If Philly becomes an investment hub, it's because of these 2 tiny tax changes - Technical.ly Philly

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Jan. 26, 2015 12:29 pm

If Philly becomes an investment hub, it’s because of these 2 tiny tax changes

Can a quiet 2008 change to the city tax code and its legislative update in 2012 get more venture capitalists (and the startups who follow them) to set up shop in Philadelphia? Years later, it may be too early to tell.

The BNY Mellon building is part of a Center City skyline that could benefit from a stronger investment community.

(Photo by Flickr user Henk Sijgers, used under a Creative Commons license)

Don’t call it a tax break. That makes those involved in this 2012 City Council legislation nervous. But almost three years later, that minor change to the city tax code is a major reason why Philadelphia proper has any chance of developing an early-stage investment community. Even then, there’s still no guarantee it’s coming.

Consider this scenario:

Let’s say you managed a venture capital fund in the Philadelphia region in early 2008, and, with urban enthusiasm growing, you wanted to consider moving your office to Center City. The city has a crummy reputation for its business friendliness and tax policy, but you don’t really know the specific impact on your business, so you float the idea to your accountant. She can’t find comparable businesses that have done the same — there simply aren’t other modern venture capital funds in the city and the handful of serious private equity firms here are shielded by tax-free zones or other one-off perks.

So, as your team does its due diligence, it gets to a curious obstacle: you’re not actually sure how the City of Philadelphia’s Revenue Department would treat your firm under the existing tax code. Here’s the central question you encounter:

  • Is a pool of capital, like a venture capital fund, itself a business that should be taxed as if it is operating in the city or is it something else, simply a temporary way station for money that has or will be taxed in other forms?

In predictable investment hubs like New York City, San Francisco and Boston, most entities defined by the landmark federal Investment Company Act of 1940 are passthroughs, not businesses. But there was less clarity in Philadelphia then, so an investment firm did ask for clarification — while others before had simply avoided the process altogether.

In those heady early days of the Nutter administration, the question was researched and, with little revenue to lose and a precedent set by other municipalities, the answer was clear.

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On Nov. 13, 2008, then-Revenue Department Commissioner Keith Richardson signed a clarification to the city tax code that described investment funds — private equity, venture capital and the like — as simply passthroughs, not independent taxable businesses. Tilahun Afessa, the precise and mild-mannered City of Philadelphia Revenue Department policy director, says so.

But the change didn’t get much attention at the time.

In the fall of 2008, the effects of the Great Recession were far more widely understood — this was only weeks after Lehman Brothers collapsed — and just about every new initiative at a financial institution was halted. The inquiring investment firm lost interest in relocating, and the Nutter administration went about tending to the city’s plunging revenue.

Now fast forward a bit.

By 2011, the partners behind First Round Capital, then based in sleepy West Conshohocken with offices in New York and San Francisco and already one of the better respected funds for seed-stage startups in the country, were looking to raise what would become a new $149 million fund, their fourth.

Cofounder Josh Kopelman — the Wharton alumnus, whiz kid entrepreneur-turned-sneaker-clad investor — was interested in moving First Round to the city for greater access to a growing tech community and the places young people wanted to live.

That 2008 tax code clarification was important, but there was another quirk of how venture capital works that the city tax code didn’t seem prepared to address. This next clarification request was also sent to the Revenue Department, but city lawyers felt it was too far “a stretch” for an agency to change on its own, said Afessa. That’s where a wonky piece of legislation from former Councilman Bill Green, who had also been working on the idea with a real estate investment firm, comes into play.

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To understand the importance, you need an over-simplified refresher on venture capital.

Though other investment classes are included in the legislation (like hedge funds, mutual funds and all private equity firms), VC is most relevant here. Remember, there is both the investment firm (group of people) and the investment fund (pool of cash) those people manage. The investment firm (like First Round) and its general partners (like Kopelman) are compensated by both a set management fee (call it two percent of the fund) and profit sharing (call this carried interest 20 percent). Find a nice video tutorial on the subject from the Khan Academy here.

While the partners often also receive a salary that would be subject to city wage tax if that firm were located in Philadelphia city (just like any other employee of the firm), investors crowed that also taxing the industry-standard management fees would conflict with the spirit of the 2008 Revenue Department clarification that pools of cash ought not be taxed.

“The reality is, a private investment fund has a duty to its investors to maximize returns, so they could not locate here without the certainty that legislation provides,” Green wrote in an email to Technical.ly Philly. With this change, the city lost no more than $5,000 annually, Green said, because there were simply no serious or sizable investment funds here. (Green, who left council last year to join the School Reform Commission, never got his sweeping business tax reform, but he’s “proud” of this and other related tax policy changes.)

