It’s only April, but investors have already claimed—pending approvals—the Maine Seed Capital Tax Credit program’s entire annual allocation of $5 million, an event that proponents of the program say could hurt the ability of startups founders to raise funds the rest of the year.

The Maine Seed Capital Tax Credit offers investors in eligible early-stage Maine companies a chance to recoup 50% of their investment (up to $500,000) over the course of at least four years in the form of credits that reduce their Maine tax liability (or, in the case of out-of-state VC funds without Maine tax liability, in the form of cash).

The Finance Authority of Maine (FAME), which administers the tax credit program, has already approved $2.7 million worth of tax credits for investors this year and already has applications “in house” seeking another $3 million, according to Chris Roney, FAME’s general counsel. If FAME approves those applications and the remaining $2.3 million worth of tax credits are allocated, that means investors (and the startups courting them) won’t have access to the tax credit again until 2019. (Last year, the $5 million cap wasn’t reached until September.)

Hitting the program’s cap so early in the year concerns some proponents of the program who believe that startup founders who had planned to raise funds this year could find it more difficult as investors will be unwilling to invest until more tax credits are available.

“Seed-stage investing is extremely risky,” said Tim Agnew, a principal of Masthead Venture Partners who helped create the tax credit program in the late 1980s as CEO of FAME. “The Seed Capital Tax Credit is a substantial incentive for investors to take that risk. Without that credit, many investors will either sit out the rest of the year or only invest in more established companies where they feel the potential rewards justify the risk. The result will be a steep reduction in venture capital flowing to Maine businesses for the next eight months.”

Agnew continued: “For some founders the only option will be to bootstrap for the remainder of the year and target a closing in January. That means delaying product development, hiring and marketing efforts.”

Jeff Spaulding, a business attorney with Eaton Peabody in Bangor who works with several startups, agrees.

“The credit is a big incentive and has been part of the calculus in nearly every startup investment deal in the state,” he said. “Some investors will probably wait to do deals, or lower the amount they invest overall. And most companies can’t hold things up for nine months waiting for next year’s credit. So there will be fallout.”

Another unintended consequence of the program’s success is that with out-of-state VC funds now eligible to receive “refundable” tax credits (details on the program are in the last section), it’s squeezing out Maine’s angel investors, the Maine Venture Fund points out in a blog post.

“Funds and angel investors that might not have looked at startups in Maine are taking notice, which was one of the primary goals of the tax incentive,” the MVF post says. “The result has been substantially more capital available to Maine entrepreneurs, which they use to accelerate their growth and increase their hiring. But the heavier use means the program runs the risk of becoming a victim of its own success. As the program continues to attract new investors from outside the state, Maine investors get squeezed out.”

FAME wouldn’t release details of who is receiving tax credits until after all the applications have been approved. However, we know of a few companies that closed rounds in the first quarter—Ourly raised $3.5 million in equity financing, Hyperlite Mountain Gear raised $1.1 million, and Pika Energy raised $1.5 million—so there’s a good chance some of the credits will be going to investors in those deals. If FAME has received requests for $5.7 worth of tax credits, though, that implies there’s been a total of $11.4 million invested in Maine early-stage companies in the first quarter.

FOUNDERS REFLECT

Owen McCarthy has experienced the tax credit’s effectiveness firsthand. McCarthy, co-founder and president of MedRhythms, a healthcare startup based in Portland that has developed a medical device that uses music to help people recover from neurologic injury or disease, said the credit was “tremendously helpful” when his company tried to raise a seed round in late 2016. However, because the tax credit hit its cap in November of that year, McCarthy said they postponed the close until January 2017 because investors would only invest if they had access to the credit.

“At the very early stages of a company, [the tax credit] adds a lot of value. At that point, there are a lot of unknowns, almost nothing built, and only a vision to be executed on,” McCarthy said. “The Seed Capital Tax Credit allows an investor to be involved in an opportunity and entrepreneur they believe in, but with much less risk.”

The equation changes a bit when a company gets into later stages of funding, McCarthy said. So while he does expect the early depletion to stall the progress of some early-stage companies, he said MedRhythms will go ahead with a planned fundraising round later this year.

“We are targeting investors that write large checks that can add value to the company, see the sizeable opportunity, and understand the industry trends,” he said. “It may impact a few of the soft-circled smaller investors timing or interest level but likely won’t impact the timing.”

Susan MacKay, founder and CEO of Cerahelix in Orono, said the tax credit has been “instrumental” in a number of her company’s critical fundraising rounds.

“It has operated for me just like it was designed to do—as an instrument to bridge a pricing gap and as a vehicle to bring outside Maine financing into my company by ‘de- risking’ the deal,” MacKay said.

Both McCarthy and MacKay said they support an expansion of the program.

PUSH FOR EXPANSION

The early depletion of the tax credit program has led to calls for legislative action to expand the program, but the time is short, said Spaulding.

“I fully support these efforts, but it will be difficult. If it can’t be accomplished this year there will be a major push for next year,” he said.

Agnew has advocated for an expansion of the program ever since it began hitting its cap before the end of the year, albeit not as early as the first quarter.

“I hope that the powers that be will recognize that the program has been extremely successful, that it is having a significant impact on company growth and job creation, and that it justifies legislative changes to avoid the problem of the credit expiring so early in the year,” said Agnew.

TAX CREDIT DETAILS

The Maine Seed Capital Tax Credit program allows investors—both individuals and venture capital funds—to recoup 50% of their investment (up to $500,000) in an eligible, early-stage Maine company in the form of tax credits, which can be used over at least a four-year period to reduce state income tax liability. To be eligible, the company must have sales of less than $5 million in the prior 12 months, and it must either be a manufacturer, derive at least 60% of its sales from outside the state, develop or apply advanced technologies, be a visual media production company, or a value-added natural resource enterprise. Investors must also own less than 50% of the business to receive the tax credits. The aggregate investment limit per business is $5 million for which tax credits may be received.

The program was originally created in the late 1980s, but it took roughly 25 years for it to meet its lifetime cap of $30 million, which it did in 2013. The Legislature revived it in 2014, changing it from a lifetime cap to an annual cap. That annual cap equaled only $635,000 in 2014, but ramped up to $4 million in 2015 and to $5 million in 2016 and each year after.

The Legislature also tweaked the program so the tax credits could be enticing to out-of-state venture capital funds, which don’t have any tax liability in Maine. The program now provides out-of-state VC firms (and only out-of-state VC firms) with what are known as “refundable” tax credits, meaning they could be redeemed for cash if no tax liability exists.