Capital Formation as the Engine of Economic Growth

Posted by | May 28, 2010

A lot of media and industry attention has been focused on one particular provision in Congress’s Financial Reform Act, which changed the taxation on “carried interest” from 15 percent (long-term capital gains tax rate) to 35 percent (ordinary income) in order to raise revenue to pay for tax credits, such as the R&D tax credit that expired at the end of 2009. Although a recent Senate amendment apparently aims to lessen the dramatic shift, this policy would essentially double the taxes for venture capitalists. While we are always suspect of new or higher taxes, there are more insidious aspects of the proposed legislation that have received less attention, but have the potential to be far more detrimental.

Another provision in this bill targets to raise the financial thresholds of “qualified investors,” which may represent a more serious threat. By some estimates, raising the threshold would eliminate two-thirds of the entrepreneurial capital provided by angel investors, effectively chasing this money out of the market. Over the past several years, angel investors have increasingly become the “go-to” source of early/seed funding as larger venture capitalists move “up market.” Consequently, the loss of angel money will reduce the number of entrepreneurs who get funded, stifling innovation, slowing job growth, and reducing overall economic activity. Not a particularly desirable outcome.

Most of the companies in which Safeguard Scientifics has deployed capital, which we refer to as our “partner companies,” had already raised angel funding before coming to us for additional growth capital. Over the past few years, these partner companies have increased payrolls by more than 50 percent from 900 to 1,400 highly skilled, highly compensated jobs. That’s a lot of new jobs during one of our nation’s worst periods of unemployment. If not for the angel investors who provided the original seed capital, 1,400 additional people may well have been out of a job.

While unemployment rates have been rising, venture capital has remained the sole engine of innovation and job creation to reignite our economy. The proposals currently winding through Congress could inhibit this growth at the most inopportune time. Congress has a serious misperception of the venture capital industry as wealthy investors who can afford higher taxes. What they fail to realize is that the venture capital community, including angel investors, is really just one part of the American engine of innovation and entrepreneurship. Take away the VCs and the angels, and you are actually hurting the entrepreneur.

We need sound policy that reflects the inexorable link between entrepreneurship and economic growth. As always, that seems to be a challenge for our legislators who prefer to cut down trees rather than manage forests.

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