Minnesota’s Angel Investor Tax Credit Is Dead — And Why That’s A Good Thing

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As you read the words that form this opinion, know that we have a vested interest in the success of Minnesota’s technology entrepreneurs and the startup community at large. It’s formed with only the longest and strongest views in mind — extending beyond blind, blanket support in any form just for the sake of it.  Not all support is created equal as some methods have unintended consequences, moral or practical trade-offs to consider.

The end of an era is here for Minnesota’s most popular corporate welfare program, at least the one that hits closest to home for so many of our readers and their business dealings.

The Angel Investor Tax Credit (AITC) was born in the spring of 2010 as a part of a broader bill among new laws pertaining to government sponsored economic development.  The method used political means to influence the private business community by taking money from all of Minnesota tax payers and funneling it to a very select group of individuals known as accredited investors — defined as those who have a net worth of a million dollars plus or earn in excess of $200k/year.

The “credit” component equated to a 25% kickback on an investors tax return, up to $125k/year per person, on select startup investments made through the program. It was only available to the few at the expense of the many, and while accredited investors may not be within the top 1% statistically, they are surely among the top 10% of income earners across the state of Minnesota.

For those with strong beliefs one way or the other about trickle down economics, there could not be a more explicit example in action than the AITC premise: if the government stepped in to bend the tax laws in favor of the wealthy, then a broader ripple effect would occur for all.

With a 25% discount available on their dollars, the theory is investor risk would be reduced, potential IRR increased, and/or purchasing power extended.  The intention here would be to stimulate their appetite for action, to push them past the tipping point by manipulating the math into their favor, to incentivize accredited investors to invest more money, more often.

As a hypothetical consequence, AITC certified startups could now position themselves as more attractive when pursuing investment or seeking that extra concession to close a deal.  For these ventures, it was like going on sale by offering a discounted stake without having to actually pay for the price break since that kickback was indirectly covered by all the taxpayers, not the startups founders or shareholders themselves.

Recipients of this investment money (that they otherwise might not have) could then, in turn, spend their new/extra capital on resources such as hiring more employees to increase production and probability of success out there in the market.

For enabling this scenario to exist in the first place, the government gets what it wants: public relations and the impression of new job creation to expand the local tax base and revenues necessary to perpetuate its own business model.

And for the public, those not part of the technology industry, not entrepreneurs or investors, they indirectly get…the promise of a better future for Minnesota as a result.

Everyone wins, right?

Suddenly, Minnesota’s Department of Employment and Economic Development (DEED) became a intermediary at the table, party to an otherwise private transaction, picking winners and losers when determining which private companies and investors were qualified to participate in the scheme.

For seven years now, Minnesota’s tech investors and entrepreneurs generally embraced the government intervention as a solution to their free market challenges, touching many different Minnesota corporations, local and national investors over the years.

At the highest level, the welfare spanned 450 different companies and 2,000 unique investors with one hundred million dollars in credit kickbacks tallied up by the end of this year.  It was said that investors came off the sidelines, new capital was deployed, startups got funded that otherwise wouldn’t have, companies stayed instead of leaving, and overall the directive was working as intended.

And some jobs were made: they key metric scored by AITC’s political advocates to subjectively judge efficacy was 1,168 related jobs when last reported at the end of 2016, which breaks down to a public cost of $77,637 per job.

 

The AITC will now be laid to rest at the end of 2017 based on a new and different law introduced by Minnesota’s political actors, one that does not legally permit DEED to take money from all classes and redistribute it to the highest in the name of innovation.

Welfare lobbyists mourn as this development disrupts their ability to continue receiving millions of free dollars, forcing them to step up or step aside for the savviest of investors, many of which never needed or accepted welfare in the first place.  On the startup side, surely there will be pain in the process of accepting a new norm, one where the carrot must cultivated 100% by the entrepreneurs themselves, no more public support for their private profit pursuits.

Combined, the net effect will initially look like a reduction in the quantity of deals done and dollars invested, as far as Minnesota tech is concerned, considering that approximately 50% of the AITC transactions were Internet/hardware/software oriented.  As more time passes, the market will adjust on its own and the best startups will naturally rise to the top, continuing to capture the necessary funding without crutches, as they have been doing all along.

