In the United States, the majority of states compete for startups, talent and venture capital investment. Ironically, investment policies that states implement to spur innovation can actually end up altering it negatively. SMU Cox Finance Professors Nuri Ersahin and Ruidi Huang and co-author Naveen Khanna analyze the effect of state investment tax credit policies on startups and venture capital (VC) investment. “We were surprised to see that reputable VCs reduce their investments when these investment tax credits are offered,” Ersahin says.

The research considered states that offer investment tax credits to attract venture capital and startups. Not all states offer the inducements, for example, Texas and California. Research shows that states spent $8 billion in tax credits from 1989 to 2019.  “As empiricists, we wanted to see how competition affects the VC market,” Ersahin says. “There are so many moving variables which makes it hard to identify what is impacting competition among VCs.”

VC behavior

The introduction of investment tax credit policies has had some interesting effects on how VCs invest. Huang says that more reputable VCs are being crowded out because good startups choose to work with less reputable VCs. The serial founders of start-ups, those with good track records and street cred, look for better terms from the investors. Those investors are most likely the less reputable ones who want to establish themselves.

These policies cause some shift in VC activity moving to states where this competition isn’t so heightened. “In investment tax credit states, the returns of VCs are reduced given these competitive effects,” says Ersahin, “so they move to states where they can have higher returns.”

Interestingly, Texas was not in the study’s list of states offering these investment tax credits. It attracts start-ups and economic activity owing to its competitive market dynamics. Huang notes that states only offer these programs when they want to attract investors. Two other states known for having their own vibrant tech industries, California and Massachusetts, are also particular cases, with California absent the list and Massachusetts only to start those programs in 2017.

More than money

Ersahin aptly suggests that attracting VCs is more than just attracting capital. “When it comes to VC activities, this includes monitoring, staging of investments, and syndication,” he says. There are different aspects of investment. One effect of states offering the tax credits is that VCs “stage” more often, i.e., the time period between investment stages is reduced; they also provide smaller investment amounts. Given that the returns are smaller in “treated” states, i.e., those offering the credits, VCs want to monitor the startups more closely and determine the impact and performance of the investment case. Huang says, “That basically means the investors want to keep the portfolio companies on a tighter leash.” In other words, investors hasten their expectations of the startup’s investment in states with investment tax credits.

The significant finding, Ersahin states, is that reputable VC are crowded out. Another implication for Huang is the diversification of reputable VCs in this competitive dynamic, an area in which the researchers are currently exploring. VC activity is typically concentrated within a geography, that is, location specific. Huang offers the example of many VCs originating from Menlo Park, California. They then expand to places such as Austin, Texas. “So larger, more diversified VCs can retreat from competition and re-surface where there is less,” he adds.

The quality of capital that VCs bring is important, according to Ersahin. The VC world is about relationships, so monitoring, advice, and professionalization becomes important. These intangible services that VCs offer are a net benefit to the economy. The withdrawing of reputable VCs’ activity is not good for a state, Ersahin notes of the policy implications. Huang agrees that it is bad for states to lose good VCs. “The better VCs are ones that have the next IPO—the next Facebooks or Apples of the world.” The other unintended consequence is that talent then leaves too. Thus the very innovation a state wished to attract is driven out.

Better policy

“Every policy has its pros and cons,” Huang says. “However, in my opinion, it’s better to have a policy in the first place.” The best recourse is to make better policy and more informed decisions. The Inflation Reduction Act is one such policy on the federal level. Ersahin mentions that in a global context, “many times a successful policy in one country does not necessarily translate well in another.” Differing countries may not reach the same level of success.

“The result of a policy is actually hard to predict,” Ersahin says. “It’s very tricky.” A policy may have good intentions but crowd out those types of firms specifically targeted. Huang echoes the idea that an intention to attract capital and talent may have different results. “We have to question everything that seems obvious,” Ersahin concludes. “So you incentivize competition, talent and so forth, but what kind of competition are you creating? As economists, we need to question everything.”

The paper “The Impact of Competition on Startup and VC Behavior” by Nuri Ersahin and Ruidi Huang of Southern Methodist University’s Cox School of Business and Naveen Khanna of Michigan State University is under review.

Written by Jennifer Warren.