Opportunity Funds: Incentive For Investment in Underrepresented Founders
With the recent passage of the Opportunity Zone Legislation and the subsequent proposed regulations that were released on October 19, 2018, private investors have, justifiably, been eager to understand and establish the necessary infrastructure to take advantage of the potentially substantial tax benefits which will accompany compliance with the legislation. While there has been much excitement about the potential tax benefits, a significant though understated aspect of the legislation, is the potential to incentivize investment in the form of angel and venture capital into these traditionally underserved neighborhoods. Though much of the marketing surrounding the potential benefits of the Opportunity Zone program has been based on the legislation’s ability to incentivize capital to get off of the sidelines of the unrealized gains columns of investors’ balance sheets, and instead invested in underserved communities, much of the focus has thus far been based on potential investment in real estate. Notwithstanding this early focus, the legislation also provides a benefit for the investment in businesses that have 90% of their assets in these Opportunity Zones (an “Opportunity Zone Business”). This favorable tax treatment provided for investment in these Opportunity Zone Businesses provides a benefit for angel, venture capital and social impact investors.
By providing an upfront tax benefit in the form of a deferral of the payment of tax obligations until 2026 coupled with a tax basis step-up if such investments are maintained for at least 5 years (with an additional step up if maintained for 7 years) and a 100% tax basis step up if investment in an opportunity zone is maintained for 10 years, the Opportunity Zone Legislation effectively lessens some of the risks inherent with investing in start-up companies generally, but specifically for those start-ups operating in traditionally underserved communities. While angel and venture capital investment are by their nature risky, with participants understanding the potential of losing the entirety of their investment, the Opportunity Fund Legislation serves to provide somewhat of a safety net to those investors, because in the worst case scenario they would be permitted, if investing capital gains into such companies, to defer the payment of their taxes until 2026; and in the best case scenario, they are able to identify and invest in a unicorn for which they will be able to eventually have a tax free exit.
With statistics consistently indicating the scarcity of angel and venture capital to companies founded by black and brown founders, with less than 1% of such funding flowing to such businesses, the safety net provided by the Opportunity Zone Legislation and the built in focus on companies operating in underinvested communities, may inadvertently serve to incentivize funding to more of these companies. While the numbers will still have to bear out with regard to the demographics of the individuals starting companies in these opportunity zones, there seems to at least be some potential for this legislation to provide for increased opportunities for investment in companies founded by black and brown founders, who often may be the companies with products or services in these neighborhoods. As such, this legislation may inadvertently help to combat the oft discussed discrepancy in funding availability for companies founded by this large and growing demographic of entrepreneurs.
This blog was written by Venroy July at Miles & Stockbridge.
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