In essence, pulling out the safety rug out from underneath will weed the weak while the strong will soar. It’s a future of quality over quantity, one where companies and their investors that prosper will be fortified to withstand the globally competitive marketplace in which they operate because they’ve earned it, not because it was propped up by political programs to appear larger than life.

This is exactly how business functions at the ground level where the product meets the market and pure Darwinism, like it or not.

The AITC existence only meant that the local market could continue along in its dysfunctional ways without facing the facts of what’s broken between startups and investors.  Consider that investment — whether it comes from customer sales or investors — can either be found in abundance or in scarcity, and is always an effect, never the cause.

Money is a measurable byproduct of economic value creation, therefore a lack of value created in the market correlates closely to lack of sales and investor appetite, or vice versa, it never fails.

This happens all the time and is the way of the venture world where a deal stands on its own merits and is priced accordingly, or it doesn’t, and the failure rate is high at the tip of the startup spear because is bar is set by the market. When the market itself isn’t supporting the fundamental value proposition, via revenue — or investment capital in the case of AITC — that’s a warning sign that something isn’t right in the business model.

Greater alignment between these factors (product-market) now means that entrepreneurs will find out faster if their venture has what it takes to succeed in the real world, to create actual value, and offer sustainable employment opportunities that are derived naturally, not watered down government sponsored economic development.  Real jobs come from strong companies that are proving their value based on true market demand from customers and capitalist investors, nothing less.

Built to last style entrepreneurship happens when companies are created using their own resources, not off the backs of the public sectors labors.  Perhaps the most entrepreneurial environments by default actually have the least amount of government involvement  — the two variables could be inversely related.

And perpetuating a business culture that is tied to the volatility of politicians and their antics, one that reinforces dependency, now that’s just unnecessarily risky.  If so much of business is about reducing risk, then why would any entrepreneur or investor intentionally create a scenario whereby their prosperity is contingent upon the whims of politicians? Or an environment that becomes dependent upon having a long term, essentially permanent, welfare system that becomes status quo. The whole point of introducing a stimulus should be to one day stop it because whatever was off in the first place has been figured out and such subsidies are no long deemed necessary for the market to function.

No more AITC means no more political intermediaries, less time and energy spent lobbying, less rhetoric about ‘support for startups,’ which frees up time and space for becoming an active and/or better investor who doesn’t need tax credits to make a favorable return.

For those afraid of what happens next as the corporate welfare runs dry, consider what it means to support startups in a true entrepreneurial environment where deals price fairly, judged only by those with the knowledge to know and courage to participate.

A place where corporate life, death, and resurrection are naturally occurring phenomenon, just like nature itself.  A thinning of the herd is about to occur as a new generation of makers, doers, creators — such capitalistic risk takers emerge.

The AITC’s demise is good for Minnesota tech because it brings out the best entrepreneurs and investors by forcing everyone around to adapt or perish, freely letting the tenets of capitalism decide who wins and loses, not the government.   It’s good for Minnesota tech because it makes for an entrepreneurial community focused more on real value creation, not the pretense of it, nor one distracted by inflated job numbers.  It’s good for Minnesota tech because it reduces dependency on bureaucrats, and brings the two parties together that matter the most to sort things out like the adults they are. It’s good for Minnesota tech because there are sufficient numbers of capable entrepreneurs and active investors to adequately represent this great state without welfare handouts in the mix.

Whether you agree or not with this opinion set forth, doesn’t change the circumstances that exist and isn’t really important relative to what’s next. There’s nothing else left now for everyone to do but be optimistic about a futureless AITC. What matters from this point on, is if and how Minnesota’s entrepreneurs and investors decide to evolve their attitudes and actions to meet this new reality.

Everyone has a choice, it’s one they can fully control, and the opportunities abound for those who choose open hearts and minds.

ONWARD.

*Thank you to Jeff Nelson at DEED for his consistent and professional public service over the years.

