VC tax credit rarely used by startups: Less than 17 percent of incentives tapped

June 27, 2005

Last year, Indiana approved tax credits worth nearly $16.3 million to encourage speculation on local high-tech startups.

Investors left most of the credits-$13.5 million worth-on the table.

The highly touted Indiana Venture Capital Investment tax credit program debuted in January 2004. It allows investors in approved startups to write 20 percent of their outlay off their state taxes.

Indiana certified 42 young companies last year as eligible for its venture capital credit. According to the Indiana Economic Development Corp., investors in 38 of those companies filed for some assistance. But at $2.7 million, they used less than 17 percent of the credits available.

Bob O'Brien, a general partner with Indiana's largest venture capital firm CID Equity Partners, could only speculate why the credits' use rate wasn't higher. After all, similar state tax credits helped CID raise its very first fund two decades ago. That original CID fund returned more than five times the $10 million its investors risked.

"We certainly support the program," O'Brien said. "The question is, how could we help share that benefit with others?"

Venture capitalists and entrepreneurs cite many potential reasons so many of the venture capital tax credits were left unused. The program was new, they most frequently point out. Given more time, they say, investors and startups will take better advantage of the opportunity.

Indiana Venture Center President Steve Beck said Hoosier investors have already begun to expect venture capital tax credit certification from every startup they consider. Eventually, Indiana will start to see results from the venture tax credit program.

"Almost invariably today investors ask, 'Have you been approved for the venture tax credit? I may be interested, but until you are, I'm not going to agree to invest,'" Beck said. "It will only become more important when some of these early companies go to second-round funding and get some returns in a couple years."

Indiana Economic Development Corp. President Michael S. Maurer, who also co-owns IBJ Corp., said the state doesn't attempt to assess whether startups will be attractive to investors. It simply certifies them as eligible for the credits.

"The marketplace decides which of these businesses are viable," Maurer said. "The state can't bankroll these businesses. It can only provide incentives for others."

Local venture capitalists agreed with that philosophy. Ken Green, co-managing partner of Spring Mill Venture Partners LLC, pointed out that investors have a different mind-set when their own money is at risk. When they invest other people's cash, he said, they tend to take chances on "what-the-hell-I've-gotnothing-to-lose" propositions.

"Governments tend to not be very good at picking winners and losers. The ones that are aware of that are probably wise," Green said. "You certainly don't want a system where everybody gets funded."

The Indiana Venture Capital Investment tax credit program was properly structured to spur venture investment, said Jean Wojtowicz, president of locally based Cambridge Capital Management Corp. It leaves the onus of whether or not to invest on the due diligence of equity investors.

"It lets the market work the way it's supposed to work," she said.

The venture capital tax credit was intended to be an extra incentive to investment in Indiana's startups; it was never expected to be the sole motivator.

"It wasn't that [investors] were more interested," said Russ Gray, CEO of Theron Inc., which used the credit to help leverage investment in a spinout. "They were on the fence, and the tax credit helped tip them over."

Some startup companies already swear by it. Although investors haven't yet used all $500,000 of the credits approved for his company, locally based BioStorage Technologies LLC CEO Dr. Jon Mills is an unabashed fan.

"There is absolutely no doubt whatsoever that, with a couple of investors, it encouraged them greatly," he said. "I wish we'd had it when we were starting up."

Although his company was certified for the credits, Michael Hall, CEO of locally based Managed OutSource Technologies, didn't raise any money in 2004. Now that he is raising money this year, his investors are eager to claim the credit.

"It's definitely been something that has, on a few occasions, pushed investors to go ahead and invest with us," Hall said. "We pulled in just recently five individual investors who brought in close to $350,000. For us, a small startup software company, that was a significant chunk."

But investors don't always have enough state tax liability to use the credits. If they reside outside Indiana, they may have none at all. Although his company was certified by the state and has raised $1.5 million from investors to date, Mike Copley, CEO of Lafayette-based Celltrack LLC, hasn't been able to use any of the credits.

"I'd like to take advantage of it, if you could find someone to cash in on it," he said. "We sure could use that about now."

Scott Law, CEO of locally based Zotec Solutions Inc., wanted to provide his largest investor some of his state-certified credits. But the investor had already put money into Zotec in 2002. Since the investor wasn't new, Law said, the state declared him ineligible.

"It seems like, if you're trying to build a program that not only attracts investment to Indiana, but keeps the investments coming, you should probably not preclude people from reinvesting in Indiana companies," Law said.

Ryan Hou, president of Columbus-based LHP Software LLC, was able to pass venture capital tax credits to Fifth Third Bank when it underwrote a $2.3 million loan for LHP's new building. But that hasn't helped LHP find additional investors.

"It's a very good program. But I don't see any publicity," Hou said. "How do people know they can invest in me and get a tax credit? I didn't see anything out there to help promote it. That's the problem."

Indiana needs time to change its riskaverse culture, Indiana Venture Center's Beck warned. In the years to come, Hoosiers will see more than 42 startups apply for venture capital tax credit certification.

"The three legs on the stool are smart people, smart ideas and patient capital. We haven't always had people patient with the process willing to wait," Beck said. "This tax credit [motivates] them to wait because they get 20 percent on their money in the first year. Where else can you get that?"
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