Greater Greater Washington

A tech investor tax cut won't help the tech sector

Tomorrow, the DC Council will vote on a bill to give investors in tech companies a huge tax break. Taking steps to build the tech sector and diversify our economy makes sense, but this tax break will simply not actually stimulate more technology investment.


Photo by spike55151 on Flickr.

The Gray administration proposed the bill, the Technology Sector Enhancement Act, this past spring. It has some good provisions: for example, it will remove a requirement that tech companies locate in special zones to receive start-up tax breaks. We need startups everywhere, not just in a few places.

But the centerpiece of the legislation reduces the capital gains tax for DC investors in DC tech companies from 8.95% to 3%. The rationale is to encourage more investment in tech companies, but it won't work.

Venture capitalists don't choose investments based on capital gains taxes

I own a software company in Tysons Corner and have worked with several venture capitalists over the past decade. It is inconceivable that these investors would avoid investing in a company that otherwise would produce a tenfold return simply because the capital gains would be taxed at 8.95%.

Most venture funds look for companies that could potentially grow big and make back 10 to 30 times the initial investment. Instead of trying to make a few percentage points on each investment, venture captalists figure they'll lose money on most of the startups, and then make their profits with the occasional home run.

Let's say an early-stage fund has $10 million, and invests an average of $200,000 in 50 companies. Its goal is to make a multiple of 3, which means it wants its investment to be worth $30 million after taxes at the end of 10 years. But every company won't be worth 3 times as much. Instead, it might expect only to make money on 10 of those 50 companies.

To make $30 million, it will need each of those 10 successes to be worth 15 times as much as when they invested. If the fund pays 3% capital gains tax, they need a multiple of 15.5. If the fund pays 8.95% capital gains tax, they need a multiple of 16.5.

Does anyone seriously think that that difference will bring in additional investment for DC tech companies?

The Gray administration also argues that reducing the capital gains tax rate for tech investors will keep them in DC. In Virginia, capital gains tax rates for tech investments is 0%.

But investors aren't going to fund a DC company that they believe less likely to succeed just because, if it does, it would only have to be worth 15½ times as much instead of 16½. They are looking for companies most likely to make it to the stage of getting bought or going public at all.

Also, venture capital at any stage is regional, not confined to a county. In fact, most investors in DC tech companies live outside of DC.

What is a tech company?

If this tax cut passes, it will create a loophole that is big enough to drive a truck through. Why? The definition of a technology company is such that, according to an analysis of the DC CFO, many companies would reclassify themselves as tech companies in DC to enjoy this loophole.

The CFO testified that the "negative impact cannot be reliably estimated at this time, but it could be substantial."

If the goal of this policy is to increase revenue by keeping investors in DC, then why limit it to tech companies? This tax loophole won't contribute another dime in investment to DC tech companies, and will only make it harder to reduce tax rates for everyone.

Mayor Gray created a Tax Revision Commission, led by former Mayor Anthony Williams, to recommend broad-based tax reform. Let's wait for the commission to finish its work instead of undercutting its with a poorly-conceived tax loophole.

If you agree, use the form below to tell the council to hold off on this tax loophole.

Take action

This petition is now closed. Thank you for participating!

Ken Archer is CTO of a software firm in Tysons Corner. He commutes to Tysons by bus from his home in Georgetown, where he lives with his wife and son. Ken completed a Masters degree in Philosophy from The Catholic University of America. 

Comments

Add a comment »

If you don't want the founders of a successful startup to "flee" to Florida at the first whiff of success you have to address that 8.95%...

I put it as "flee" because they will still live here 180-1 days, you just won't get any cap gains going into DC coffers.

by NikolasM on Sep 18, 2012 3:23 pm • linkreport

If you don't want the founders of a successful startup to "flee" to Florida at the first whiff of success you have to address that 8.95%. I put it as "flee" because they will still live here 180-1 days, you just won't get any cap gains going into DC coffers.

