Abstract

Can tax subsidies prompt investors to fund riskier ventures? We answer this question under a framework in which venture capitalists (VCs) combine outside funding with incentive-based compensation and study a policy change that eliminated capital gains taxes on certain startup investments. Using bunching methods, regression discontinuity designs, and a triple-differences design exploiting industry eligibility, investment year, and holding requirements, we analyze data from 158 thousand investor—firm pairings over two decades. We first identify strategic investment timing, with tax subsidies prompting concentration at required holding-period thresholds. We then document strategic capital allocation, with investments just below the eligibility threshold receiving more follow-on funding than those just above. When and where tax subsidies apply, VCs shift their project selection toward riskier ventures: they increase investments in pre-commercial stage startups and firms carrying pre-existing debt. They also become more likely to invest across state lines, provide a company’s first institutional funding, and invest as sole financiers, while becoming less likely to require equal footing (pari passu) contract terms. In turn, their portfolio companies show higher failure rates and greater multi-year funding gaps. The increased risk-taking yields salient return outcomes: tax-subsidized VC-backed ventures attain high exit values and are more likely to reach “unicorn status.” None of these patterns are observed for comparable non-VC investors receiving the same tax subsidies. Data on board-voting rights and executive turnover suggest that observed outcomes do not stem from changes in post-investment governance or monitoring activities. Our study is the first to show that tax policy can shift entrepreneurial financing toward riskier, more experimental, valuable ventures, with outcomes shaped by investor organizational structure and incentives.