Nothing Ventured, Nothing Taxed

Previously in this space, I’ve discussed the collapse of the venture industry since the bloodbath began with the collapse of two Bear Stearns funds. While publicly traded stocks have been hammered, the private market is undergoing its own painful restructuring. As of the first quarter of this year, available venture capital had collapsed to 2003 levels, according to a PricewaterhouseCoopers study.

Furthermore, seed financing has effectively vanished. Angels are investing only 26 percent of their capital in seed and startup funding, compared with 35 percent in 2009 and an impressive 45 percent in 2008, notes a report from Center for Venture Research at the University of New Hampshire.

Even though the total amount of angel capital fell from US$26 billion in 2007 to $18 billion in 2009, the same volume of companies was funded — roughly 57,000.

Startups Squeezed Out

In other words, angel capital is funding the same number of deals but with smaller rounds, and these smaller rounds are going into more-mature companies. This represents a significant shift in both the appetite for risk and the valuations of privately held companies.

Two years ago, companies of this maturity would not have bothered to come to angels for funding — much less for the peanuts being tossed their way.

This effect is propagating up the food chain, as general venture financing follows the same trends as angel investing. First-time venture financing deals decreased 14 percent from 2009 levels, and seed investment declined a whopping 30 percent in the first quarter of this year, the PwC report shows. A total of only 6 percent of venture deals were for startups.

Plop, Plop, Fizz, Fizz

Will there be any relief? Recent legislation gives investors tax relief on investments held for five years. (See Robert Wood’s excellent summary.) This is good news for investors but bad news for those hoping that this will stimulate job creation.

Because of the desire to retrench and reduce risk, this break is more likely to go to middle-stage and expansion deals, rather than early stage companies. However, job creation comes primarily from companies less than five years old (see the Kauffman Foundation’s excellent report on this topic). Therefore, this tax break is unlikely to stimulate job creation.

Don’t Hold Your Breath

Cynical investors recognize that many exits are going to be delayed by a couple of years anyway, so even those investments that look ripe for exit in three to four years may qualify for these tax breaks. The interest in startups has changed everyone’s time horizon since we have finally caught on that it has been more than 15 years since Netscape illustrated the meteoric rise to IPO (just 18 months after the company was formed).

So, even though some capital has returned to private investors — thanks to a recent round of exits — this cash is not replenishing the pot for startups. Instead, “tortoise companies” that have grown slowly and steadily for several years will suddenly find themselves ready to compete for capital.

Unfortunately, if the tax break was designed to stimulate job creation, it will fail. However, the tax break will succeed in helping tortoises move along, particularly now that the hares have largely gone extinct.