VCball

Speaking up More about VC Carried Interest Taxation and the Destruction of U.S. Innovation

The debate about taxing carried interest reminds me of the following poem by  Martin Niemöller in 1946:

"In Germany, they came first for the Communists, And I didn’t speak up because I wasn’t a Communist;

And then they came for the trade unionists, And I didn’t speak up because I wasn’t a trade unionist;

And then they came for the Jews, And I didn’t speak up because I wasn’t a Jew;

And then . . . they came for me . . . And by that time there was no one left to speak up."

So I am going to speak up once more about this subject on raising taxes on venture capitalists and I believe, on entrepreneurs and the people that join startups.

One of the commentors, Stephen Larson, to my prior post, mentions that this VC carried interest treatment as capital gains is a "loophole"; I appreciate the comment deeply, but I very respectfully disagree and give him credit for sparking my thinking on this.  This idea of loopholes and fairness of  a low current carried interest taxation policy is a common misperception among politicians and the press and I want to talk a bit about that.

I think it's the heart of the issue.  Many VCs themselves think of the carried interest taxed at capital gains as a "loophole" and don't want to speak up, as they are embarrassed a bit about their success-- or worse pilloried in the press as an example of a rich fat cat that doesn't want to pay higher taxes.

Taxing "carried interest" at a capital gains rate is not a "loophole".  In their infinite wisdom, historically, the IRS regulators, and tacitly, by the Congress, have agreed that "carried interest" should be treated as if it's a long term asset that a VC owns, and doesn't earn like income over time.  The Congress is having second thoughts about that which is why this debate is happening now.

Try the following thought experiment:

Suppose a entrepreneur starts a corporation, and invests $50,000 in it.  Then they raise $100,000,000 by selling 80% of it in preferred stock;  preferred stock means the investors get paid first, and is quite typical structure with startups.  Then the entrepreneur sells the corporation for $300,000,000 after 5 years.  Should the entrepreneur who continues to own the 20% piece that he owns, pay capital gains tax of 15% or ordinary income tax of 35%?

Today the law is 15%, as these are long term capital gains. 

Now change the word "entrepreneur" to "VC".   

Is that OK in your book if a VC creates such a company, and generates capital gains this way? 

Because if you are ok with that, then that's exactly what VCs will do.  Right now, VCs use the structure of "carried interest" instead of creating this other type of partnership, but they can easily change that structure, and investors will be happy to comply.   The IRS historically agreed that this is a long term held asset that a VC owns -- a VC isn't paid a fee, he owns the carried interest, just like a minority interest in a company that an entrepreneur owns.

So if Congress changes the law and says if you get "carried interest" we will tax this higher, VCs will simply change the structure to be more like a typical entrepreneurial company structure.  VCs will dissolve their structures, and get LPs to agree to a new structure so that VCs get treated like entrepreneurs.  So perhaps, this point is mute, but I am sure Congress will turn around and try to tax that "loophole", but this time they capture entrepreneurs in that "loophole" as well, taxing them at higher tax rates-- entrepreneurs didn't really own the stock, they got a "bonus" that they "earned" when they sold and it should be treated as "ordinary income".  Sound familiar?

Taxes destroy or reduce whatever gets taxes.  Higher taxation of anything, means you will get less of it.  That's just an economic fact of life.  It's unfair.  There has never been an instance where higher taxes creates a boom in the activity that is taxed, and in fact the opposite ALWAYS happens.    Reduce taxes on SUVs and guess what?  People buy more SUVs, even if it destroys the planet. Increase taxes on SUVs, and I can let you guess what happens to SUV sales.

Stephen concedes in his comment that this might be the case; there will be less VC capital if carried interest is taxed higher whatever the form.  He mentions that if taxes are raises on a VC's capital gains then the "vacuum" left by departing VCs will be filled by something else.  Perhaps, he means that angel investors or entrepreneurial sweat equity will fill the void.

Those dollars that used to flow into VC,  will go into more mature companies and debt instruments, and fewer Americans will be employed by VC firms.   Angels will not fill the vacuum, and sweat equity only goes so far.  There will be less enterpreneurial activity in this country; those dollars will go elsewhere, and those people will work elsewhere is lower paying and slowing growing economic opportunities.   It also means that money will flow to other parts of the world where high risk capital and high end entrepreneurial talent are treated better.  It's no accident that Europe has virtually no venture capital industry, given the crushing taxes on wealth and especially on capital investment in technology.

And ironically, as I also mention in my prior post, this is not really about fairness in the sense that this policy means less taxes to the government.  Ironically, a lower tax on startup investing net generates MORE taxes to the government, given the massive creation of higher paying jobs.  It's a bit counter intuitive but the tax base that VCs and entrepreneurs create hugely benefits the economy, and pay significantly more amounts of taxes ultimately than what would happen if there was no or less VC activity. 

