STIMULATING STARTUPS: THE TROUBLE WITH THE PRESIDENT’S PROPOSAL

Date: February 7th, 2011

Recently, I traveled to Washington D.C. to be with my brother-in-law, Sean Duffy, for his swearing-in as a freshman Representative for Wisconsin’s 7th Congressional District. On the flight to D.C., I sat next to my own Congressman, Rep. Jay Inslee, and we had a wide-ranging conversation over a number of topics. Mid-way through the flight, our conversation turned to economic issues and particularly those affecting startups. Mr. Inslee was obviously serious and genuinely interested in these issues and encouraged me to share with him my thoughts about how to kick-start private investment in startups in Washington State. I think he could tell I think about this issue quite a bit, and I got the clear sense from our conversation that, in principle, encouraging job creation by incentivizing private investments in startups is a goal over which Republicans and Democrats can come together.

After arriving in D.C., I learned that Rep. Duffy has been assigned to the House Committee on Financial Services. Who knows? Maybe a Duffy-Inslee Bill or an Inslee-Duffy Bill could be drafted to really address the issues facing startups. As with any political initiative, the devil will be in the details.

Then came President Obama’s State of the Union address, in which he emphasized the need to re-energize the entrepreneurial spirit and promote the growth and development of startup companies as a way to ignite private sector job creation. The President referenced his administration’s idea, first announced in May 2009, to eliminate the capital gains tax on investments in “qualified small business stock.” Currently, 50% of gain is excluded from sales of qualified small business stock acquired prior to February 17, 2009, and 75% of such gain is exempted from sales after that date. On the surface this sounds like a terrific idea, but upon deeper examination the President’s proposal doesn’t go far enough and reveals a reluctance (perhaps ideological or political) to fully unleash the job creation potential of American entrepreneurialism.

It is a well-established fact that startup companies are terrific at creating new jobs. In fact, a July 2010 report by the Kaufmann Foundation found that without startups, “there would be no net job growth in the U.S. economy,” and that data from 1977 forward confirms that to be the case in every year except for seven years. To better appreciate the job creation dynamics of startup companies, consider the following observation from the Kaufmann Report:

“For example, in 2005, startups created 3.5 million jobs, compared to the 355,000 gross jobs created that year by firms founded in 1995. However, the 1995 firms also lost a gross 422,000 jobs. Indeed, existing firms in all year groups have gross job losses that are larger than gross job gains.”

In other words, without the vibrant dynamic of American entrepreneurialism and risk-taking that causes individuals to create new ventures, job loss outpaces job creation and leads to higher unemployment. The importance of startup companies to our economy is self-evident.

In that context, the President’s proposal to encourage private investment in startup companies is a welcome move. The proposal is entitled, “Eliminate Capital Gains Taxation On Investments In Small Business Stock.” Let’s look at some of the specifics of the proposal:

• No capital gains tax on sales of “qualified small business stock” by “non-corporate taxpayers”;
• To qualify, the stock must be held for five years before being sold;
• The capital gains tax exemption would apply to qualified small business stock acquired after February 17, 2009;
• The issuer of the stock must be actively involved in a trade “other than one involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any other trade or business where the principal asset of the trade or business is the reputation or skill of one or more employees; a banking, insurance, financing, leasing, investing or similar business; a farming business; a business involving production or extraction of items subject to depletion; or a hotel, motel, restaurant or similar business. There are limits on the amount of real property that may be held by a qualified small business, and ownership of, dealing in, or renting real property is not treated as an active trade or business”;
• The issuer of the stock may not have gross assets exceeding $50 million, including the proceeds of the newly issued stock;
• The issuer of the stock may not be an S corporation;
• The amount of gain that is exempted is capped at the greater of (1) ten times the taxpayer’s basis in the stock and disposed of during the year or (2) $10 million minus gain excluded in prior years from sales of the same issuer’s stock;

Again, at first glance it would appear that eliminating the capital gains tax on such investments should spur a tremendous amount of investment in startup companies, which in turn should lead to job creation. While I believe the proposal will increase private investment in startups, it does not go far enough. Now let’s look at the proposal’s shortcomings.

