angels in Georgia – if there are, Startup Lounge and Startup Riot need bigger venues.

So most of these households aren’t involved in investing for the future of the state. In fact, a number of people have told me they would be shocked if we hit the full $10m tax credit in any of the three years that the angel tax credit law applies. But these folks are prospering and are an asset that we should tap. How do we do that? Create a situation where they are penalized for not being involved but rewarded if they are. Most entrepreneurs realize that an angel’s money is only one part of the equation – their expertise is often invaluable.

The angels that are actively involved would get the benefit for leveraging their money and expertise in helping to improve and propel the state forward. Still can’t stand having a tax applied to the rich and not letting them get any benefit for it? Fine, let’s give them a tax credit for investing into Georgia based venture funds as limited partners – that would start moving us in the right direction of freeing up additional capital for funding startups.

Conclusion

Okay, so that’s what I could get behind. An approach that incents the behavior we need (more people with money and expertise involved) as well as building up resources (venture capital) that are much more needed than just more angel investing.

Again, I’m happy to take comments, criticisms, or observations on any and all of this. I prefer you comment publicly so your insights can be debated (as mine will be, I’m sure – especially the thought that these ramblings are indeed “insights”) but if you must, you can reach out to me via phone, email, twitter, or in person and share your agreement or disagreement with anything I’ve written. I won’t publish anything you tell me unless you specifically tell me that I can share your name.

One last note, the extremely awesome (I live here – so plug!) Gwinnett Chamber of Commerce is holding an event this Friday to discuss the angel tax credit. Even though I disagree with a good bit of this bill, if it can be used to improve startups in Georgia, we’ll have a case study that we can use to get legislators to pass additional bills that can help out our community and the state as a whole. Unfortunately I won’t be able to go but if you do, take good notes and let me know what I missed!

Thanks for participating in this exercise and hopefully by doing so we can improve our state (and our nation) in the long run!

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The Problem With Georgia HB 1069

June 15, 2010

In case you didn’t notice, Georgia HB 1069 passed and was signed into law last week. A lot of people were happy with this but I had more of a blasé feeling about it. There are a few reasons for this and I thought this would make the perfect kick off for starting to write about public policy.

My Bias

First I want to make sure I make my own bias clear. I’m an entrepreneur. I’ve launched one company that was later acquired and I’m also an angel investor both individually and through Shotput Ventures.

From both of those standpoints I should be a proponent for the angel tax credit. More money into startups would mean an easier time for me as an entrepreneur and a tax credit means my risk exposure is reduced as an angel.

That said, I’ve never let my own economic desires stand in the way of what I thought was right. Also please recognize that nothing I say in this post (or really, ever) is sanctioned or endorsed by any place that I am affiliated with. In fact, most organizations should disavow anything and everything I say. At least, I would if I were them. Comes with the territory I suppose.

Startups Subsidized by the Poor

My first issue with HB 1069 is how the angel tax credit is (apparently?) paid for. Along with the angel tax credit, the bill also creates a tax credit for buying more energy efficient products. Personally, I think this is a great thing. The less energy we use means the less energy we have to import and the less we pollute our environment. No complaints so far especially since this tax credit is paid for by federal funding.

But the bill also removes a tax credit for low income individuals. Granted the amount per citizen is low (maximum of $52 per year), this removal saves the state $21 million per year which is then partially used to pay for the angel tax credit which will cost $10 million per year. Where does the other $11 million go? Good question – I have no idea.

Now, I’m all for increasing angel investments in Georgia. But personally I don’t want that to come on the backs of the most needy citizens in our state. Some have argued with me that by increasing angel investments in Georgia will mean for a better economy and these individuals will benefit. Sure, that may be true in the long run but how are these folks going to pay for their needs today?

Comparison to Other States

There was a common comparison made during the discussion of this bill that twenty-one other states had enacted angel investment tax credit legislation. First let me point out the obvious that 21 out of 50 states is not a majority. But that’s okay, there are more issues with this argument.