The Green bill amended the city tax code to clarify that general partners are not subject to net profits tax for compensation that is “measured by or otherwise based on the financial performance of the entity” — namely, those percentage-based management fees.

During City Council finance committee hearings held in March 2012, DreamIt Ventures cofounder David Bookspan and city Revenue Commissioner Richardson, among others, testified in favor of the legislation. Gabriel Investments managing partner Richard Vague called it a “monumentally positive thing,” in a recent interview. The bill passed Council 16-1, with only Councilman Curtis Jones dissenting.

It was unique for a municipality to require a strategy like this because, of course, “most local jurisdictions do not have the business and income receipts tax,” said Afessa of the Revenue Department. More often these conversations happen at the state level, and many have these exemptions, like Colorado, Georgia, Kansas and New Jersey, he said.

Now, clear as day, if you look to move your venture capital firm to the city, you know that the funds you manage and the percentage-based management fees you receive are not subject to municipal business tax, as is the case in much of the country.

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Six years after the administrative change and three years after the legislative change, you might reasonably think that surely an impact would have been felt if there was going to be one.

Not so, say local investors.

“It’ll take five to 10 years more, easy,” said Vague of Gabriel Investments, in his slight Southern drawl, sipping on a can of “diet anything.” Of course, businesses can blossom without traditional investment, as a bootstrapping culture and national fundraising suggests, but surely it’s part of the mix of an advanced and diverse ecosystem. You want investors as part of your entrepreneurial density.

Most regional investment firms have long-term leases and the lifecycle of an early-stage investment fund is often 10 years, even if the most active firms may have multiple funds operating at one time. What’s more is that the first generation of early-stage entrepreneurship capital grew up here as a suburban thing. But if you look at the early-stage capital that is first to follow where younger firms are growing, there is a trend to spending more time in the city, if not formally incorporating as a city entity.

Consider the following examples:

  • First Round Capital made the move to University City in fall 2012, raising its fourth fund ($149 million) there and then quickly raising a fifth ($175 million). As is the industry norm, the funds are both Delaware incorporations but First Round (the firm) can hold governance meetings in Philadelphia without fearing unclear and costly tax implications. So far, First Round may be the only early-stage investment firm managing a fund in Philadelphia following the legislative change. (Full disclosure: Technical.ly Philly is a tenant in the same building as First Round.)
  • DreamIt Ventures has operating offices at 3401 Market Street in University City but the celebrated accelerator program is incorporated in Delaware, like its second fund, said managing partner Karen Griffith-Gryga. “Having that exemption is important but this is not the only tax that impacts decision making,” she said, referencing how much a company liquidity event (like being acquired) comes into the strategy.
  • Gabriel Ventures has glassy offices on the 25th floor of 1735 Market Street where Vague and Managing Director Holly Flanagan are often based, but is incorporated, as is its second fund, in Bryn Mawr, where Vague’s fellow managing partner Scott Tarte works. Gabriel has “a couple years” before looking at a third fund. (Vague said a similarly-named incorporation in state records from Lebanaon, Pa., is not related.)
  • Genacast Ventures is a seed investment firm managed by Gil Beyda that partners on a fund with Comcast Ventures. Beyda, a sort of one-man band, splits his time between New York and Philadelphia. Beyda declined to comment for this story.
  • MentorTech Ventures, the seed-stage investor focused on startups with Penn ties, has both its firm and third fund ($24 million) incorporated in Ardmore, Pa., according to state records, but has offices at the University City Science Center. Its fourth fund was rumored for 2014, but MentorTech Managing Director Brett Topche said “look for something from us in 2015.”
  • SeventySix Capital, the oft-renamed investment firm from Wayne Kimmel, is incorporated outside the city but Kimmel has become a familiar face at city tech events, though he is no longer working from Rittenhouse coworking space Benjamin’s Desk.
  • Robin Hood Ventures, the only angel investment group listed here, has effectively been headquartered at the University City Science Center since Director Ellen Weber herself moved into the city (Fitler Square) in October 2009. The group is incorporated in Chester County, as are most of the new partnerships it forms when making investments

In all these cases, there is some footprint in the city.

There is also some later-stage money in the city, though largely already sheltered from city taxes. It was a colleague of Michael Forman, the CEO of mid-market lender Franklin Square Capital Partners, who called for University City to become the region’s new investment hub. Large asset fund manager Independence Square Capital is based alongside healthcare-focused seed investor Quaker Partners, thanks to both firms sharing prominent cofounder Ira Lubert, at the Cira Centre, which is considered a Keystone Opportunity Zone (KOZ) tax shelter until 2018, despite complaints.

Forman told the Inquirer that he’d stay in the city after the KOZ expires thanks to the tax code changes. A handful of other investors interviewed for this story cited rumors of other suburban firms looking seriously at city relocations thanks in part to both the community’s development and the tax code clarification, but none would speak on the record, citing active negotiations.