This is about politicians finding a political football with great sound bites, with words like "loopholes for fatcats" or "nurses and firemen pay less tax than fat cat private equity investors".   It sounds great on TV, and it might make you more popular, but it's stupid economic policy to tax at a higher rate this entrepreneurial activity.  No politician will every say "Let's tax entrepreneurs more".  It's easier for a politician to say, "Let's tax those rich private equity guys more", not realizing that indirectly this will include all VCs and a good percentage of entrepreneurs.  In the end, entrepreneurs will bear this burden, and the millions of "unborn" companies that never get funded in this "vacuum" of VC money and talent.  We will all bear this burden.

What blows me away, is that politicians (like Charles Rangle of New York, Charles Schumer of New York, Hillary Clinton of New York, Barney Frank of Massachusetts, and Nancy Pelosi of California) that represent New York, California and Boston, where 90% of these pools of venture capital and private equity exist, want to tax their own constituents more.   

Any other politician would defend their region, or at least bring resources to their region and support their local industries.  Texas politicians would never suggest a higher tax on those "rich fat cat" oil developers in Texas; Florida politicians would never suggest a higher tax on retirees.  Detroit politicans would never suggest that a higher tax on car producers is a good idea.   Personally, I am an independent that supports pro-growth politicians that defend their regions interests.   Lets elect politicians, Republican or Democrat, that supports their regions economy and their nation's long term interest. 

Taxing venture capital and entrepreneurship in America at a higher rate is about the stupidest thing, outside the destruction of the SBIC program and the invasion of Iraq, that this country has ever done.  Ironically, a veto of this legislation, would be probably be one of the shiniest moment of the Bush administration with the most lasting impact on this country.

It takes a bit a bravery to take this stance, but it needs to be said, for our future, and our childrens future.   Those that are too old in the industry, don't really care that much; those in the VC industry that already have built wealth, at best are trying to do something, but at worst, fits their political bent toward higher taxation of all kinds, or kind of like the idea of raising taxes on the profession as this will diminish competition and incentives for new VCs to emerge. 

Some entrepreneurs, if they consider this issue, see this whole carried interest tax as more of an us vs them type of thing, when in reality its very much and us vs us thing.    There are efforts out there by the NVCA, but it needs to be said louder by all of us, both VCs and entrepreneurs and those people who care about our future economic prosperity.  There are lot of stupid things this country can do.  Innovation is the one thing that gets us out of all the other stupid things we do.  So if we kill innovation, through taxing VCs and entrepreneurs more, I fear for our future far more than short term stumbles on other economic and policy fronts.

You might recall the T-shirt "God, please give us just one more bubble" that was popular in Silicon Valley during the last recession.  I pray that we don't cripple our abilities to innovate for generations to come (not just this generation), and in our infinite wisdom, we tell our elected officials to back off on this one.  It sounds like that message is getting heard, but I hope we don't blow this one, as the blowback will be felt for a very long time.  I know this might sound over the top, but I think the economic leadership of the U.S. itself is at stake.  That's how important this debate over taxation of VCs and entrepreneurs really is. 

So, if you can make an impact, now is the time to do so, and speak out, before it's too late.
 

Don't Kill the VC Golden Goose! Why Raising Taxes on Carried Interest Doesn't Make Cents

On this blog I rarely wax political.  However, I am in a unique situation to comment on this carried interest tax debate: as a VC fund manager myself, and recovering entrepreneur; as a economics and public policy wonk as an undergraduate; and a holder of both business and law degrees where I studied tax policies and their business impact on our economy, particularly when applied to technology innovation and venture capital, generally.

When I saw the recent press that Congress is contemplating raising taxes on venture capital fund managers by increasing taxes on what is known as “carried interest”, my heart sank.   It sank, not just because I recently launched a VC fund, but because of 1/ the huge ramifications of the U.S. economy if this legislation ever comes to pass, and 2 /the potential loss of future tax revenues from the yet to be born industries that venture funds are critical to the process of forming and 3/ yes, it's unfair.   And for some reason even some of my fellow well intentioned VCs somehow think raising taxes on VC fund managers is a good idea.

Allow me to explain a bit further.

1/ Economically, this is a dumb idea

Half of all economic growth the past 2 decades is directly attributable to entrepreneurial activity, much of which is venture capital backed. The other half is population growth.  Furthermore, a substantial portion of technology companies on the NASDAQ and S&P 500 at some point took venture capital financing. If you don’t believe me, look it up.

