State's venture capital incentive seldom used

November 27, 2006

Savvy investors seldom pass up a chance to slash their tax bill. But in Indiana, that's exactly what they've done for more than three years.

Since the inception of the state's Venture Capital Investment Tax Credit in late 2003, investors have claimed only about one-third of the $37.5 million in credits available, according to an IBJ analysis of the program.

"[The incentive] works. It does what it's intended to do," said Bruce Kidd, the Indiana Economic Development Corp.'s director of small business and entrepreneurship. "Now, we've just got to get more people engaged in it."

Indiana doles out the tax credit to promising companies, which, in turn, dangle it in front of potential investors as a way to sweeten the pot. The incentive is meant to spur speculators to gamble on unproven high-tech ventures they'd otherwise pass over in favor of more certain bets. It allows investors to write 20 percent of their outlay off their state taxes.

Indiana now has granted tax credits worth $37.5 million to 116 young, innovative Hoosier companies, but investors have scooped up just $12.4 million. The gap may suggest the incentive isn't enough to sway investors to bet heavily on risky startups.

Supporters, though, say that doesn't mean the program is faltering. They say it's a key reason Indiana has moved ahead of 15 other states for proportional share of venture investments over the last four years.

The impact of those investments might take time, they say. Further, just because a company hasn't doled out credits yet doesn't mean it won't. The credits generally don't expire for years.

"These are long-shot companies. It will take a decade to see [the tax credit's] impact," said Mark Lawrance, the Indiana Chamber of Commerce's vice president for corporate development.

Unless the program is renewed by the General Assembly, it's slated to expire in 2008. The chamber is among the supporters lobbying hard to make it permanent.

But even the tax credit's administrators admit the incentive has languished without much promotion. They remain far from meeting the program's expectations.

For one, Kidd said, more investors might bet on startups if they knew about the benefits of the program.

Few outside of central Indiana's business circles may even realize the program exists. IBJ's analysis of the geographic distribution of the tax credit shows central Indiana is accruing the vast majority of the program's benefits. Indianapolis alone received more than half the credits available (see graphic). Carmel came in a distant second.

IEDC acknowledges it needs to do a better job boosting awareness.

"I don't mean to be too glib about it, but it's sort of Marketing 101. We created a great product," Kidd said. "[But] if you don't tell the world about it, how are you going to be successful?"

Unused incentives

Indiana business leaders have long been concerned about Indiana's relative lack of venture capital. High-tech startups are seldom immediately profitable; they need outside investors to underwrite their organization and growth.

Legislators created the venture capital tax credit in 2003 and launched the program that December. Its mechanics are simple: Young companies apply to the IEDC for certification. If deemed sufficiently innovative, they receive tax credit vouchers. Then, during fund raising, companies pass the vouchers along to their investors, who claim the credits.

About three dozen firms have been granted tax credits during each full year of the program. Investors in just under two-thirds of the companies have claimed at least part of the credits available. But only seven startups have used all their credits.

Some companies still have credits left over even after successfully raising money. Take Indianapolis-based Internet music platform Digonex Technologies Inc. IEDC records show Digonex's investors have claimed more tax credits than any other Indiana company's: $955,200 worth since July 2004. But since Digonex was authorized to offer up to $1 million in tax credits, it still has $44,800 worth remaining.

"It's quite a selling point to investors," Digonex CFO Michael O'Brian said.

Other startups shelve fund-raising plans despite IEDC certification. Indianapolis-based utility management firm ViaStar Energy Inc., for example, was authorized in November 2004 to give its investors up to $500,000 in tax credits.

But ViaStar hasn't used any because, after exploring the concept, it decided against raising additional outside money.

"It was just a timing issue for us," Via Star co-CEO Christopher Day said. "It would be nice if it were retroactive. Literally, I think some of our [previous] investors missed it by a matter of months."

Some supporters of the credit argue retroactive incentives could increase the total money a startup raises. Theoretically, investors might choose to plow tax gains back into a company by buying more shares.

Investment bankers, who help line up investors for companies, say the credits are having a big impact.

"If a deal is good enough to get done, it makes it easier to get done," said Joe Broecker, managing director of Indianapolis-based Periculum Capital Corp. "Or it gets done at a size larger than you would normally have been able to do."

Even so, 42 of the 116 companies certified in the program haven't yet made any use of their tax credits.

Administration comparison

IEDC, launched by Gov. Mitch Daniels in February 2005, is regularly touted as more effective than its predecessor, the Indiana Department of Commerce. But when it comes to the tax credit program, it isn't producing better results.

More credits were awarded and claimed in 2004 under Gov. Joe Kernan, a Democrat, than in either of the next two years under Daniels, a Republican.

Of the companies approved by the Department of Commerce, 77 percent have claimed tax credits, using 46 percent of their value. Only 57 percent of the companies approved by Daniels have claimed credits, using just 23 percent of their value.

There's a reason the tax credit program hasn't reached its potential, said Tom McKenna, a former Department of Commerce commissioner under Kernan. When the Daniels administration took over economic development, he said, it tended to throw out the baby with the bath water.

"They had the attitude that anything [previous Democratic administrations] did was, by nature, bad," McKenna said. "I'm disappointed. I wish they could have understood the value of the ... tools the executive branch and Legislature gave them instead of out of hand dismissing them because it was somebody else's idea."

Kidd disagrees. He said IEDC focused on entrepreneurship-stimulus programs in order of likely greatest impact. As a result, the agency began by reshaping Indiana's 21st Century Research and Technology Fund, which distributes grants to promising companies. After that, it concentrated on efforts to increase Indiana's share of federal research money.

Kidd said that, in recent months, he's been making regular presentations about the tax credit to investors and business leaders around the state. IEDC also has stepped up efforts to train its regional employees and local economic developers about the program so they can increase awareness of its benefits.

"We're certainly not doing a worse job with the program, and it's not less of a focus. We just don't have enough people and time to devote to every program and initiative. I've only got so many miles on my car and so many hours in a day to make these presentations," Kidd said. "But now I'll have evangelists. That's going to spread the word much more quickly than in the past."

In the end, the underperformance of the tax credit program might have less to do with its administration than with its inability to stimulate investments.

Pete Kissinger, chairman of West Lafayette-based contract research firm Bioanalytical Systems Inc., also serves as CEO of the startup Inproteo LLC. The Indianapolis firm, a collaboration among Purdue University, Indiana University and Eli Lilly and Co., has received $200,000 worth of tax credits, but hasn't been able to use any of them.

Kissinger said Inproteo has never seriously attempted to attract venture capital investment, perceiving "no chance" of success.

He noted that investors' highest priority is always the potential upside of a promising high-tech startup.

"No tax incentive can substitute for a really good investment with a very promising return," Kissinger said. "It cannot turn a pig into a racehorse."

"It does reduce risk a bit going in," he added. "But saving a little on taxes is nothing like making a 5,000-percent gain."

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