For venture capitalists and startup entrepreneurs, 2023 was a year dedicated to the destructive phase of Joseph Schumpeter’s notion of creative destruction. Silicon Valley Bank collapsed in the second-largest bank failure in American history, 400,000 tech jobs were eliminated in what Wired dubbed “The Great Tech Layoffs,” and dozens of high-potential startups transformed from unicorns into “zombies.”
Destruction is a necessary ingredient to creativity. Not all ideas are good, and not all firms can make it. Economic dynamism is predicated not just on the rapid generation and growth of winning startups, but also on the implosion of failed companies, which frees up time, money, and talent for other, hopefully better, purposes. America has never secured its innovation edge by sustaining the walking dead.
It’s no surprise that the startup industry needed to retrench—that’s been clear to observers for some time. What is surprising, however, is the reaction of policymakers in Washington, D.C., who apparently see this moment of tech-industry weakness as an opportune time to hobble the innovation economy. Take the mess that’s become of Section 174 of the Internal Revenue Code. For decades, this section has allowed companies to expense their research and development costs for software in the current year, which means that salaries paid to software engineers are entirely deductible upfront. That’s a critical calculation for early-stage tech startups, since development costs are high and revenues are low at inception.
But as negotiators were finalizing the 2017 tax reform, they ran into a quandary: they needed to find an accounting gimmick that would add revenue to the bill so that it would be budget-neutral in the ensuing decade and pass muster with Congress’s arcane budget reconciliation process. Among other components, negotiators settled on a poison pill: five years on, starting in 2023, Section 174 accounting benefits would radically shrink, suddenly choking off the cash flow for America’s most innovative companies.
No one considered that the punishing provision would arrive just when startup innovation is shriveling in the face of higher Fed interest rates after the inflation-stoking over-exuberance of the Covid-19 economy. Industry publications and commentators have warned about the impending doom for more than a year. This week, a bipartisan group of legislators offered a path forward, coupling an antidote to the R&D poison pill with an expansion of child tax credits. But with days to go before companies must start calculating their taxes, the prospects are dim that Congress will pass the fix.
Hiring software engineers and technical talent just got a lot more expensive. But that’s not the only negative shift in the calculus of America’s startup economy. Adverse changes in antitrust policy and private-fund advisor rules are adding new burdens to an already-challenging environment.
Lina Khan’s Federal Trade Commission has cracked down on one of the most vital aspects of entrepreneurial success: the ability to exit a company for a profit and pay back founders, employees, and venture capitalists for years of work and capital investment. Under the guise of expanding antitrust enforcement, the FTC has moved to investigate and block several major transactions in December alone—including Adobe’s $20 billion purchase of design software Figma, Sanofi’s licensing agreement with Pompe disease-pioneer Maze Therapeutics, and OpenAI’s tie-up with Microsoft—sending shockwaves across the industry. As IPOs become rarer amid heavy regulation of the public markets, mergers and acquisitions have become the default way for innovative companies to make their exit.
As the FTC has moved to depress financial returns from innovation, the Securities and Exchange Commission has moved to hamstring private fund formation with strict new rules on the benefits that certain fund investors can be offered over others. The rules are meant to improve fairness: small investors in a private fund should have equal rights to material economic and information rights as large investors. Unfortunately, these new rules neglect some of the primary reasons that the largest funds invest in private funds. Some pension funds—among the largest and most important funders of venture capital—need special redemption options to make an anchor investment in a long-term private fund, given their ongoing cash-flow needs. Some investors into venture capital funds are willing to invest more money than they otherwise would to secure proprietary information rights. All parties here—large and small alike—are sophisticated investors supported by strong legal, tax, and accounting teams.
The SEC’s new rules threaten to make constructing new private funds even more challenging in 2024. PitchBook, which tracks venture capital formation and deal data, estimates that last year, approximately 38 percent of VCs disappeared from the U.S. market—defined as conducting fewer than two investments in a calendar year. Frustrating the interests of the largest allocators into the venture-capital asset class will do nothing to shore up that collapse.
The destruction of the 2008 global financial crisis was met with the creation of technology products built on a wave of mobile, cloud, and data platforms that transformed our lives and ways of doing business. After more than a decade of blistering growth and ballooning valuations, it was time for the technology industry to go through a period of retrenchment and regrowth. What no one could have predicted is that the federal government would actively seek to stymie America’s most dynamic industry.
It wasn’t so long ago that Congress and the executive branch crafted policies that helped make the American innovation economy a world leader. R&D tax expensing began with the 1954 edition of the Internal Revenue Code. In 1981, Congress introduced the research tax credit, a system that represents about half of America’s support for the innovation economy, according to OECD data. Congress passed the Employee Retirement Income Security Act of 1974 (ERISA), and the Department of Labor updated the “prudent man” rule in 1979, opening up the venture capital industry to a new universe of funders like pension funds, while a contemporaneous revolution in antitrust theory expanded the pipeline for innovative businesses to exit and return capital to employees and investors.
These policies created the most innovative economy in the world, even amid the disruption of the digital revolution. America is home to six tech companies worth $1 trillion or more, while the European Union’s most valuable tech company, the Ozempic-manufacturing Novo Nordisk, sits just shy of $500 billion. Now, policy changes both intentional and unintentional are aligning to destroy an innovation model that other countries long to clone.
To compete with America, the number of OECD countries offering beneficial tax treatment has nearly doubled over the past two decades, as governments have increasingly recognized the spillover benefits of research-intensive economies. This is particularly evident in semiconductors. Last year, Taiwan initiated a tax credit for semiconductor R&D to stay competitive with the United States after the passage of the CHIPS Act. South Korea’s president has reiterated his goal of maintaining prodigious credits for the semiconductor sector. The European Union is also using legislative and executive action to expand aggressively its presence in the sector.
Silicon Valley must return to the business of creation, get back to building the next generation of technologies: artificial-intelligence platforms, biotech therapeutics, next-generation electric vehicles, space-launch vehicles, virtual-reality entertainment, as well as over-the-horizon tools like quantum computing and nuclear fusion. The process of creative destruction remains sufficient. We don’t need more regulatory adversaries bent on destroying the engine of America’s economy.
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