That's a different issue than building a tech sector. If we're concerned about losing revenue because people move into VA suburbs or live half of year in FL, why would we restrict measures to address that to the tech sector?

by Ken Archer on Sep 18, 2012 3:27 pm • linkreport

Ken,

You live in Georgetown, but the IT company you founded is in Tysons. Why's that? Have you given consideration to relocating the company to DC? Being closer to home and not having to commute has to be a big plus. What's holding you back? Just wondering.

by Sage on Sep 18, 2012 4:24 pm • linkreport

You live in Georgetown, but the IT company you founded is in Tysons. Why's that? Have you given consideration to relocating the company to DC?

I'm one of three managing partners. The other co-founder lived in McLean before he moved to Charleston and opened an office there, and the president lives in Great Falls.

The other co-founder and I started the company in DC in 2000, but quickly moved it to McLean because (a) my reverse commute was faster than his commute to DC and (b) his family didn't want to live in DC. I owned 2 cars then, and own 0 cars now, so I've changed some.

I moved our VA headquarters to a Tysons building next to a future Silver Line station a year ago - that's been my main success when it comes to site location decisions at our company.

by Ken Archer on Sep 18, 2012 5:11 pm • linkreport

[Deleted for violating the comment policy.]

It's been several years since venture capital firms were a major factor in early stage funding for startups. The game today is all about angel investors. Wealthy individuals who open up their personal wallets and make risky investments in startups. Angel investors are the lifeblood of a startup ecosystem and they're in short supply in DC. Many of us are out there working hard to create new channels to convince wealthy individuals in DC to step up and become angel investors. We need every tool that we can get. Period.

[Deleted for violating the comment policy.]

Best,
Evan Burfeld
Chairman, Startup DC
Chairman, Synteractive
Chairman, Hallway.co

by Evan Burfield, Chairman, Startup DC on Sep 18, 2012 6:35 pm • linkreport

Evan: Thanks for your comments. It seems that the arguments in the article could apply to angels as well. Startup angel investing is very risky, and takes a lot of knowledge and involvement. Are there really people who would be doing angel investing, but aren't just because of taxes?

Would angel investors not support a startup they think has a good chance of making it, just because they would have to pay a few percentage points in capital gains taxes (which apply to other kinds of capital gains one could get for their money anyway)?

It seems that you're right we need to do more to foster angel investors in DC. It doesn't seem clear that the tax rate is the obstacle.

by David Alpert on Sep 18, 2012 7:31 pm • linkreport

Hi ken,
Disappointed to see you on the wrong side on this. I'm an angel investor. I've made 37 investments over the last few years.

1. This change would absolutely make me more likely to be resident in dc which naturally makes it more likely that I'll meet and fund a dc entrepreneur.

2. I became an angel investor after founding a company that went public. Where I located when diversifying out of that position is affected by tax rates. I bet this is the case for others. Where people are when they make $ effects where they're likely to make angel investments. Until I spent time in dc I had not written a check to a dc based company. Now I've backed several.

You're right about many things you write about. In this case I have more direct relevant experience with what this bill is focused on and respectfully disagree with you.

by Sean Glass on Sep 18, 2012 7:47 pm • linkreport

Evan and Sean,

I recognize that I'm probably parting ways with most DC technology CEOs and investors on this issue, and I absolutely respect your views on this and your experience in DC startup funding.

Most of the agenda of the DC startup community is, as you say Sean, in agreement with the agenda of smart growth activists. The letter that the InTheCapital bloggers and I drafted for several DC tech CEOs and investors, asking the city for investments that would create better space for startups, reflected that common ground.

My general view would be for the city to support our tech community through such investments, as well as investments in public spaces, public schools and public transit that attract talent to DC as they already have. That's the idea behind urban policies geared to attract creative class workers that are central to high growth sectors like yours.

But those investments require money. Every new Circulator route, every new streetcar route, every school modernization requires tens of millions of dollars. I think the reason that you have chosen to move and/or stay here is precisely because DC is an attractive place to live, not because of its capital gains tax. If so, then shouldn't we build on whatever strengths attracted you to move or stay here?

by Ken Archer on Sep 18, 2012 8:21 pm • linkreport

Ken-

I appreciate your skepticism of the DC government's ability to pass fair and balanced legislation - they've certainly earned it. I am signer of your previous letter regarding the "Social Commerce Act of 2012", however I do not support your stance on this issue.