Looking at the Angel Capital Association’s list of states with an angel tax credit, you’ll see that half of the twenty-one states (Minnesota has a tax credit both above and below Georgia’s tax credit amount so they count twice), have tax credits at a rate less than what was just passed in Georgia. Also notable is that Hawai’i has a tax credit of 100%. That’s some good living there, beaches and a 100% tax credit. But I digress..

The most interesting thing about this list though is not the amount being given by each of the states. What I find most interesting are the states not on the list. Any idea what the tax credit rate is in California? That would be none. What about Massachusetts? Again, none. Okay, well there has to be one in Washington, right? Nope, no tax credit there either.

Three states that are among the most prolific in creating and funding startups have no need to have an angel tax credit. So are we focused on the wrong thing here? Perhaps. Let’s take a look at the numbers.

The Financial Breakdown

The financial aspect of HB 1069 is perhaps the part that I find most disturbing. Let’s get into the nitty gritty.

First, the bill provides for an aggregate allotment of $10 million annual tax credit for investments made in 2011, 2012, and 2013. That means $30 million in tax credits. From an angel perspective there is one painful wrinkle here. For investments made in each of these years, the credits cannot be claimed until two tax years later (so investments in 2011 can be claimed in the tax return for 2013 but really that means the 2014 calendar year). This was a smart move by the state of Georgia because the tax credits are deferred up to three years into the future.

The bill gives an individual angel a 35% tax credit of no more than $50,000 total in a single tax year. So that means we would need at least 200 angels each year investing $142,857 to fully use up the credit. Obviously if more angels take the credit, there would need to be a lower average amount invested. To use the entire $10 million tax credit then would require an annual angel investment of about $28.57 million each year.

For each angel investor that takes this tax credit, their tax basis for their stock is reduced by the amount of their tax credit. This makes perfect sense. If you take a tax credit of $50,000 that means your cost basis for your stock goes down by $50,000 so that the state can receive tax revenue when you successfully sell your shares in the startup. Herein lies the problem.

Doing the math on the $10 million credit implies that $28,571,428.57 worth of angel investments were made. These investments then have a cost basis of $18,571,428.57. Assuming a top Georgia tax rate of 6% (this is the optimistic view, by the way), means that to recoup the initial $10 million tax credit would require these investments to gain $166,666,666 in value. Or said another way, these investments would need to, on average, return 6.48 times their original investment amount.

Sure, 6.48 times an investment may not sound too difficult but the Kauffman Foundation reports that experienced angel groups achieve returns, on average, in 3.5 years and receive 2.6 times their investment. So the state of Georgia needs angel investors getting the tax credit to achieve almost 2.5 times the returns experienced on average by other investors. We may think people in Georgia are smarter than average but they aren’t that much smarter than average.

Note: I do recognize that I’m not taking into account any effects of income taxes, etc. into this break-even analysis but I did use an optimistic view when I could.

What this means is that the angel tax credit is a big tax subsidy. There is little to no chance that we’ll recoup our initial investment. So to me, the angel tax credit is akin to welfare. Do individuals who are doing angel investing need to be on welfare?

In Closing

I know I haven’t provided my solution to this issue quite yet. This post is quite long and so I thought I’d leave that for next time. In the mean time I’d love to hear from you why you do or don’t like this bill (or this blog post) and what, if anything, you would change (in this post or in the bill).

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CNN Covers Entrepreneurship at UGA

June 1, 2010

I love the fact that CNN continues to cover entrepreneurship in Georgia (they covered Startup Riot earlier this year). That said, I really have to question the mentality and approach of the winning entrepreneurs for refusing the $50k prize money they were awarded. Not only did they refuse money for themselves, but they prevented another worthy entrepreneur from winning and getting the money. Personally, I’d be pretty upset if I was in the competition and came in as a runner-up.

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Emory Magazine did a half-page writeup on Startup Riot this year. You can grab the PDF issue here and flip over to page 11 (it’s page 13 of the PDF though). UPDATE: the article has been posted here as well. #

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Stephen Blank has a great post on why business plan competitions are a huge waste of time. As an entrepreneur, I’ve found business plans to be of little value. So who is going to be first to run a business model competition? #

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