Recently, I have heard much discussion in Canada and internationally about offering tax incentives to angel investors in life science deals. Typically, these tax incentives are either or both of
(i) Entrylevel tax credits, whereby an investor receives a refund calculated as a percentage of their upfront investment
(ii) Capital gains holiday, whereby some or all of the capital gains tax is forgiven when an investor realizes on (I.e. liquidates) their investment
In my observation, there seems to be an unquestioned belief that these incentives are beneficial, and the focus is lobbying the government and tax authorities to enact the change. The purpose of this article is not examine the latter, but to reconsider whether tax incentives will increase the number of life science angel deals as suspected. Specifically, will they have a sufficient impact on an investor’s expected return to make an otherwise unattractive opportunity seem attractive?
In order to answer that question, I will suppose that most life science angel investors require a compounded pretax annual return of 3040%, which, depending on the tax rate, roughly equates to something north of 25% aftertax. (NB: It should be noted that the disposition of shares are taxed as capital gains, which, in most countries, are taxed at lower rates than other sources of income). This range of desired return is certainly debatable, and I welcome comments from anyone with recent experience raising or investing capital at the seed level.
I will consider a “borderline” investment opportunity before and after the tax incentives to determine the extent of the impact. Suppose an investor provides $1,000,000 to a seedstage startup to conduct preclinical drug development. At the time of investment, the investor believes there are four possible outcomes:
(i) The drug development fails and the company is dissolved for nil proceeds. There is a 20% chance of this happening
(ii) Drug development does not fail but is also not promising. The company is able to divest its intellectual property and data for $1,000,000. There is a 20% chance of this happening
(iii) Drug development is successful and the company enters into clinical trials. The company secures followon funding and within eight years, the company is acquired after Phase 2. The market is not as large as initially suspected, and the return is a 3X. There is a 20% chance of this happening
(iv) The outcome is the same as in the previous scenario, however, the market is quite lucrative, and the return is a 10X. There is a 40% chance of this happening
Assuming a capital gains tax rate of 20%, the outcome for each of the scenarios is as follows. Note that, in the first scenario, the proceeds of $200,000 are based on the tax shield of the loss. For those unfamiliar with taxation, losses and expenses can be offset against gains and revenues, and a tax shield is the amount by which either reduces the balance of tax owing.
Outcome 
Aftertax proceeds ($) 
Probability of outcome 
Weighted ($) 
(i) 
200,000 
20% 
40,000 
(ii) 
1,000,000 
20% 
200,000 
(iii) 
2,600,000 
20% 
520,000 
(iv) 
8,200,000 
40% 
3,280,000 


Total 
4,040,000 
In total, the expected aftertax outcome is about a 4X, which, on an eight year time horizon, is a compounded annual rate of return of 19.07%. Although this is good, it does not meet the hurdle set forth of 25%. So, if a capital gains holiday were to be enacted, would this make the investment sufficiently attractive? Again, the outcomes are as follows. Note that, in the event of outcome (i), I am assuming that the investor is still able to claim the tax shield of the capital loss, which might not be the case, as a tax authority might feel that taxpayer should not enjoy nontaxable gains and deductible losses.
Outcome 
Aftertax proceeds ($) 
Probability of outcome 
Weighted ($) 
(i) 
200,000 
20% 
40,000 
(ii) 
1,000,000 
20% 
200,000 
(iii) 
3,000,000 
20% 
600,000 
(iv) 
10,000,000 
40% 
4,000,000 


Total 
4,840,000 
This equates to a compounded annual return of 21.79%, meaning the capital gains holiday increased the expected rate of return by only 2.72%. Again, this is insufficient to reach the hurdle rate. However, suppose we combine the capital gains holiday with an entry angel tax credit of 20%. In this case, the principal value of the investment is $800,000, which helps to increase the rate of return. (NB: For the first outcome, the tax shield of the loss is reduced by the pro rata amount of the credit, as the credit also reduces the cost of the investment)
Outcome 
Aftertax proceeds ($) 
Probability of outcome 
Weighted ($) 
(i) 
160,000 
20% 
32,000 
(ii) 
1,000,000 
20% 
200,000 
(iii) 
3,000,000 
20% 
600,000 
(iv) 
10,000,000 
40% 
4,000,000 


Total 
4,832,000 
Due to the decrease in the principal amount of the investment, the compounded annual return is 25.21%, which is an increase versus the base case of 6.14% and barely clears the hurdle. If the tax incentives doubled or tripled the expected return, one would expect a serious influx of capital to this sector, but this is clearly not the case. Therefore, in all likelihood, implementing tax incentives would not result in more life science angel deals being done, but rather benefit those deals that would happen regardless. Although this is of merit, it would be up to the government to decide whether the cost justifies the benefit. Without tax incentives, expected tax revenues are $760,000, and with both tax incentives, expected tax disbursements are $192,000, resulting in an expected cost of $952,000.
With that being said, it is important to note two nonfinancial reasons as to why angels might not invest in a deal for which no amount of angel tax incentives will suffice. First, many angels struggle with understanding the life science underlying the business, as well as the business of life science, specifically the regulatory and reimbursement process, as well as provider adoption. Second, there is a generally acknowledged lack of Series A capital in the ecosystem, and it makes little sense to seed a deal for which the prospect of followon funding does not exist. Personally, I believe resolving these issues, particularly the latter, is of greater benefit to the life science startup community than offering tax incentives to angels, although, they are not mutually exclusive.
As always, I welcome any comments or criticisms people have. I am hoping this article stirs a little bit of debate in terms of accelerating earlystage funding.