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.

http://feelthefunc.com/content/binary/3d147899-410d-4b4d-ac29-90817ec12f44/FTF-09-CodeStock_Starting_a_Software_Company_Panel.mp3

Picture of Knoxville area software entrepreneurs Curtis Jones with Voice’s Heard Media, Chris Van Beke with Voice’s Heard Media, and Patrick Hunt with Tingz. Big thanks to the three of them for doing this.

Basically, Q2 of 2009 showed some signs of life out of the IPO market with five offerings, four from into tech and one from non-high tech. While we’ll celebrate those as the first real high technology IPOs since Q1 2008, we can’t over do it. We’re still a long way from the IPO payday; for example, in 2007 there were 86 IPOs for the year. The IPO market imploded in January of 2008, which in hindsight was probably an early sign of the financial fiasco we’re still struggling with to this day. I still feel like lots of politicians were trying to talk us into a little recessionary dip with pre-election angst and finger pointing, but in retrospect I don’t think I paid enough attention to the stalling IPO market. But I digress…

The venture industry needs liquidity events. Right now, many funds have all capital tied up in portfolio companies that can’t exit even though they’ve reach profitability, or the fund is tied up pumping capital into companies unable to raise additional outside equity. Either way, funds are limited on their ability to engage in real value-add, early stage investing. In addition, some funds are taking huge cram-downs and dilution as portfolio companies go through recapitalization and down equity rounds (i.e. raising money at lower valuations than before). Now, I’m not waving a “poor pitiful VC” flag. I’m just saying we need a healthy, vibrant, and liquid venture industry to keep entrepreneurship going.

The thing about entrepreneurship and early-stage investing is that it’s an expertise lost to the general public and most public officials. Frankly, you don’t really hear major media reporting on innovation, new business creation, IPO registrations, and patent filings. It’s all too complicated for the average Joe or Mary, so real high-growth entrepreneurship seems reserved to those fringe elements of society. Lots of people want to claim some title in this arena (angel invstor, entrepreneur, etc), but few of them really have the somatch and even less ahve the know-how. In addition to the complexity and unknown of this space, the target is always moving as a result of disruption and hyper competition. In my experience, working in this industry requires a high level of commitment to learning and a deep humility/sensitivity to how much you need to learn and relearn each and every day.

In conclusion, we’ve seen some sign of life in the IPO market, but we’ve still got a lot of capital clogged up in venture-backed companies. Exits are approximately 60% of their high over the past five years, with IPOs still anemic.

Here are some graphs showing venture0-backed liquidity events in the US (sorry for the poor pic quality):

On CNBC, their is a brief boom, doom, & gloom commentary on the US having a high chance of hyperinflation in the next 5 to 10 years. The premise is that large fiscal deficits and easy monetary policy leads to a sort of tipping point where inflation begins to grow exponentially overnight. In layman’s terms, if the government continues printing money and continues debt spending, the demand for the dollar internationally will decrease and the value of the dollar domestically bottoms. Traditionally, the Fed has kept inflation under control by raising and lowering the federal rate. With the federal rate already at all time lows, that instrument has been disabled. There are still some interest rate adjustments that can be done, but none are as effective as lowering the federal rate.

At this point, the economy is perilously perched on this ledge. If inflation begins to mount signs of a return, the government has little strength to keep the economy on the ledge. Underestimating the future cost of education and health care (which is driven up by very immigration and welfare friendly policy), creates a very dangerous false sense of security on inflation growth. If President Obama expects to overhaul health care and increase it as a part of government expenditure and gross domestic product, it leaves this country even more inhibited. The more mandated government spending, the less discretionary money the government has to return to the people in the form of tax breaks/incentives and the less money the govenrment has for those responsibilities really preservibed in the social contract–national defense and security. There is no such thing as a strong defense without a strong offense.

In the end, I don’t have the necessary data or training  to really derive any conclusions on how to handle inflation, but I can say that things are getting so complex that few are going to have the foresight and intellgience to really anticipate the future. I fully expect that unemployment will rise in the short-term, stocks will find a leveling point, and the value of the dollar will continue to get pounded in currency exchange.

I’m really impressed by this editorial by David Moon on the Knox News website. First, I really agree with what it says. Second, it reallys helps articulate why government intervention in failing industries is a dangerous and bad thing.

