Nevada New Tech Investment on the Fiscal Cliff

Once in a while I get lucky, as when a local Nevada story about start up tech companies in Las Vegas has implications for our nation-wide discussion of economic policy. There area some start up tech companies in the Las Vegas metro area that could use financing, and there’s the problem:

In spite of the city’s recent startup boom, there remains a small number of local investors willing to put cash into tech companies. And the funding gap could stanch tech development in the valley, as most startups earn paltry revenue and could easily flop or stagnate without outside capital.  [LVSun]

The problems associated with the lack of start up funding are common: Las Vegas has fewer local investors than other areas.  Las Vegas isn’t a tech hub center.  Local wealth doesn’t come with expertise in tech investment.  Venture capital funds don’t have offices in the Las Vegas area.  There aren’t enough “angels.” [LVSun]  It’s one thing to list the issues, but to address them requires some thought given to economic policy.

#1. Are we promoting an economic climate in which investment in start up companies is valued?

Speak to me of a gubernatorial candidate who didn’t campaign vigorously on his or her Economic Growth Plan, and I’ll show you a person who didn’t get elected.  Everyone has one, and everyone loves Small Business, and everyone prints out forest killing quantities of Economic Plans designed to create a pro-growth business climate.   Right?

Not so fast. Too much campaign literature is dedicated to the climatological issues of  existing businesses.  For example, candidate Bilgewater carefully explains to us that low taxes will create economic growth because the wealthy will have money to invest in new businesses.  Of course, what Bilgewater leaves unsaid is that the money and the expertise may not be a match.  There are two problems specified in the article and neither one is addressed by the proponents of the Trickle Down Hoax.

First, as observed in the article, people are reticent about putting money into tech companies if they don’t understand the milieu.   Why shouldn’t they be? Enough individuals got burned during the Tech Bubble Crash to leave many sensitive fingers behind.   If we would create a climate for successful ventures in tech-based firms, then we need to apply some assets toward educating potential investors in the characteristics of likely successful start ups, especially in tech-related fields.

Secondly, also as noted in the article, start up firms usually need some mentoring.  As in any market, some ideas are better than others, but even the brightest idea can devolve into disaster if there isn’t a cogent business plan behind it.   If local mentor-investors aren’t available, who is?  Here’s where we need to be watching the Fiscal Cliff (Curb) discussion carefully.

The Republican Party has offered a budget which severely cuts non-defense discretionary spending — and included in this category are funds for the Small Business Administration — in the interest of diminishing the Great Gloomy Cloud of Debt.   Existing businesses may have an over-arching interest in the Great Gloomy Cloud of Debt because it could restrict their access to capital. However, start ups haven’t gotten that far.  They’re still trying to get initial capital.  Or, to put it more bluntly, if SBA loans aren’t available this is no skin from the fingers of existing businesses, it burns the start ups.

As the NYT small business writer explains:”Much of the S.B.A.’s mission is to guarantee loans to small companies that banks would otherwise not make, and steep cuts would likely force the agency to turn away borrowers.”

In short, small start-ups are the very ones which find funds (either investments or loans) difficult and need assistance.  If we would improve the climate for innovative tech-based firms then it doesn’t make sense to slash funding for the Small Business Administration.

A third question should be raised in this part of the discussion: Do our economic and tax policies reward investment in technology and innovation, or do they favor already existing firms? This question splits into two topics: Taxation on Capital Gains and the diversion of wealth into speculative investment as contrasted with venture capital.   Let’s leave the second part for now, and look at the capital gains side of the argument.

For the record, capital gains are taxed as ordinary income if the investment is made for less than one year.  Since 2003 taxes on long term capital gains, defined as investments held for more than one year are at 15%.  Without going too deeply into the weeds, venture capital invested in a start up company for more than one year gets the 15% “bonus.”

If the contention that low rates of taxation, especially on capital gains, creates economic growth then the first speed bump on the road is that it is extremely difficult to infer a causal relationship between the number of new businesses and the tax rate for capital gains.   If the causal relationship is true, and low rates of capital gains mean more start up entrepreneurial enterprise, then why has the start up trend declined?