So what other investment firms could be looking?

Osage Partners is based in Bala Cynwyd, New Spring Capital is in Radnor and the offices of Next Stage Capital are across the street from a Walmart in Audobon, Pa. They might all be interested in getting closer to a community of city-based entrepreneurs.

There’s also the iconic Safeguard Scientifics, whose founder, Pete Musser, and his gravitational pull are almost entirely responsible for the region’s Route 202 suburban investment bent. (More recently, Safeguard has also been a big factor in luring a couple of health IT startups to the region.) Still, Safeguard’s long-held campus in Wayne makes a satellite office addition more likely than a move.

Boston’s OpenView Ventures and Cincinnati’s River Cities Capital have both done deals or looked at deals in Philadelphia or partnered with Philly investment firms. They could both spend more time here.

These two tax code changes, in 2008 and 2012, are instrumental in making that possible financially, said Vague, while the city’s tech community growth during that time has made it likely, culturally.

“You have to be where the companies are,” said Gabriel Ventures’ Holly Flanagan. Gabriel gets a lot of value from its Center City offices, which also host portfolio companies Squareknot and Cloudamize.

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For all the apparent positives, there’s sensitivity to speaking publicly about these tax code changes, lest they be used as fodder for culture warriors.

When First Round Capital made the splashy announcement that it was moving its headquarters to University City from West Conshohocken, managing partner Kopelman was careful to focus on the proximity to student entrepreneurs and being part of the city-centered tech community’s growth. But at a launch event back in September 2012, he did briefly mention the legislation as an important factor.

Kopelman declined to comment for this story, as did most other investors contacted.

They don’t, it seems, want it to appear as if they’ve been catered to by city officials.

Several investors pointed to the original media coverage of the 2012 Green legislation: the Inquirer, the Philadelphia Business Journal and, yes, Technical.ly Philly all referred to the policy change as a “tax break.”

“Giving a ‘tax break’ to a bunch of one percenters isn’t exactly good press,” said one investor, who asked not to be named. But this simply isn’t a “tax break,” he said, echoing several other investors and at least one city official. Green, the former city councilman, understands the subtlety, calling it “an exemption” that follows the norm elsewhere.

This, they say, was a clarification of what most modern taxing authorities already say about business levies: tax fixed compensation, not variable pools of cash.

“The greater the physical density of capital sources and companies, the more attractive a place becomes for startups,” said Bookspan of DreamIt. A tax break is a one-time windfall for a specific group, but this is an important policy clarification that will make it easier for a broad array of businesses to work here, he said.

Nationwide, this trend of density is happening back toward the urban environment, where entrepreneurs and the younger tech talent they covet are choosing to live.

Bookspan points to the satellite offices and relocations of a handful of storied investment firms in the Bay Area: they’re leaving Silicon Valley’s legendary, suburban Sand Hill Road for the more urbane San Francisco. Nearly 65 percent of Silicon Valley VC investment in 2013 happened in San Francisco proper, compared to less than 7 percent in 2003. City-based investment is a national trend that Philadelphia has lagged behind.

These changes to the city tax code are a vital step forward for investment firms, said Bookspan. (The city wage tax remains a lingering concern for wealthy investors, he added, who often have more assets to protect and therefore a greater incentive to avoid taxes by choosing to live in the suburbs than the often younger and relatively less wealthy entrepreneurs they fund.)

To speed the process of investment clustering, Bookspan has called for “an early-stage investment tax-free zone,” which sounds somewhat like a more focused Keystone Opportunity Zone. But that may be happening already.

“Progress is all about density,” said Ellen Weber of Robin Hood Ventures. “So the more funders and the more startups and supporting organizations that are close by, the better.”

Where that density happens can change. After the dot-com crash in 2001 made the storied Radnor Hotel less a tech-investor hotspot, Weber took a lot of meetings at Minella’s Diner in Wayne. “Today the clear line is for the city,” she said.

“It’s no secret why industries cluster together,” said Richard Vague of Gabriel Investments. “It starts because it makes things easier; then you have to be there. For now [for early-stage investment], you kind of gotta be in Center City at least a little bit of the time. I can’t imagine the shift won’t continue.”

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Christopher Wink

Christopher Wink is a cofounder and Editorial Director of Technical.ly, the local technology news network. In that capacity, he is a co-organizer of Philly Tech Week, Baltimore Innovation Week, Delaware Innovation Week and other events that bring smart people together. Previously, Wink worked for a homeless advocacy nonprofit and was a freelance reporter for a variety of publications. He writes regularly about news innovation and best business practices on his personal blog here and curates a personal monthly newsletter of ideas and links here. The bicycle commuter loves cities, urban politics and squabbling about neighborhood boundaries.

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