There no question that the life blood of any business is capital and cash flow; and this is especially true for emerging small businesses. When starting up a new venture there are myriad expenses with little or no revenue coming in, making access to adequate capital essential to getting a venture off the ground. In fact many good ideas never get off the launch pad due to a lack of access to capital. And once the business is launched, cash flow becomes “king”, as expenses inevitably outpace revenues throughout the initial survival stage of the business. It is during this survival stage in the business development cycle where managing the rate in which funds are being expended vs. sales revenue coming in is key to the business’s viability.
When it comes to capitalizing a business there are two types of capital that entrepreneurs rely on: debt capital and equity capital. We are all familiar with debt capital as it is the strategy that most of us use to finance our homes and cars. Banks and other lenders are more than willing to provide us with loans as long as we have sufficient collateral or other demonstrated means to pay back the loan with interest. But obtaining sufficient debt capital is often difficult when a small business is starting out with little equipment, real estate or other forms of tangible collateral that a lender can count on. On the other hand, equity capital is a form of investment where a financier provides outside funding in exchange for a partial stake in the emerging business. Many call this type of investment “patient capital,” as the business owner does not have to begin paying back the funds, but rather as the business grows and prospers, so does that equity stake in the business. Unfortunately, most of the financiers that make such equity investments are not typically interested in very small start-up firms as the risks are often disproportionately high in relation to the reward. Accordingly, those individuals and equity firms that choose to make investments in such start-up or early-stage companies are often called “angel investors.”
In an effort to encourage more angel investments in Minnesota the state legislature passed a bill in 2010 establishing an Angel Investment Tax Credit program. The program, which began in the latter half of 2010, requires qualified investors seeking to make such investments, as well as qualified businesses wishing to receive these investments to register with the Minnesota Department of Employment and Economic Development (DEED). The reward for such compliance with the program is a refundable tax credit to the investor equal to 25 percent of the investment.
According to a recent legislative report it seems that the program is performing as intended. In 2011 there were 623 individual angel investors certified by DEED, of which 563 made an investment in a certified business, along with 21 certified investment funds, all of which made an investment as well. As a result in 2011, 113 qualified businesses received investments totaling $63.1 million through the program and $15.8 million in refundable tax credits were issued.
While most would consider the program a success, others have concerns. As expected, the overwhelming majority of investments were made to businesses located in the 7-county Twin Cities region. In fact of the 113 firms receiving investments in 2011, only 11 were located outside the Twin Cities; 10 in southern Minnesota and 1 in Duluth. As a result of this apparent geographic inequity, a bill was drafted this session increasing the size of the refundable tax credit to 40 percent for investments made to businesses located in greater Minnesota. But is this really a good idea?
While few are more sympathetic to the concerns of rural Minnesota communities and businesses than I, at the same time I have always believed that smart equity investors make their investments in good companies regardless of their location. And while the opportunity to learn about such good companies is certainly easier if they are located in the Twin Cities area, maybe the appropriate response is for DEED to simply work harder at showcasing these investment opportunities in greater Minnesota. But is increasing the tax credit to 40 percent the answer?
Personally, I can’t help but think of a 40 percent refundable tax credit as the taxpayers of Minnesota subsidizing almost half of a private investor’s total investment without receiving any direct return on our investment. Can we even call this private investment anymore? Further, the program does not limit qualified investors to be Minnesotans. So hypothetically, an out-of-state investor who has no tax liability in Minnesota, and who makes a $100,000 equity investment in a rural Minnesota company will simply get a refund check for $40,000. Really?
Recently I was reading the remarks of Mankato’s city manager Pat Hentges in the Mankato Free Press, as he was reflecting on the strong employment growth and business development his city has experienced. Hentges noted, “The days of wielding all these financial incentives for getting companies (to locate here) is past.”
Well … maybe not everywhere.