Comments

  • Thompson Aderinkomi

    Thanks for this Jeff. Although I have long agreed with the principles you outline here I never thought of the AITC in this way. Your analysis is correct. And even if it is not, since we all know trickle down economics does not work, this is reason alone to sunset this program. Perhaps the MN government should have taken a stake in these startups so that tax payers could see a return. But that would be a risky way to invest tax dollars.

  • Alex

    As an Accredited Investor that has benefited from the AITC and entrepreneur that has sought to raise capital for my own start-up in MN, I take issue with the premise of the author that this is “welfare” and the snarky dismissal of the trickle down benefit of spending and investment is just plain naive.

  • http://thebigidea.com/ LittleDuke

    #MEOW

    We sought AITC status for Silicon Prairie Online in 2017 at the request of one of our potential investors — ironically they have yet to actually invest…however it did encourage several others to increase their offers to take advantage of it.

    One correction: The credit is available for NON-ACCREDITED INVESTORS thanks to MNVEST, but it’s a “MIN-MAX” offering requiring an investment of $10K which is the maximum a non-accredited investor can do for any single offering.

    That stated, I will relay my solidarity with the author in that I ALSO agree that it’s corporate welfare — and that in general whenever I hear the phrase “trickle-down” — I can’t help but think of “peon”

    Is this going to change the behavior of ACCREDITED investors and discourage them from investing in new ventures? I doubt it.

    At the end of the day, “capital ALWAYS flee’s to it’s highest rate of return”

    But honestly? If they want to pout about it and sit several rounds out, I know the other 97% of us would like a shot at investing in deals via MNvest. It’s time to democratize access to capital and let the crucible of the free market pick the winners and losers.

    -dvd

  • Daren Cotter

    The scenario described:
    Wealthy investor invests in ATC-eligible company and gets 25% of investment back from the State of MN in a kickback (i.e. “welfare.”) An assumption is made that wealthy investor keeps those dollars. Conclusion: transfer of funds from taxpayers to wealthy investor (who didn’t need it).

    Consider this alternative framing:
    Wealthy investor decides to invest $X from their net worth into startups, with or without ATC. If wealthy investor receives money from the ATC, (s)he reinvests those dollars into additional startups. Wealthy investor’s cash position is not increased due to ATC, but more dollars are invested into startups as a result. Conclusion: transfer of funds from taxpayers to (primarily) Entrepreneurs.

    The merits and efficacy of the ATC program can be debated, as can any public policy. IMO it’s more accurate to describe the program NOT as “welfare” for wealthy investors, but rather a stimulus program to benefit Entrepreneurs.

    As champions for the MN startup community, shouldn’t we be in favor of any policy that greatly benefits Entrepreneurs?

    • Rob Weber

      Yes. We should. There angel tax credit was a reasonable plan, and if studied over a long enough horizon, it would have more than justified itself.

  • http://tech.mn Jeff Pesek

    Thanks for those who have left opinions of their own so far, it’s good to put things out there.

  • Rob Weber

    What if the state just mandated that 0.5% of its pension funds go to new VC’s in the state focused on only investments in the state? Right now, the 2-3% of investments the state pension funds go to are almost all entirely out of the state.

    The thing that pissed me off the most is if the company went out of business after the credit was issued, the tax credit had to be paid back. That was absolutely stupid rule to put in place. The whole point of the credit should be to get investors to take risk more, not to penalize them when a business doesn’t go down.

    Also, the $77,000 per job number is bullcrap. You can’t look at these kind of investments in a 7 year period. That means more than half the investments are less than 3 years old. VC’s look at 10 year periods per fund. For something like this, needs to be like 20 years. Over time, this $77,000 per job will probably go down to like $10,000 per job as new companies have time to grow.

    The even bigger issue than funding is talent development in our state. The vast majority of local universities and colleges, many of which are state-funded, are absolutely failing when it comes to teaching for the skills that will have jobs tomorrow.

    • Darren Cox

      You are SO right, Rob. A couple of other thing that aren’t mentioned are: 1. This is absolutely NOT the end of corporate welfare for new or startup businesses. To do that, we would have to eliminate things like Tax Increment Financing and JOBZ zones, which give the very wealthiest of investors MASSIVE tax breaks and do very little to increase the overall tax base of the areas where they are targeted. PLus, unlike the AITC, there is no added penalty to the investor if the business doesn’t succeed.

