Eric Ostertag is the kind of entrepreneur states love.
A physician with a doctorate in molecular biology, Ostertag has launched three ventures: Transposagen, a genetic engineering company; Vindico Pharmaceuticals, which specializes in nanotechnology; and Hera Testing Laboratories, Inc., another biotechnology firm.
The companies began in Philadelphia, but all three are now based in Lexington, Kentucky. The state offered Ostertag a matching grant for high-tech companies that win federal Small Business Innovation Research awards. “I moved my companies because of the incentives,” Ostertag said.
Now the state is offering Ostertag’s investors an incentive too: a generous new tax credit for “angel” investors who invest in Kentucky-based small businesses.
Ostertag, who recently raised $1.5 million in early funding for each of Vindico and Hera Labs, said several of his investors took advantage of the credit. “The credit was not the deciding factor for the majority of my investors,” Ostertag said. “But I do believe the law will help Kentucky companies get more investments than they otherwise would have received.”
So far, the credit has proven highly popular.
In January 2015 – the program’s first month – 40 angel investors announced plans to invest $2.8 million into a dozen Kentucky start-ups.
According to Katie Smith, Director of the Department of Financial Incentives for the Kentucky Cabinet for Economic Development, the tax credits available for 2015 are already almost fully subscribed. Currently, the state is allotting $3 million per year for the credit, which gets its funding from a $40 million pot previously established under the Kentucky Investment Fund Act.
As of April 14, 2015, Smith said, the state had approved nearly $2.4 million in tax credits on behalf of 121 “certified” investors and 47 qualified small businesses. Overall, the program now has about $19 million left for future years.
According to the Tax Policy Center, 29 states now offer tax incentives to angel investors. Kentucky’s credit, however, is among the more generous. The vast majority of states offer credits equal to 20 percent to 30 percent of investments, while New York’s credit ranges from 10 percent to 20 percent. In other states, such as Maryland, lawmakers are considering proposals to enact a similar credit.
Some critics have argued that angel investor tax credits reward investors for behavior they would have undertaken anyway. But Jonathan Ortmans, writing for the Kauffman Foundation, cites anecdotal evidence that angel investors are in fact motivated by these kinds of fiscal incentives. Ortmans writes that after the enactment of a variety of incentives for angel investors in Europe, the number of angel investors grew dramatically from just three markets – in the United Kingdom, France and Germany – to 28 countries.
Angel investor tax credits lessen the risk of investing in start-ups, says Dean Harvey, Executive Director of the Von Allmen Center for Entrepreneurship at the University of Kentucky. “These are high-risk deals because we’re talking about early-stage companies,” says Harvey. “Many of them are pre-revenue, so there’s not a lot of history to go on. The tax credit helps more people get comfortable with these kinds of investments.”
Angel investors also play a critical role in the funding and growth of small businesses and start-ups, Harvey says, one that traditional venture capital firms and small business lending can’t fill. “Many entrepreneurs aren’t ready to go to the bank for a loan because they’re a start-up company and don’t have anything to secure that loan with,” says Harvey. “They don’t have the revenue.”
And as for venture capital firms, their interests don’t tend to be in small smart-ups looking for seed funding. “Traditional venture capital in today’s world is typically about higher-level investments at a much later stage of the company,” said Harvey. “Many venture capital firms will look for early revenue; they’ll look for customer validation; or they’ll look for game-changing technology. And if they make an investment, they will invest millions of dollars.”
Angels, on the other hand, are more likely to provide smaller sums of seed capital. Of the investments approved for the Kentucky angel investor tax credit, the largest was $500,000 while many were in the $10,000 range.
Angels also bring more than funding, says Harvey. “More importantly, they bring contacts and industry knowledge,” he said. “They bring experience and are willing to serve as mentors to entrepreneurs, which can be more valuable than access to money.”
An analysis by the University of New Hampshire’s Center for Venture Research found that in the first two quarters of 2014, 30,270 early-stage companies received about $10.1 billion in angel funding nationwide, contributing to the creation of 96,860 new jobs.
For states like Kentucky, which doesn’t have a robust venture capital environment like Silicon Valley, incentives like an angel investor tax credit can help jumpstart an entrepreneurial economy, Harvey said.
“Kentucky is very dependent on small businesses, perhaps more so than many states,” says Harvey. “So finding those entrepreneurs with good ideas and then supporting them when they need that early stage funding is an angel investor role.”
Anne Kim is editor of Republic 3.0 Follow: @Anne_S_Kim