Investments are limited to C Corporations

The President’s current proposal is limited to C corporations. Accordingly, the proposal will cover many startup companies that organize as C corporations because they want to attract investment from entity investors such as venture capital firms. However, I see this as a significant limitation. If the goal is job creation, why limit the incentive only to investments in C Corporations? There are many LLC’s, limited partnerships and S Corporations that are started up every day and do their part to create jobs. Incentivizing investments in those entities can only expand job creation. Moreover, experienced lawyers often advise entrepreneurs, particularly those who intend to be funded by angel investors, to organize themselves in these forms of entities because doing so can help them grow or facilitate an exit strategy. For example, the tax code calls for LLC’s, S Corporations and limited partnerships to allocate profits and losses to their owners. This can be a significant benefit for investors who can use their share of the losses experienced by a startup company to offset taxes on their ordinary income from other sources. Another example is that S Corporations can be attractive acquisition targets for other corporations. This is because Section 338(h)(10) of the IRS Code allows acquirers of S Corporation stock to elect to treat the transaction as if it were an asset sale. This allows the acquirer to step up the basis of the S Corporation’s assets, which in turn generates tax deductions and increases the acquirer’s cash flow. Because the target S Corporation must cooperate in making the 338(h)(10) election, acquirers are typically willing to pay shareholders a higher price, something startup company founders think about. The 338(h)(10) election is not available for C Corporations.

The President’s proposal, if passed as currently envisioned, would cause many startup founders to consider abandoning other entity structures in favor of a C corporation. If the goal is to encourage job creation, the throttle should be wide open and private investments should be encouraged in all entity types, not just C Corporations.

Capital gains taxes are not truly eliminated.

Under current law, any exemption on capital gains taxes is not applicable to that amount of gain that is the greater of (1) ten times the taxpayer’s basis in the stock and disposed of during the year or (2) $10 million minus gain excluded in prior years from sales of the same issuer’s stock. The President’s proposal does not alter that structure. Thus, despite the title of the President’s proposal, capital gains taxes will not truly be eliminated. An investor will pay capital gains taxes on any gain above 10x on their investment or more than $10 million. This cap should be eliminated. Eliminating the capital gains tax entirely for investments in startup companies would send a powerful message to the investment community and accentuates the reward side of the risk/reward investment calculus. Perhaps some in public office consider it vulgar that an investor might realize a ten-fold return on their investment, but in the context of the current national economic crisis that should be beside the point. If the goal is to spur private investment in startup companies, every tool should be used. Maintaining this cap on the capital gains exclusion strikes me as shortsighted.

Corporate taxpayers cannot benefit from the capital gains tax exclusion.

The President’s proposal allows only “individual or other non-corporate taxpayers” to benefit from the capital gains tax exclusion. This, too, makes no sense. Plenty of corporations have ‘corporate development’ departments that look for strategic acquisitions of other companies to expand their own businesses. Usually, these acquisitions are preceded by a strategic investment of cash intended to give the company a toehold and to further evaluate the business. Here’s a good example. In 2007, Amazon invested in the Series A Preferred Stock Financing of Shelfari, an Internet startup focused on bibliophiles, i.e. book lovers. In 2008, Amazon decided to acquire Shelfari. Amazon’s initial investment in Shelfari helped that company grow and created jobs. Why should the corporate investment in a startup be treated differently for capital gains purposes than an investment in the same company by an individual or a venture capital firm organized as a limited partnership? Again, given the national urgency of incentivizing private investments in startups to create private sector jobs, I see no valid reason for the difference in treatment. With unemployment currently at 9.0%, the government should be incentivizing every taxpayer (subject to restrictions imposed by securities laws, and which I’ll discuss below) to consider investing in startups.

The stock must be held for 5 years.

Why? I think the President’s proposal could be improved by eliminating the 5-year hold requirement and instead focusing on incentivizing investors to make their investments in startup companies in the near term, say within between 2011 and 2013. Let’s start with the 5-year hold requirement. This requirement penalizes an investor who made a good bet investing in a successful company. If the opportunity to sell the stock materializes in the first five years, an investor must pay capital gains tax. On the other hand, the reward of capital gains exclusion goes to the investor in a startup that takes longer to grow so that the stock is sold after 5 years. These incentives make no sense. It shouldn’t matter how long the investor holds the stock. The odds of an investment in a startup yielding gain within 5 years are not high, but they aren’t zero either; it could happen. To truly incentivize private investment in startup companies, this requirement should be eliminated. There are other securities laws (e.g. Rule 144) that prescribe hold periods for securities for the purpose of protecting the investing public, but this 5-year hold period is not targeted at such issues.