To make this more clear, over a 9 year period, my last VC fund generated about 2,000 fairly high paying high tech jobs in the New York metro area, which had a multiplier effect of creating at least 4,000 total jobs in perpetuity; our new fund which is 5X+ bigger could create 20,000+ jobs in perpetuity.  To give you a sense of what kind of impact a VC fund has, a new $500M stadium in NYC would create about 10,000 jobs for 1 year, and 1,000 jobs in perpetuity.  Do you want to encourage that, or discourage that VC fund job creation activity?

To give you another perspective, venture capital investing has held steady at around $20B a year.  That might sound like a lot.   However, in the financial markets this represents less than 1% of all investment activity in the economy.  Given the *huge* long term effects VC funds have on the economy, and the lack of ability to "import" venture capital (it's very hard to do as almost all VC investing is local), it's hard to argue that we should disincentivise VCs and would be VCs from raising such funds.

Raising taxes on VCs will result in the inevitable reduction in entrepreneurial and, thus, economic activity, dramatically.   

Why?

Because raising taxes reduce whatever activity gets taxed, and VCs have a disproportionate impact on the economy, as I noted above.

And while you might think that every VC is wealthy and should be taxed to the hilt, it’s a little known fact that about half of all early stage VCs lose money—these are the VCs that are the most important ones to our economic well being, the ones that do the earliest, riskiest and hardest stage investing. That means there is a substantial likelihood that after investing and waiting 5 to 10 years for a return, half of all VCs will not only not pay capital gain taxes, no matter what the rate, they won’t be in business and will no longer be VCs.   

Another little know fact, is that, despite the perception that raising a VC fund is a walk in the park, over 95% of “would be” VCs, after years of effort, fail to raise a VC fund.   Even after they are successful, raising future funds isn't a cakewalk either, as oftentimes, for early stage VCs, it's not clear after 5 years if their portfolio of companies is going to return lots of money to investors.   In other words, we need to keep incentives high for VCs to raise funds—because raising a fund is very hard and often ends in failure.

Would be VCs are not stupid, and they know these cold hard facts before they start their journey on raising a VC fund-- and they will respond to incentives, just like entrepreneurs do and all rationale economic beings do, and decide more often that risk/reward of raising of fund is not out weighed by the expense and cost of failure.   

And if we have fewer would be VCs we will have fewer VCs. Period. There is no question. This is an economic fact like gravity: raising taxes on all VCs will result in fewer VCs as would be VCs decide that the risk/reward of being a VC isn’t good enough and established VCs reconsider their continuing their profession, given the incentives.  There are a lot easier ways to make money in the world than being a VC.

In many ways, the creation of the U.S. venture capital industry, unique in the entire world, is the one of the best things economically this country has done right.  And ironically, it's because of our tax code in some ways. People come from all over the world to study our laws and tax incentives to figure out “how we did it”.

Earlier this decade, the government decimated the SBIC program by eliminating the preferred equity program which launched the VC industry in the U.S. in 1958.  It was essentially a program that gave VC fund managers access to funds on a 2:1 matching basis; for every dollar a VC could raise, they could recieve $2 from the government on loan basically.   The vast majority of VCs owe their start in some way to that program.  The direct result of the destruction of this program, was that in 2006, only 5% of venture funds were "emerging managers" (or in other words successful "would be" VCs), which turns out to the lowest rate on record and has historically been as high as 10 to 20%.  Raising taxes on VCs will cut that already depressed 5% rate in half, meaning that replacement funds as older managers retire will not occur.   

Adding to this pressure, a good percentage of successful VCs end up raising bigger funds (investors tend to want to give more and more money to managers that have done well, naturally), which increases the need to give incentives for early stage VC fund formation just to replace the older now bigger funds.   A clear indicator of this negative effect is that seed stage financings are near an alltime low as a percentage of VC investing. 

In my view, given the weight that early stage VC fund formation plays in economic growth, over the mid and long term, this proposed rise in taxes on VCs would be the final nail in the VC industry coffin. It could have as big an impact as Smoot-Halley Act which touched off the Great Depression.    Frankly, it's already happening as an effect of the reduction in the SBIC program mentioned earlier, as would be VCs stop forming funds, and decide to do other things with their careers.

The benefits to our economy accrue to us all for having a vibrant VC industry. These benefits far outweigh any perceived unfairness.  Even if it seems a little unfair, that *some* people make a lot of money in the VC industry, let's not forget that a lot more people lose a lot of money, and their careers to boot, and need a big incentive to overcome the obstacles of raising a VC fund.     Let's not screw up this VC fund formation thing up and destroy the goose that laid the golden egg for the sake of perceived fairness and a "soak the rich" mentality. Some rich should be soaked I guess, and I leave that up to the politicians determine what percentage of our GDP should be run by the government.  But let's not soak the VCs whose positive risk taking activities of convincing ordinarily conservative investors to back even riskier, often relatively young entrepreneur, so benefit our economy to the extent VCs do, in such a dramatic fashion.

