Photo by spike55151 on Flickr.

Tomorrow, the DC Council will vote on a bill to give investors in tech companies a huge tax break. Taking steps to build the tech sector and diversify our economy makes sense, but this tax break will simply not actually stimulate more technology investment.

The Gray administration proposed the bill, the Technology Sector Enhancement Act, this past spring.  It has some good provisions: for example, it will remove a requirement that tech companies locate in special zones to receive start-up tax breaks. We need startups everywhere, not just in a few places.

But the centerpiece of the legislation reduces the capital gains tax for DC investors in DC tech companies from 8.95% to 3%. The rationale is to encourage more investment in tech companies, but it won’t work.

Venture capitalists don’t choose investments based on capital gains taxes

I own a software company in Tysons Corner and have worked with several venture capitalists over the past decade. It is inconceivable that these investors would avoid investing in a company that otherwise would produce a tenfold return simply because the capital gains would be taxed at 8.95%.

Most venture funds look for companies that could potentially grow big and make back 10 to 30 times the initial investment. Instead of trying to make a few percentage points on each investment, venture captalists figure they’ll lose money on most of the startups, and then make their profits with the occasional home run.

Let’s say an early-stage fund has $10 million, and invests an average of $200,000 in 50 companies. Its goal is to make a multiple of 3, which means it wants its investment to be worth $30 million after taxes at the end of 10 years. But every company won’t be worth 3 times as much. Instead, it might expect only to make money on 10 of those 50 companies.

To make $30 million, it will need each of those 10 successes to be worth 15 times as much as when they invested. If the fund pays 3% capital gains tax, they need a multiple of 15.5.  If the fund pays 8.95% capital gains tax, they need a multiple of 16.5. 

Does anyone seriously think that that difference will bring in additional investment for DC tech companies?

The Gray administration also argues that reducing the capital gains tax rate for tech investors will keep them in DC.  In Virginia, capital gains tax rates for tech investments is 0%. 

But investors aren’t going to fund a DC company that they believe less likely to succeed just because, if it does, it would only have to be worth 15&frac12 times as much instead of 16½. They are looking for companies most likely to make it to the stage of getting bought or going public at all.

Also, venture capital at any stage is regional, not confined to a county.  In fact, most investors in DC tech companies live outside of DC. 

What is a tech company?

If this tax cut passes, it will create a loophole that is big enough to drive a truck through.  Why?  The definition of a technology company is such that, according to an analysis of the DC CFO, many companies would reclassify themselves as tech companies in DC to enjoy this loophole.

The CFO testified that the “negative impact cannot be reliably estimated at this time, but it could be substantial.” 

If the goal of this policy is to increase revenue by keeping investors in DC, then why limit it to tech companies? This tax loophole won’t contribute another dime in investment to DC tech companies, and will only make it harder to reduce tax rates for everyone.

Mayor Gray created a Tax Revision Commission, led by former Mayor Anthony Williams, to recommend broad-based tax reform. Let’s wait for the commission to finish its work instead of undercutting its with a poorly-conceived tax loophole.

If you agree, use the form below to tell the council to hold off on this tax loophole.

Ken Archer is CTO of a software firm in Tysons Corner. He commutes to Tysons by bus from his home in Georgetown, where he lives with his wife and son.  Ken completed a Masters degree in Philosophy from The Catholic University of America.