What State Evaluators Should Consider When Reviewing Early-Stage Investment Incentives

Many states use tax incentives to encourage early-stage investment in high-growth industries, but determining whether these incentives can effectively accomplish the many goals that policymakers often set for them—for example, boosting job creation, investment, and the state’s overall economy—comes with many challenges.

Last fall, The Pew Charitable Trusts hosted a “virtual office hours” event with Ellen Harpel, founder and chief executive officer of the consulting firm Smart Incentives, and Andy Brienzo, principal auditor for the Kansas Legislative Division of Post Audit. The speakers discussed best practices, strategies, and questions to ask when evaluating early-stage venture tax credits for new businesses. Those can include “angel investor” tax credits, which some states refer to as seed investment incentives.

States employ these credits to catalyze financing for startups, but the benefits flow to the investor, not the business receiving the backing. This adds an additional hurdle for evaluators when lawmakers ask whether a program improves business outcomes, because businesses are not the primary beneficiaries.

Harpel presented findings from her firm’s recent report on entrepreneurial incentives. Brienzo shared his team’s approach, as well as the findings and recommendations from its recent angel investor tax credit review. The pair also fielded questions.

Here are five takeaways:

1. There is no standard definition for ‘early-stage investment’ across incentive programs.

Although many states encourage investment in early-stage firms, program rules can define early stage in different ways, making it challenging for evaluators to compare programs across states. For example, the business-age parameters—how long a business has been operating before it is considered ineligible for angel financing under the program—can vary. Kansas’ angel investor tax credit program requires that funding go to businesses that are no more than five years old, while in Minnesota, certain businesses can be up to 10 years old and still qualify under the state’s version of the credit.

“What was called early stage or even seed or pre-seed in one state was entirely different than what those terms referred to in another state,” said Harpel, referring to the more than 200 entrepreneurial-related state programs she reviewed as part of her firm’s 2021 report. Early-stage business activity, she explained, “means something very specific in venture capital terms, [but] it does not mean something specific in policy terms.”

Why this matters: If lawmakers want to ensure that a program encourages investment in certain types of businesses, they should clearly define the types that are eligible so that the program can advance its stated objective. Additionally, when assessing the impact of early-stage financing incentives, evaluators should examine the authorizing statute to determine whether specific investments thought to be encouraged by the provisions reflect the legislature’s goals.

2. Providing incentives to investors does not guarantee high-quality investment choices.

Unlike small-business loans, grants, and job creation incentives, investor tax credits do not offer incentives directly to new businesses, but rather to individuals or firms that make the investment. This means that policymakers intend for the credits to encourage investment that might not take place otherwise. But evidence suggests that these programs can unintentionally lead to lower-quality investment choices, such as projects that might not attract backing on their own and are more likely to fail than those that do not require incentivized investment. There is no guarantee that these firms will produce the returns that states aim to encourage with such programs.

Brienzo cited one potential issue. “The literature in our review supports that [investors] tend not to be professional angels. … [The investors who claim this incentive] tend to have lower screening ability,” he said, which can result in investments that might simply “help lower-quality businesses survive a little bit longer.”

Harpel’s work reflects a similar concern. “The good thing about angel investment is that you have experienced investors helping growing companies,” but she cautioned that inexperienced investors also can qualify for the credit.

Why this matters: If policymakers want to support firms with high-growth potential that generate positive economic impact, they should consider whether programs such as angel investment tax credits are an effective way to achieve this outcome. Other programs, such as incentives that more directly benefit young businesses, may better serve a state’s economic development objectives. Literature reviews that include academic studies and evaluations of similar programs can help to provide the evidence that policymakers need to inform their decisions.

3. Some angels may invest regardless of an incentive.

Many states allow owners, family members, or affiliates connected to the beneficiary business to claim credits under their angel investment programs. For example, the Maine Office of Program Evaluation and Government Accountability found last year that two businesses in the state had received investment entirely from their founders. The investors were awarded nearly $1.4 million in tax credits under Maine’s seed capital tax credit, and “no outside investment was sought.”

Harpel’s research finds that this is not uncommon. “Tax credits often go to insiders, friends and family of the business owners,” she said, which raises the question of whether some of the increase in early-stage investment would have occurred without state assistance. This issue is known as the “but-for” factor.

Why this matters: Assessing the extent to which tax incentive programs influence business decisions is an important factor in determining the programs’ impact. Although states employ a variety of strategies to help key decision-makers understand this “but-for” factor, common-sense assumptions can often be just as enlightening: Policymakers can easily infer that an angel investment program is unlikely to spur new investment if the angels are closely connected to the businesses they are supporting, because they probably would have provided financial assistance regardless. Evaluators can identify these instances through case studies, business surveys, and reviews of program statutes.

4. Early investment is one of many factors that can influence business success.

New startups have many priorities in addition to attracting capital investment. Business leaders may value partnerships and networking opportunities with local businesses, assistance in complying with regulations, and help in developing a marketing or hiring strategy more than an influx of investment. “Most entrepreneurs are not thinking about state and local government policies, programs, even environment … when they’re setting up their firms,” Harpel said. “They’re focused on their business mission and customers.”

Why this matters: States with angel investment programs should consider whether business investment is the most pertinent need for new and emerging businesses, or if other resources—such as workforce development, regulatory process and compliance assistance, or business training programs —might be more valuable to the targeted industries.

5. Analyzing program beneficiaries can yield important data about inequitable distribution of funds.

Understanding who benefits from economic development incentives can help states improve program design and administration to yield the desired impacts. This could mean identifying whether funds are going to the industries, locations, businesses, or individuals intended, or whether certain target beneficiaries are receiving an outsize benefit at the expense of others. Brienzo pointed out that his office “couldn’t help but observe the lack of [equitable distribution] in the investment” across the state. Johnson County, Kansas, for example, is one of the wealthiest in the state. “It received by far the most investment” and had “an outsize benefit at the expense of rural areas and some of the other urban counties,” he said.

Harpel highlighted strategies that can help to encourage use of incentives to benefit a broad range of businesses. “There’s a lot that can be done in terms of awareness, promotion, expanding our economic development network[s] to make sure people are familiar with the program … and redesigning some of the procedures and application forms in place. … That alone could make a big difference in terms of equity.”

Why this matters: Policymakers create incentive programs to encourage a wide range of outcomes. One of the ways in which evaluators can determine whether such programs are well-designed is by analyzing who benefits. This can also identify the flip side—who is not benefiting, which may be equally important—and call attention to possible policy reforms or changes to the way programs are administered.

Early-stage investment tax credits are a common economic development tool, but they can be a challenge to implement successfully. The increasing availability of program analyses will greatly benefit policymakers as they decide whether to create, modify, or end these programs.

Shane Benz researches tax incentives with The Pew Charitable Trusts’ state fiscal health project.