The start up rate peaked in 1987 (13.02%) and is now reported at 7.87%.  [Reuters]  The capital gains tax rates have held steady but the start up trends still show a decline.   Lower tax rates, then, are not the end and be all explanation for start up growth — or start up demise — the number still indicate a long established pattern: new businesses tend to fail in the first two years.

The argument that if we increase taxation on capital gains then there will be fewer start up companies falters when we look at the graphs showing a declining number of start ups even with the 15% rate on capital gains and the lowest overall tax burden since the Eisenhower Administration.   It also can’t be successfully argued that business “success” is better insured by lowering tax rates — the Sell By date is still about 2 years.

It’s easier to argue that small business efforts are best promoted when Small Business Administration funds and mentoring projects are available, and when the small business in question can overcome the more common problems associated with failure than esoteric questions about taxation rates.

#2. Are we diverting wealth from investment toward speculation?

On a micro-level this is an oversimplification.   If venture capitalists and “angels” can find good start up firms with a substantial service or product, a good business plan, and adequate resources to break the Two Year ceiling, they’ll invest.  Unfortunately, there’s also money to be made by making big bets on incomprehensible financial products — if a person can find someone to take the other side of the bet.  If not, then we have the spectacle of JP Morgan whose London Whale turned out to be the sucker at the exact time the CEO was arguing against the implementation of the Volcker Rule.  []  [Reuters]  Even if the Wall Street Casino isn’t siphoning off investment at a substantial rate, there are still problems for start up firms.

In the wake of the speculation begotten Financial Crash of 2007-2008 more entrepreneurs found getting bank financing more difficult.  The role of family, friends, angels, and venture sources became more significant.  There are two forms of venture capital, corporate and independent, and both have different motives.

CVCs typically make a financial investment and receive a minority equity stake in an entrepreneurial company. CVCs also facilitate investment of in-kind resources into portfolio companies. In return, the parent corporation gains a window on new technologies and strategically complementary companies that could become strategic partners. CVCs generally invest with a combination of financial and strategic objectives. Strategic objectives include leveraging external sources of innovation, bringing new ideas and technologies into the company, and taking “real options” on technologies and business models (by investing in a wider array of technologies or business directions than the company can pursue itself). [NIST] (pdf)

And, corporate venture capital investment tends to be in smaller amounts than independent sources.

“Because corporate venture capitalists are making partially strategic investments, while independent venture capitalists are making purely financial ones, corporate venture capitalists can accomplish their goals by putting in less money. The ability to tap knowledge from an investment in a young company is not proportional to the size of the investment, but earning a financial return is. Therefore, corporate venture capitalists tend to make smaller investments than independent venture capitalists.” [SmBizTrends]

We need to ask better questions?

If candidate Bilgewater is pontificating on the necessity of reduced capital gains tax rates, or any other tax rate reduction, then the question needs to be asked — On what basis do you draw the conclusion that a reduction in the marginal tax rates will spur increased investments in entrepreneurial enterprise?  Because the numbers simply don’t support the conclusion when we have declining start ups, with the same life expectancy, in the least burdensome tax environment we’ve had for decades.

If candidate Sludgepump is preening before the cameras with the message that “We Must Support Small Business The Backbone Of American Life,” then the next inquiry ought to be how do we incentivize investment in small business enterprises by making it more attractive to invest in the business than to hedge bets on the little business’s securitized loans?

If candidates Bilgewater and Sludgepump argue that the Great Gloomy Cloud of Debt threatens to rain on our business parade and we must deplete it before doing anything else, then someone needs to ask:  How do you reconcile the reduction in Small Business Administration funding when you presume small business activity is the motor impelling our economy forward?


See also: Monthly Labor Review, Amy E. Knaup, May 2005. (pdf) “Corporate Venture Capital: Seeking Innovation and Strategic Growth,” National Institute of Standards and Technology, Department of Commerce, June 2008. (pdf)

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