Columbus, Detroit, Cincinnati, Chicago, Cleveland — startup hot spots like these are popping up across the nation as innovation and entrepreneurship are on the rise. However, while momentum is building in the Midwest, several misguided business regulations are stunting the startup community’s full potential. After much discussion with fellow VentureOhio board members, including Mark Kvamme of Drive Capital and the leaders at the NVCA, we’ve identified four key regulations in particular that are throttling growth: the Volcker Rule, Qualified Small Business Stock Rules, Section 382, and the Registered Investment Advisor Rules.
Since Congress and the Trump administration are prioritizing regulatory structure, and tax reform is the premier economic policy issue under consideration in Washington. The startup community currently has a unique opportunity to make its voice heard and influence policymakers as they deliberate future regulations. The time is right to enact changes that can boost the entrepreneurial ecosystem to greater heights and encourage economic growth.
The Volcker Rule
Sparked by the financial crisis of 2007 – 2010, the Volcker Rule was created to prevent banks from taking unnecessary chances with your money. The rule is meant to protect financial stability by prohibiting risky speculative investments — sounds good, right? Though beneficial on the surface, the rule was written in an overly broad fashion and ended up preventing banks from investing in venture capital funds.
When the rule went into effect in 2015, banks stopped supporting venture capital funds, and some even went so far as to sell their interests on the secondary market in order to comply with the rule immediately. Venture capital funds aren’t inherently risky and they’re incredibly important to economic growth and opportunity. By preventing banks from investing in venture capital funds, the rule removed a key source of investment for a number of vital regional funds, which in turn decreased the amount of capital flowing toward innovative entrepreneurs and stunted startup growth. If we can encourage a narrower interpretation of the Volcker Rule and allow banks to invest in venture capital, we can reverse the effects and see an economic boost overall.
Qualified Small Business Stock Rules
Drive American job creation, innovation, and long-term economic competitiveness — that was the goal of the QSBS. The idea was to award a generous tax benefit to investors who provided long-term capital investment to innovative small businesses. It’s no wonder it passed with strong bipartisan support.
Unfortunately, in a well-intentioned effort to prevent abuse of the program, Congress and the IRS created a labyrinth of strict and complex rules on what counts as a qualifying small business for investment. To demonstrate that a particular small business qualifies the investor for the benefit, the investor must adhere to a compliance process that can actually take a toll on the resources of even a Fortune 500 company. This creates hesitancy to invest and undermines the potential of the provision.
If investors could have a better understanding of when their investment is eligible for the benefit, QSBS could be one of the most powerful federal policies for encouraging entrepreneurial capital formation in emerging startup regions. By reducing the complexity of the rules defining a qualified small business, the government could unleash the full potential of the QSBS.
Written in mid-1980s, the loss limitation rules in Section 382 of the tax code are intended to prevent loss trafficking, or the strategy of companies acquiring failing businesses with enormous losses on their books for the sole purpose of using the tax losses to offset other unrelated income. Though intended to prevent large companies from abusing the tax system, the rules often impact startups.
Startups often accumulate net operating losses (NOLs) when using investment capital to build a company. These NOLs can then be used during a future tax reporting period to recover past tax payments. Due to these accumulated NOLs, startups will often trip the Section 382 rules when they undergo a merger or acquisition. This causes them to lose value because their NOLs and research and experimentation (R&D) tax deduction credits are suddenly limited and a penalty on R&D expenditures is imposed.
This plays out to be a tax penalty for investment in innovation and entrepreneurship, negating the effects of Section 174 which encourages R&D through an R&D credit system. It’s time to reform this rule that has become a burdensome tax regulation for startups.
Registered Investment Advisor Rules
These rules require a number of private funds to register with the SEC and undergo a substantial amount of compliance cost to continue functioning. These costs can be six, or even seven, figures annually.
Because of the size of the burden, Congress wisely directed the SEC to exempt venture capital funds from this regulatory requirement, but it let the SEC define what constitutes a VC fund. The SEC took an excessively narrow view of the definition, and as a result, a number of venture capital firms have been subjected to this significant regulatory burden. Most affected have been growth equity funds, or later stage venture capital funds that often provide the capital for hiring and scaling for emerging companies.
To allow the necessary access to capital for proven startups on the verge of scaling, the government should revisit the RIA definition in order to limit the regulatory and compliance burden on the entrepreneurial ecosystem.
Rich Langdale is a cofounder and managing partner at NCT Ventures and the President and Capital Committee Chair of VentureOhio. Before cofounding the Columbus-based VC firm, he was founder, CEO, and Chairman of Digital Storage, Inc. and SubmitOrder.com
Ray Leach is the founding CEO of JumpStart Inc. a Cleveland, Ohio-based non-profit venture development organization. He currently serves as the Chair of the National Venture Capital Association’s (NVCA) Alumni Council and is a founding member of the NVCA’s Diversity Task Force. He also serves on the board of VentureOhio, Invent Now, and the Global Center for Health Innovation.
This post originally appeared in VentureBeat on May 6, 2017