2/ Financially for the U.S. Treasury this is a dumb idea, as tax receipts will fall from this tax increase

The U.S. Treasury would lose tax revenues by raising taxes on VCs. This will happen because of the depressing effect on growth in our economy mentioned earlier that will occur from increase of taxes on VC fund managers and the inherent reduction in VC activity; hence, tens if not hundreds of billions of dollars of future tax revenues will be lost if we raise taxes on these fund managers.   If you take Google alone, a famous VC backed company, the taxes that Google will generate for the U.S. Treasury in the past year will pay for a century of capital gains treatment for VC fund managers-- and that's just one company.  Go ahead, name a well known tech company and you'll likely find a VC fund manager backing them, so it’s not just Google, but hundreds and thousands of companies which owe their existence to the venture capital industry.    Bottomline: for every $1 we tax VC fund managers, apply a negative tax receipt from lost of never born industries and businesses of at least a $1000. I am not exaggerating, and before Congress raises taxes they should do the math as well.

3/ It’s totally fair for society to tax VCs at the lower capital gains tax rate we use for entrepreners and at risk capital

Entrepreneurs receive a lower capital gain treatment on their founder shares and options; in our infinite wisdom we believe it’s fair as a society to incent entrepreneurs to take the risk of starting up or joining up as a manager to a new venture.    Some of the arguments against low capital gains tax treatment on VC carried interest include that VCs use "other people's money" that it's a fee income "bonus" for success.  The same arguments could be used on entrepreneurs.  Entrepreneur also use "other people's money" and technically you could call their gains "ordinary income" as it's a "bonus" without risk of actual "capital".  We should continue the tradition of giving VC funds managers a similar tax break that we give entrepreneurs, as their efforts are long term in nature, are very entrepreneurial, and we all benefit as a society from these efforts. VCs are entrepreneurs too.

If as a country we believe we should increase capital gains generally or on wealthy people generally, and not just on the biggest wellspring of economic activity, the VC industry, well then that sounds fair to me.  Fair, but stupid economically to generally inhibit people from investing in our economy, but that's another issue.   But it's even stupider (yes I know that's not a word), to throw the VC industry under the bus in an effort to somehow "get" some of these wealthier people.  The law of unintended consequences kicks in *way* too hard, and will backfire in a big and very predicable way.

4/ The government shouldn’t dictate to private enterprise how it allocates profits and losses among partners

If I am not mistaken, partnerships have historically had the right to allocate profits and losses as they see fit.  So long as the tax gets paid, the government shouldn't give a flip how it's divided up.  That a partnership sees fit to reward some of it's partners in the form of a higher share of the capital gains is the very principle of what makes a partnership a partnership.  The last thing we need is the government to get it's nose into a business structure that has worked, so long as the government gets paid all the taxes are due it. In this situation, if VCs weren’t paid a carried interest, generally 20% of the capital gains profits, the LPs themselves would pay only capital gains to the government, not ordinary gains. So if the LP shifts those gains to another partner, that partner should also pay capital gains, not ordinary gains.  Why should the government care how that tax bill is split up?

5/ The VC industry is the engine of U.S. economic growth.

So, in conclusion, let's go back to economics.  While we lose U.S. jobs in a variety of sectors due to foreign competitive and the laws of competitive advantage among other reasons including technical progress, the U.S. venture capital sector is creating huge new ones; if we shut off the VC industry, who and what is going to replace those jobs?  Magic?

And here's the worst part; it's not Boston or Silicon Valley that will suffer as much, as the regions of the country where VC is still not strong, like in the Midwest, the South and the Southwest.  That's where there is the biggest need to encourage would be VCs to raise funds-- and if we raise taxes on VC fund managers generally, those regions of the country can just about say goodbye to any prospect of having a VC presence, as it's hard enough to raise a VC fund in a region known for it's venture industry, let alone in a region that has little of it.  VCs need the lower capital gains tax to incent them to start in these more difficult areas even more than other more VC populated areas.

I fear for our country if we do further direct damage to the VC industry, as we will also impact the entrepreneurial community adversely and destroy our future economic selves.  On a financial basis, on an economic basis, on the basis of having a free economic system, as well as on a fairness basis, raising carried interest taxes on VC fund managers just doesn't make any sense-- or cents.

It looks shiny, but, let's not kill the golden goose.

P.S. If you agree with the sentiment, please comment or take a moment to link to this post and send a message to the people in Washington that can change the course of this debate.