The healthcare industry, which gets a serious boost from venture capital investments, could see even more money start flowing in thanks to a provision in recently enacted Internal Revenue Service reforms.
The provision, part of the Internal Revenue Service Restructuring and Reform Act of 1998 signed into law by President Clinton July 22, allows individuals who invest in small businesses through venture capital funds to sell their stock and roll it over -- tax free -- into another venture capital fund or other similar investment vehicle.
Venture capital funds provide financing mostly to start-up companies. The money might replace or supplement bank loans. The upside to the investor can be high returns; but high returns can also mean high risk.
The change clarifies a provision in the Taxpayer Relief Act of 1997 that was unclear about whether tax-free status extended to investments in small businesses through venture capital funds. The 1997 law was ambiguous as to whether the tax-free benefit could be passed from the venture capital fund to individuals investing in that particular fund. The clarification extends the benefit not only to venture capital funds but also to individual investors in other vehicles, including partnerships such as limited-liability companies. Limited-liability companies can be investment companies in which a general partner manages the investment and limited partners pool their money to make the investment.
The new provision will bring more tax-free investments in entrepreneurial companies, observers say. That's good news for the healthcare industry. According to the Price Waterhouse Coopers National Venture Capital Survey, healthcare accounted for 21%, or $768 million, of the $3.6 billion invested in venture capital funds during the first quarter of this year. Of the healthcare total, 55%, or $421 million, was invested in healthcare services, making it the third-largest venture capital investment behind software and communications.
"The more funds that are available in this type of investment, the more innovation there is likely to be," says Kirk Walden, director of the survey. "The beauty of venture capital is that you are fostering this kind of innovation from the bottom up instead of top down, and these companies are creating value."
The tax savings haven't been quantified yet, but they could be significant to the individual investor, says Mark Heesen, director of legislation and entrepreneurial affairs for the National Venture Capital Association in Arlington, Va. For example, investors who sell their stake after holding it for a year or less and do not reinvest it wind up paying a 39.6% tax. For long-term investors -- those who hold their stock for 18 months or more -- the rate is 20%. With the new provision, long-term investors could essentially defer that tax hit indefinitely.
Observers are skeptical that the clarification will make a big difference in individual investment patterns. Historically, only 10% to 15% of venture capital funds come from individuals. Although the new provision has a huge upside in tax benefits, many investors will still shy away, mostly because venture capital is seen as more risky, Heesen says. Venture capital also can be a hefty investment for the individual; it's not unusual for firms to require minimum investments of $100,000 or more. Pension funds, endowment funds and other large institutional investors are usually the risk-takers with venture capital.
However, John Runningen, principal at Atlanta-based Cordova Capital, says stock market volatility and increasing fears of a major market correction might push more sophisticated investors with deep pockets into venture capital funds.
And even though venture capital has historically been high-risk, returns have been dramatic compared with other equity investments, Heesen says. In addition, venture capital investments are typically held for longer time frames, and investors are beginning to see that investments held longer usually yield higher rates of return. Investments held longer have smaller tax bites, Heesen says.
"The real quick buck isn't always the better buck," he says.
Still, while the tax-free rollover provision might not be a boon to Cordova's business, it will help the 150 individual investors currently in Cordova's four venture capital funds. Cordova started its venture capital business nine years ago pursuing individual investors and has grown 42% annually to $160 million, a third of which is invested in healthcare. Cordova requires a minimum investment of $250,000.
"We do go after individuals," Runningen says. "This (provision) is another arrow in our quiver."
Heesen says some of his members are looking at this provision very seriously and are in the process of setting up funds that specifically target individual investors.
There are some catches to the new provision, however. Investors must hold the stock for at least six months and roll over the proceeds of the first investment to the new fund within 60 days after the sale. Investments also must be made in companies that have gross assets of no more than $50 million.