There is no doubt that senior executives of emerging biotechs spend much of their time on the trail of investment capital. The Coalition of Small Business Innovators (CSBI) would like to ease that burden. A study by the group shows that several proposed changes designed to help small R&D-intensive start-ups better use existing tax provisions and incentivize investment in small business innovation would have the dramatic effect of increasing total investment in small businesses by $20.6 billion.

Although we have noted a continuing influx of capital into public companies over the past 18 months, a consequence of their surging stock valuations, the same situation has only just started to spill over to private capital generation. In the second quarter, for example, private biotech companies developing therapeutics raised almost $1.3 billion – a massive 190 percent increase over the amount raised in the first quarter and a 153 percent jump over the $510 million raised in the second quarter of 2012. (See BioWorld Insight, July 8, 2013.)

Despite this uptick many biotech execs feel that venture capital is not flowing as fast as it should. They could be right. According to analysis from BioWorld Snapshots data in July global private biotech companies raised just over $300 million from 17 deals compared with the $325 million from 13 deals in the same period last year, an 8 percent decrease.

It wasn't too long ago that monthly VC deal making was consistently raising about $400 million. For example, from BioWorld Insight analysis, for the five-year period spanning 2006 to 2010 the average amount of private capital raised in the month of July was $421 million; the average amount raised in July for the past three years has dropped to $311 million.

VC Firms Consolidating

The dramatic fall is a reflection of a VC industry in consolidation and their concomitant smaller fund sizes. This conclusion was drawn by an analysis conducted by Thomson Reuters (which recently acquired BioWorld) and the National Venture Capital Association (NVCA). They found that U.S. venture capital firms raised $2.9 billion during the second quarter of 2013 – a 54 percent decline from the levels raised during the comparable period in 2012, which "marks the lowest quarter for venture capital fundraising, by dollars, since the third quarter of 2011."

"The second quarter reflects not just the consolidation of the venture capital industry, but also the overall contraction of fund size," noted Mark Heesen, president of the NVCA. "Many long-standing, pedigree venture firms are heeding the guidance from limited partners and raising smaller, more agile funds. Consequently, dollar values of capital under management are declining from historical levels."

With this smaller pool of available capital the Washington D.C.-based CSBI would like to see some changes to the current tax incentives that would encourage spending on R&D and help the investment climate.

The CSBI consists of 17 organizations, including the Biotechnology Industry Organization, dedicated to stimulating sustained, private investment in small, highly innovative companies focused on the development of new technologies.

The group released a study last week, prepared by Ernst & Young, showing that several potential proposed changes could go a long way in helping small R&D-intensive start-up companies and other small businesses better use existing tax provisions, and incentivize investment in small business innovation.

Like countries such as Canada and Australia, the U.S. has in place tax incentives to encourage spending on R&D. However, the report notes that research-intensive start-up companies are unable to take full advantage of them.

Start-up companies organized as C corporations generate net operating loss carry-forwards because they are in their pre-revenue phase of development and do not have taxable income to offset. As a result neither the start-up company nor its investors in can use the tax incentives generated by their R&D investments.

Potential Tax Changes

The report considers the economic impact of three potential tax changes that would encourage additional investment in R&D-intensive start-up companies and other small businesses. These include:

• An R&D partnership structures proposal would reform the passive activity loss (PAL) rules in Section 469 of the tax code. This would allow qualifying start-up companies to raise money from investors for specific projects and their investors would be able to use tax losses and credits generated by those projects on a current basis. Under the current PAL rules, investors are prevented from using losses or credits from a passive investment, such as an investment in a biotech, to offset their active income, or salary.

• The second proposal would reform the net operating loss (NOL) restrictions in Section 382, allowing growing biotechs to maintain the value of their NOLs during transactions, increasing their value. Currently, new rounds of investment and merger and acquisition deals can trigger legal limits on the use of their R&D deductions.

• A final proposal would extend and expand the qualified small business stock provision in Section 1202, which the report states would permanently extend the 100 percent capital gains exclusion from the sale of qualified small business stock (QSBS). The result would reduce capital gains taxes for dispositions of equity interests in qualifying companies, increase the size limit for qualifying companies from $50 million to $150 million in assets, and extend the exclusion to companies organized as pass-through businesses.

This report finds that, if enacted together, these three proposals would increase total private sector R&D spending by 6 percent in the long run. Their economic impact would be huge – increasing total R&D investment by $20.6 billion and result in an estimated 623,000 jobs.

In a statement announcing the report, Timothy Tardibono, vice president of Public Policy at CONNECT, a regional program that catalyzes the creation of innovative technology and life sciences products in San Diego County, said, "These tax proposals would make it more attractive to invest in pioneering industries, providing the time needed to develop breakthroughs in next generation technologies."