CMM May 19th, 2010
With all my travel, I’ve been off the radar and away from my blog for the last few weeks. I’ve been meaning to dedicate some time to this issue, and now that its coming down to the wire in DC, I’ve forced myself to spend a few minutes on the topic. I’m writing about the discussion in DC to change the tax structure on venture capital carried interest from capital gains to ordinary income. I’m hopeful that logic and good economic sense will prevail in this discussion, but hey, who knows these days? If they change VC carried interest from capital gains to ordianry income, the unintended and downstream consequences will be dire.
Background
I previously wrote on this issue on December 10th. You can find that post here.
Also, here is a really solid post from Jason Mendelson, a VC (Foundry Group) in Builder, Colorado.
From the legislative perspective, a change to carried interest taxation from capital gains to ordinary income for all asset classes was included as a “pay for” in the Tax Extenders Act of 2009. This bill is designed to provide a short term tax break for big industry and passed the House of Representatives with a clause to increase taxes on carried itnerest for all asset classes. Fortunately, the senate version of the bill did not include carried interest as a revenue source. Unfortunately, the health care reform legislation that passed created a $30 billion shortfall and put carried interest as a pay-for provision back on the table since many of the identifiable sources of revenue have been fully tapped. Mind you, the Tax Extenders Act of 2009 was written to provide short term tax extensions for large corporations. Now, a long term tax penalty for those who foster small business growth and job creation is being presented as the solution. You can read more by visiting the public policy page for the National Venture Capital Association (NVCA).
More than 1,700 stakeholders from VC and start-up communities urge protecting VC carried interest. See press release from NVCA here.
More than 1,400 CEOs, company founders, and entrepreneurs support preserving capital gains tax status for VC carried interest. See press release from NVCA here.
How are VCs compensated? What is carried interest?
Let’s spend a couple paragraphs and provide a little perspective on compensation in the venture capital industry. Typically, senior staff (i.e. general partners, fund managers, etc) in a venture capital fund receive compensation in two ways. First, they receive an annual salary that compensates them at a base level. In my experience this is typically a healthy salary, but it may not be competitive with the salary many of these men and women would demand if they worked in other industries. Also, this compensation is taxed as ordinary income at 35%, just like the salary most anyone earns.
The larger motivator of performance for senior staff is the carried interest benefit (Investopedia article here) they receive on the returns of the fund. Most funds are structured in a way that all paid-in-capital is repaid to limited partners as a primary obligation, before the senior staff receive any payouts. After that principle amount is repaid, the remaining amount is split between the general partners and limited partners as “carried interest.” It’s important to note that their is no guarantee of this return, it typically occurs over a long period of time (8-12 years, by my estimate), but has unlimited potential upside based on the performance of the fund. This serves to keep the senior staff motivated to work for the long-term goals of fund performance. Currently, carried interest is taxed as capital gains at 15%. The rationale has been that this return is not guaranteed, is directly attributed to investment performance, and is earned over a long period of time.
To be clear, I am not “venture capital senior staff” but I’d like to be one day (in the not too distant future, hopefully). I’ve spent three years working in a venture fund, and while I’ve loved it, I’ve seen our senior staff work incredible hours into the late night and weekend, spend weeks at a time traveling, and do an excellent but difficult task of balancing their personal and professional lives. All of this is done for years without any guarantee that the long-term carried interest benefit will even materialize. I don’t want to provide some knee jerk commentary on how adjusting this tax rate effects my career plans, but this is certainly something I’ll be thinking about.
Why is this a big deal?
Aside from raising taxes an incredible 133% in a single action (would any industry do well with that kind of radical adjustment to its tax structure occurring overnight?) let’s look at the downstream effects of having a healthy venture capital economy. Venture capital backed companies represent more than 500,000 jobs in our country, and have added thousands of new positions each month through the recession. This is only a small piece of the pie, as it doesn’t even consider the publicly traded companies that originally received venture investment. Those companies–including HP, Microsoft, Apple, Xerox, etc–are estimated to represent 11% of America’s workforce. Take into consideration the thousands of smaller supporting companies that exist as a product of the industries these companies have created, and the over all economic impact is staggering. According to the Small Business Administration, over 60% of workers are employees of small businesses. What does all o this mean? According to a 2009 Global Insight study, venture-backed companies accounted for 12.1 million jobs and $2.9 trillion in revenue in the United States in 2008. America is envied across the globe for its economic engine because no other country has proven to be as innovative, and entrepreneurial. This gives America the flexibility, resilience, and strength that puts us in the driver’s seat for the world economy.
Some people take issue with the idea that multiple tax rates exist. For the sake of discussion and background, I’ll explain the theory of having a capital gains tax rate. The theory of capital gains is that we should encourage those activities that most spur stable long-term economic growth. Having a capital asset class that is dedicated to the creation and growth of companies is a critical part of accomplishing that goal. Allowing carried interest to be treated as capital gains allows rewards job and wealth creation, and it also allows more capital to be available for continued investing.
Ultimately, tweaking the economic model that drives venture capital investing is like cutting off your nose to spite your face. Trading off short term tax relief for big business on the back of long term tax burden to economic agents of entrepreneurship and small business doesn’t make sense. Where does most job growth come from? Small business. If you strangle off the agents that support small business, you effectively take a critical piece out of the entrepreneurship and small business ecosystem.
Don’t stream, who knows what the effect might be? There has been discussion by some of our foreign competitors to adjust their tax structures to completely exempt VCs from start-up investing. Would you like to see our economic engine gone to Russia and China? There is already data showing an increase in VC investment activity overseas.
Misconceptions
Venture capitalists did not cause the economic recession we are currently experiencing, but we have certainly felt the effects of it. I’ll let smarter and braver heads than mine go about explaining who did.
Venture capitalist do not operate the same as billion dollar hedge and buyout fund managers. We invest in private opportunities, not the public markets. We typically manage smaller amounts of capital and are highly involved and engaged in our investments. Our investments are small businesses with incredible potential. While many of them fail to survive the turmoil of being a start-up, the ones that do historically create jobs and wealth that greatly outweigh the losses.
Venture capitalists do pay ordinary income taxes on their salaries, the same as most every working man and woman. The capital gain tax status is assigned only to those returns earned as a result of effective investments. As I said before, the time horizon for these returns is long-term and undefined. In addition, there is no guarantee of these returns.
