A Market-Based Approach for Crossing the Valley of Death: The Benefits of a Capital Gains Exemption for Investments in Startups

New companies with high growth potential – and with high potential to create jobs – often struggle to obtain sufficient capital to cross the so-called "Valley of Death" in the process from concept to prototype. With continued economic uncertainty, government funding is no longer a guaranteed solution, and private investors have become increasingly risk averse. According to a report released by the Ewing Marion Kauffman Foundation, both startup activity and investment would be increased by a permanent tax exemption on capital gains on investments in startups held for at least five years.

This idea is embodied in the Startup Act proposed by the Kauffman Foundation in July 2011, in Startup legislation proposed by the Administration, the Startup Act legislation recently introduced in the Senate by Senators Moran and Warner and in a Small Business Tax Extenders Bill introduced this week by Senators Snowe and Landrieu.

In "A Market-Based Approach for Crossing the Valley of Death: The Benefits of a Capital Gains Exemption for Investments in Startups," authors Robert Litan, Kauffman Foundation vice president of research and policy, and Alicia Robb, Kauffman Foundation senior research fellow, argue that this approach would reduce risk and enhance after-tax rewards for long-term investment in these important startups.

Litan and Robb drew on estimates from the National Venture Capital Association, the Center for Venture Research and the Kauffman Foundation to calculate a total baseline investment eligible for the capital gains preference of $10 billion in 2010. Assuming that a permanent capital gains tax exemption would generate a 15 percent increase in the real return of startup investments (relative to the current capital gains tax), this should conservatively lead to a 7.5 percent increase in investment volume: $0.75 billion in additional  investments in new companies per year.

While it is difficult to directly estimate the number of incremental new jobs this additional investment could create, the report offers ample indirect evidence that the amount would be significant.