To encourage investments in the short-term, the government could allow investments in startups made between 2011 and 2013 be treated as a deduction from taxable income in the year of investment. This would be in addition to the elimination of capital gains treatment. This kind of incentive would certainly trigger an immediate increase in investment activity and job creation. And although the availability of such a deduction would certainly impact tax receipts at the U.S. Treasury, the short-term investment would create jobs and other tax-generating economic activity to offset the impact.

Accredited Investor rules still limit the pool of investors.

Investment opportunities in startup companies are almost exclusively directed to ‘accredited investors.’ The definition of ‘accredited investor’ has 8 categories, but the ones most applicable to individuals are:

1. A director, executive officer, or general partner of the issuer of the securities being offered or sold, or a director, executive officer, or general partner of a general partner of that issuer.
2. A natural person whose individual net worth, or joint net worth with spouse, is at least $1,000,000, excluding the value (if any) of such investor’s primary residence.
3. A natural person who had individual income in excess of $200,000 in each of the two most recent years or joint income with spouse in excess of $300,000 in each of those years and a reasonable expectation of reaching the same income level in the current year.

When the accredited investor standards were first issued in 1982, 1.87% of U.S. households qualified for accredited investor status under Regulation D. By 2003, the Securities and Exchange Commission (SEC) estimated that figure had grown to 8.47%. This increase was largely due in part to inflation, but also to the explosive growth of home values, which increased the financial net worth of many taxpayers. There is a paternalistic impulse behind the accredited investor standard. A primary motivation of the standard is that individuals who are not sophisticated with respect to risking capital, who may not have enough experience to understand investments and who may not be able to withstand the loss of an investment should not be permitted to invest in private companies. Just last year, as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress tightened the standards by excluding the value of a home from a potential investor’s net worth. The motivation behind this change is, again, protecting individuals from making bad investment decisions. Now, estimates are that only 2% of U.S. households qualify as accredited investors.

Congress clearly intends to keep the pool of accredited investors limited. This is reflected in provisions of Dodd-Frank that require the net worth criteria to be revised every four years. On January 25, 2010, the SEC proposed a new rule to conform the accredited investor definition to the requirements of Dodd-Frank and issued a press release stating:

“The new net worth standard must remain in effect until July 21, 2014, four years after enactment of the Dodd-Frank Act. Beginning in 2014, the Commission is required to review the definition of the term “accredited investor” in its entirety every four years and engage in further rulemaking to the extent it deems appropriate.”

Again, the legislative goal is clearly to keep the pool of accredited investors small by adjusting the standards to keep a large segment of the citizens ineligible for accredited investor status.

On the surface, it is hard to argue with the paternalistic impulse behind the accredited investor standard. It protects people from making bad decisions. On the other hand, it is also restrictive, discriminatory (at least as to income and judgment) and contrary to notions of free choice in economic decision-making. It also has the direct effect of shrinking the pool of potential investors and ensuring that only the wealthy can risk their capital to become wealthier. As part of the effort to encourage private investment in startup companies, Congress and the Administration should revisit the accredited investor rules and the wisdom of locking out 98% of the public from opportunity to invest in startups.

The President’s proposal does not address other legal obstacles facing startups.

There are many other legal obstacles facing startups that are not addressed in the President’s proposal. It would be ideal if the Administration and Congress would use the opportunity presented by the President’s proposal to consider the following:

• Revising the “general solicitation” restrictions in Rule 502 of Regulation D so that startups can use their own websites and other Internet-related technologies to reach potential investors.
• Revising Rule 502(b)(2) to reduce the information requirements startup are required to give to Purchasers (i.e. non-accredited investors). Startups don’t have the financial statements and other information the rule contemplates, and hiring professionals to create such information is a significant expense for a fledgling company.
• Facilitate a startup’s use of restricted stock grants as a form of incentive compensation for employees by allowing the recipient of the stock grant to automatically treat the value of the grant as taxable income in the year received. Currently, Section 83(b) of the tax code requires the recipient to make this election within 30 days of receiving the grant, or else the opportunity to treat the grant as income in the year of receipt is lost.
• Exempt startups from the provisions of Section 409A of the tax code that require companies to get expensive, formal valuations of their common stock before issuing incentive stock options.