1) Your biggest complaint with the so-called Living Social Act was that the city should create comprehensive legislation supporting the entire tech sector, rather than one-off, reactive legislation. I agree with that premise and this legislation accomplishes a balanced and thoughtful approach.

2) Your point regarding this legislation's lack of usefulness in making the DC tech scene competitive with other jurisdictions is not well founded.

The largest shareholders in most tech exits are the founders. As an entrepreneur, I have started and sold three companies while living in the District. This legislation would have saved me significant dollars had it been in place for my exits. I have certainly contemplated relocating my businesses or my residence outside of the District to make business sales less of a tax burden. This legislation would put any temptation to move outside of DC to rest.

Rather than becoming a perennial nay-sayer when it comes to DC's ability to craft fair legislation, I challenge you to consider this legislation from all angles - founders, employees, investors, as well as the local businesses supporting this ecosystem. The long-term impact of this legislation will make DC a more competitive place to do business for both entrepreneurs and investors.

by Michael Goldstein on Sep 19, 2012 12:31 am • linkreport

[This comment has been deleted for violating the comment policy.]

by Evan Burfield, Chairman, Startup DC on Sep 19, 2012 1:01 am • linkreport

Ken,

In general I agree with the view that the best way for DC to attract more startups is for DC to continue to grow into being a great city. I didn't build my last startup in DC for any reason other than a great lifestyle. But those are long term trend issues.

Unfortunately DC faces much more urgent issues. Whether or not sequestration happens early next year, this region will start seeing significant reductions in federal spending, which will impact employment. As one slice of our employment pie shrinks, we have to urgently work to grow the other slices, particularly the ones unrelated to federal spending.

Four years ago, Living Social was called Hungry Machine and it was generating about four jobs in the city. Today, it has over 1,000 employees in the city, making it one of the top 10 private employers. Startups are our fastest and most efficient path to diversifying and growing the jobs in our city.

Having the city invest in great spaces for startups is a wonderful idea, it's just not particularly important.
The rank ordering of issues facing DC startups begins with early stage capital and talent and proceeds through a number of issues before it gets to space.

Startups need early stage capital. Early stage capital comes from wealthy individuals making risky investments. We don't have enough of them at the moment despite significant personal wealth residing in the city. It's really that simple.

As for the argument that the Technology Sector Enhancement Act would take investment away from the things that make our city so wonderfully livable, show me the data. Our city's independent CFO analyzed the Act and disagreed with you.

Best,
Evan

by Evan Burfield, Chairman, Startup DC on Sep 19, 2012 1:40 am • linkreport

Startups need early stage capital. Early stage capital comes from wealthy individuals making risky investments. We don't have enough of them at the moment despite significant personal wealth residing in the city. It's really that simple.

But how will reducing the capital gains tax rate suddenly result in an early stage/angle investment making sense to a wealthy person that otherwise did not make sense?

That's the central question, it feels like a fair question, and I'm not the first person to ask it since this bill was introduced. If I heard a compelling answer to this question, I would absolutely support this bill, just like I've supported other targeted tax policy (e.g. TIFs) that would reduce revenues in short term but increase revenues in long term.

As for the argument that the Technology Sector Enhancement Act would take investment away from the things that make our city so wonderfully livable, show me the data. Our city's independent CFO analyzed the Act and disagreed with you.

That's not true. The CFO points to other provisions of the bill, which have nothing to do with the investor tax cut, that would modestly increase revenues. This is where the “positive fiscal impact” claim comes from. I support those provisions as I make clear in this article.

The CFO’s analysis of the investor tax cut, by contrast, and another provision of the bill, finds that the long-term “negative impact cannot be reliably estimated at this time, but it could be substantial” as I quoted in the article.

by Ken Archer on Sep 19, 2012 7:36 am • linkreport

I agree with the article, as I would rather see a broad based corporate tax cut or individual income tax cut.

by H Street LL on Sep 19, 2012 8:26 am • linkreport

Where I located when diversifying out of that position is affected by tax rates. I bet this is the case for others.