      2. You know as well as I do that most start-ups can’t afford dedicated resources for every task, so we entrepreneurs hire contractors to do most of what needs to be done. Coders, marketing, staffing/sourcing and sometimes even sales are frequently done by individuals who aren’t employed full-time by the companies enjoying the benefits of the AITC.

      As for my last company, even though we raised a significant amount of money (and participated in/benefited from the Angel Investor Tax Credit (AITC) program) we had more than 35 contractors employed at some point during the build-up process, but never had more than six full-time employees. This wasn’t because we wanted to keep from paying the administrative and health care costs of full-time employees. Instead, it was because we were required to be good stewards of the investments made in our company. We simply didn’t need, nor could we have ever afforded, 35 full-time employees as we were building our company and securing our first customers.

      Having said that, there are tens-of-thousands of people who prefer not to be employed by a single company. They enjoy the freedom and relative security of being able to choose who they work for and how much they need to make in order to fulfill all of their financial obligations. This also affords many of them the time to work on their own ideas and inventions, which, in turn, often result in new companies sprouting up. The gig/contractor ecosystem is too complicated to quantify in a simple “FTE Jobs” number and even f you could, you’d never be able to fully account for the various levels of economic impact of the money being spent.

      • Rob Weber

        Ah yes. Definitely good point regarding contractors.

        By the way, the idea I mentioned about the State of Minnesota dedicating a small percentage of their investments to tech funds… I found out there is already at least one state int he Midwest already doing this, Illinois. They have a program called ILGIF (https://www.ilgif.com/investment-policy/) Anyone wonder why Chicago has so many more VCs than the Twin Cities? We need an MNGIF program and over time, this could be solved.

  • Dave Mao

    First of all, thank you to Jeff Nelson, who has been a true and stalwart champion of startups. Jeff, I don’t know what this means for you, but I hope you can continue to stay connected to startup space.

    I know this article is a few days old, but I commend Jeff Pesek’s courage in taking such a strong stance on a really controversial topic. I share much of his perspective, but I’ve been too chicken to speak up about it publicly for fear that it would make me seem anti-startup or anti-investor. In truth, I’m pro both of those things, I just happen to believe the AITC, the way it was drafted, was a flawed program. This largely boils down to the stated primary goal of the program, job creation. I strongly believe that the most valuable startups actually ELIMINATE jobs — or the nice economist way to say it — they create value by freeing up excess capital or labor by making production more efficient.

    The AITC, though well-intentioned, was implemented in a way that gave investors some really perverse incentives. It distorted the market in ways that I don’t feel like writing about in detail, but would be happy to draw out on a napkin and discuss with anyone over a coffee or beer. But here are some of my random thoughts on the matter:

    -Startups are in a struggle with each other for two limited resources: capital and talent
    -Founder talent attracts capital, capital attracts early-hire talent
    -Talent is the far scarcer resource — there’s enough capital, if you have enough talent
    -Portions of the AITC made it more favorable to invest in lower-risk companies, as Rob Weber pointed out
    -AITC-funded companies were subsidized in the battle for talent, yet had lower risk/return profiles
    -This perpetuates the low-risk, low-outcome startup environment that is the hallmark of the Midwest.

    !!! We have the talent and the capital in our own back yard to do better, folks !!!

    The REALLY good companies never needed the AITC, so the real beneficiaries of the program are the “good-not-great” (GNG) companies that raised money when instead they should have gotten the market signal of “fail and try again.” Each one of these GNG companies consumes the limited resources of our startup community: talent, media attention, patience of angel investors — and worst of all, they contribute to they high amount of noise in the environment, crowding out the signal of the best companies and making it hard as an investor to cut through to the real deals.

    So I, for one, am happy to see an end to the program. I am optimistic that smart angels will continue to invest in startups in MN, and now their incentives will be properly aligned with the founders: long-term returns, not short-term guaranteed payouts.

    I’m happy to meet in the school parking lot at 3:15 to fight about this if anyone wants to :)

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