About Venture Capital

The federal tax code bends over backwards to encourage investment by taxing it very preferentially relative to earned income. The round of tax changes signed by the President this week gilded the lily with yet another round of tax breaks designed to do just that.

But, maybe tax rates on profits from investments aren't really a good tool for achieving that end. As long as an investment is profitable and the tax rate is less than 100% there is some incentive to make that investment. And, as long as the return on investment is taxed similarly for all different kinds of investments, there is no really obvious reason that tax rates should affect the amount of investments made in the aggregate very strongly.

Generally speaking, one can't easily substitute earned income for investment income. A particular person has a certain amount of abilty to earn income and a certain amount of funds available for investment. Perhaps lower tax rates on investment will encourage people to invest rather than consume, but the famous paradox of thift says that while it may be in some individual's interest to save in hard times, it may not necessarily be helpful for everyone to save more rather than consuming in economic hard times.

There is a quite fundamental and intractable problem with a loan based approach to financing young businesses. They have a relatively high rate of failure, which means that banks making loans to them share in a big downside loss risk, but also I potential for immense growth, which banks don't share in, hence the unattractiveness of debt financing for young businesses.

The alternative, of course, is to make equity investments in young businesses.

No country in the world has a big business equity investment sector as large as that of the United States.

We have divided our banking system into two parts. Commercial banks make loans, mostly as principals although sometimes reselling loans in a secondary market, with money borrowed from depositors and other banks and funds invested by their shareholders. Investment banks facilitate the process of securing loans (in the form of corporate bonds) and equity investments (in the form of initial public offerings of stock) by serving as brokers between firms that need money and individuals and institutional investors who have money to invest in "public offerings." Investment banks also broker similar arrangements where only small numbers of institutional investors and high end individual investors are allowed to invest and the investments aren't as easily bought and sold in what are called "private offerings."

But, investment banks are an expensive way to finance businesses that involve costs sufficiently high that they only make sense as a way to get very large sums of money. Also, raising money from "the public" only works well for businesses that are basically turnkey operations where investors don't have to monitor their investment very closely to be sure that it continues to be managed well.

Commercial bank lending and lending by finance companies, turns out of be a pretty decent substitute for corporate bond offerings for smaller scale debt financing at a quite affordable cost. But, the same is largely not true in the case of equity financing.

A company that wants equity financing in smaller amounts than are economically to raise with a public offering of stock usually turns to a venture capital firm, or if the amount is smaller, to a small number of individual "angel investors" who are often successful entraprenuers in the same industry themselves. Smaller amounts still are typically secured from the owner's personal resources, and investments by family and friends.

The amount of equity investment available from venture capital firms and from angel investors is much, much smaller than the amount available in the public offering market, and was particularly hard hit during the financial crisis.

Venture capital firms typically invest in businesses that have already established themselves to some extent with less formal investment arrangements, and are typically focused strongly on businesses with very rapid growth potential in very rapidly growing industries, with an eye towards putting money in and then recovering it by making a public offering or sale of the developed business to some other big company in a time horizon on the order of about five years. Venture capital firms very actively monitor their investments, typically insisting that management of the firms that they assist put some of their representatives on the board of directors, put some professionals they trust in select management positions and often secure various kinds of business consulting in areas that the venture capital firms see as weaknesses of the current management team.

Angel investors typically buy shares of common stock, sit on the board of directors, routinely visit the firm's facilities and management on a day to day basis, and also have an orienation towards making a profit by selling their interest when a venture capital firm, public offering or sell of the business to a larger one comes along. But, the tend not to be as formal, as intrusive in how the business is managed, or as short term in their time frame for bringing the business to the next level. They too tend to be heavily focused on businesses with extremely high growth potential in industries that are growing rapidly. But, there are typically few formal institutions that help them connect their funds available for investment with businesses that need equity investment.

There a lot of good reasons why equity investing by third party investors is so rare in the small business sector. Gathering together the information needed to make full disclosure in that kind of investment is expensive. And, in a typical stock ownership arrangement, there are lots of ways for the management to deprive the owners of a fair return unless the devote a lot of time to monitoring the investment. It isn't hard to increase compensation to the point where it makes a company look less profitable.

The headquarters operations of franchises and shopping mall leases typically address the difficulties involved in measuring profits by receiving their share of the bounty as a percentage of gross sales, much like retail sales taxes imposed by state and local governments. Shopping malls are effectively making equity-like investments in their tenants by offering lower rent in exchange for a percentage of gross revenues from their tenants.

Still, the weak U.S. small business sector compared to other countries, may in part reflect poor institutional arrangements for venture capital financing of small to medium sized businesses that are not publicly held, particularly from a non-tax perspective.