There can be only so many parasitic tax havens in a given country. You've chosen to live in one of them. That doesn't mean that DC should engage in a race to the bottom to try to attract people like you. Likely there are lower cost means of getting the same benefits.

by Tyro on Sep 19, 2012 8:39 am • linkreport

[This comment has been deleted for violating the comment policy.]

by BTDT on Sep 19, 2012 9:54 am • linkreport

Why don't you write an article about how VA should raise capital gains to 8% on tech companies because it makes them more attractive?

by Brian on Sep 19, 2012 10:45 am • linkreport

"But how will reducing the capital gains tax rate suddenly result in an early stage/angle investment making sense to a wealthy person that otherwise did not make sense?"

Very simply, angels and high net worth individuals leave states and jurisdictions for tax reasons. Not having these folks in the district means less chances for them to interact with entrepreneurs, less chances to grab coffee down the street, to run into an entrepreneur at an event downtown. In the early stages, these personal relationships drive a significant portion of capital allocation.

Any corporate law firm in DC tells their clients to leave the district (move to Virginia, spend 1/2 the year in Florida, etc) when they have a liquidity event. These tax-related relocations kill opportunities for potential angels to invest in DC entrepreneurs.

by Allen Gannett on Sep 19, 2012 10:50 am • linkreport

Given that

1) We need an increase in the federal cap gains tax -- whcih is being discussed this week in Congress -- does cutting in on the state level make a difference.

2) given that fed level, you're looking at en effective 18% rate vs. 24% combined.

3) So, this would only apple to DC residents? There is a lot of money out there in DC, not sure how much is active investing, and it would be easy to set up a LLC to move the investment to a lower rate state if that is your concern.

by charlie on Sep 19, 2012 11:06 am • linkreport

I've really tried to absorb the comments made by supporters of the 3% cap gains tax for DC tech investors, and it feels to me like there are multiple arguments being made in support of it. Different supporters are thinking of different alleged problems that this tax cut would address.

1) Wealthy persons in DC are not investing in tech companies, because the capital gains tax is too high.

I've heard this from several supporters, and this argument is the central one that my post confronts. I still don't understand how a wealthy person would avoid an investment that promised any kind of a meaningful return, but would make the investment if the capital gains were taxed at a rate 5 points lower.

2) Tech investors, founders and employees are moving to Virginia before a liquidity event.

This is the argument that CM Catania made today. The problem with that argument is that VA only offers 0% capital gains tax on technology investments made in VA.

3) Investors are moving their companies to Virginia very early, before getting investments, to secure a 0% capital gains tax.

This may seem plausible if it wasn't for the fact that the number of startups in DC, both pre- and post-financing, has steadily increased over the past decade. This has to be demonstrated to be a real problem first.

4) Tech investors are claiming to live half the year in Florida, because FL is one of 9 states to charge 0% capital gains tax with no strings attached, depriving DC of needed revenue.

This is happening to some extent, but why is this a tech problem? Doesn't this warrant a comprehensive review of our tax code to make it more competitive with FL, which is exactly that the Tax Revision Commission can do?

5) A dozen DC-based early stage tech investors have told DMPED that they are going to leave the area if the onerous capital gains tax isn't reduced.

DMPED and the Mayor have repeated this for months. There's two things that make me, and probably some of the 11 CMs who voted NO today, incredulous about the threat. (1) Somehow our tech sector was growing fine for years, and then these dozen investors decided to make their threat at exactly the time DC hired its first DMPED staff to help build the tech sector. That seems like a coincidence. (2) These dozen investors all chose to move and/or stay in DC for reasons other than the capital gains tax. What did they like about DC before that they now dislike about DC?

I would absolutely support a change to our capital gains tax by the Tax Revision Commission, if I knew exactly what problem we were addressing. Can anyone help me here?

Until then, I'm still encouraging DMPED to deliver low-cost office space for start-up founders, and advocating for investment in public places, transit and schools that will attract and retain creative class workers that are vital to the tech sector.

by Ken Archer on Sep 19, 2012 8:14 pm • linkreport

Add a Comment

Name: (will be displayed on the comments page)

Email: (must be your real address, but will be kept private)

URL: (optional, will be displayed)

Your comment:

By submitting a comment, you agree to abide by our comment policy.
Notify me of followup comments via email. (You can also subscribe without commenting.)
Save my name and email address on this computer so I don't have to enter it next time, and so I don't have to answer the anti-spam map challenge question in the future.

or