How would you like to be Ford? Ford made difficult decisions a few years back that left them in a competitive position to say “no” to government funds and intervention. As a result, they’re being rewarded by the government “saving” the competition from failing. Its really ridiculous and contrary to most free market economic theory. Nothing is too big to fail.

The scary thing about the reckless abandon of the Obama administration is that they plan on repeating this process. They’ve already done it with banks and automobile companies. I think the health care legislation is setting the stage for a similar result in that industry. Where next?

I’m not really a doom and  gloom kind of guy.  I mean, Obama and the Democrats won pretty squarely and they deserved an honest chance. But seriously, I’m starting to think that we’ll need something like Ron Paul to get us back on track. And if you know me, you’ll know that I think he’s WAY wrong about foreign policy. I’m starting to see a place in the not-to-distant future where we’ve got a REAL economic problem– unemployment rates stays high, GDP goes stagnate or decreases, and new business creation stalls out. The players won’t have the resources or the free movement to survive, let alone succeed. Entrepreneurs won’t be able to seed opportunities or find early adopters with discretionary income. There is going to be sooooooo much to undo.

Maybe I’ll get it in two years? Watch this rabble rousing on the floor of the Chicago Trade. I love it! Is it proof that something is happening? Viva La Revolution…

http://www.cnbc.com/id/15840232?video=1039849853

Scary, really. One of the largest federal expenditures of my lifetime was shotgunned… I hope the Senate can stand its ground against this ridiculousness, but I don’t put much stock in either house these days.

Minority Leader Boehner makes such solid commentary… Just look at the size of that legislation… And it was completed at midnight last night. I’m speechless.

Honestly, we need something to happen… Unfortunately, I think Congress and the White House are chasing the wrong economic philosophy. The president COULD see to it that the 14,000 page stimuls bill wasn’t so loaded down with pork. Congress COULD take legitimate action towards freeing up credit and responsible use of TARP funds. Instead, we’re worrying about executive compensation, cramming incredibly partisan legislation through the legislative process, all the while screaming “the sky is falling, the sky is falling.”

In the end, things are going to be fine… as long as we let things be and free up asset allocation. Remember, this is NOT the first time we’ve faced a recession. In fact, over the last 100 years we’ve faced 21 recessions( see Seeking Alpha for more information). The market needs to reestablish an equilibrium, which will only happen once the necessary information is made available and assets have liquidity to move around. In the mean time, look at some of these historical quotes on economic downturns in order to gain a little perspective:

“The truth is that Wall Street gamblers are one of the causes of our frequent business depressions” –FLoyd Parsons, October 1923

“There are two great dangers to the continuance of prosperity. The first is the false idea that business is still governed by a cycle of boom and depression, and the second is that the leaders of business will think that the country is broke because some of their friends are. And also there is the danger that many executives who have been playing the market instead of working will not know how to get back to real work.” –Samuel Crowther, January 1930

“Those who favor a deficit as an alleged anti-recessionary measure tell us that it will be ‘temporary.’ But there is no such thing as temporary large-scale deficit financing.” –Senator Harry F. Byrd, October 1958

“Prosperity is when people buy things they can’t afford; recession is when they stop doing it.” –H. E. Martz, February 1963

“A recession is when your neeighbor loses his job. A depression is when you lose your job. And panic is when you wife loses her job.” –Winston Pendelton, November 1990

I’m not going to tell you what’s going to happen in the next few months, because I don’t know. I have a feeling that things will find bottom and gradually start to improve over the next 9 months. I say this because I  feel confident that a free and uninhibited economy will always grow long-term, assuming population growth and societal advancement. History has shown us many examples of this model working. Operating under that theory, I’d like to share some thoughts and observations on the current economic situation.

Last week was another depressing stretch for the Dow, closing at below 8,000. As a side comment, I think there is a convincing case that the S&P 500 makes a better benchmark for overall economic health, but I’ll use the Dow since it is so frequently referenced by media.  With that disclaimer, it is easy to get frustrated/depressed/concerned when a major index seems to melt away 1% of its asset value in a single day. My question today is about understanding the “value” of the Dow and interpreting the measurements.

I’m a big fan of history, so I think it is a logical starting point for tackling the issue. The Dow Jones Industrial Average (aka The Dow or Dow Jones or Dow) was started by Charles Dow, an editor for Wall St. Journal and founder of Dow Jones & Company. It is the second oldest American index (behind the less well known Dow Jones Transportation index) and represents 30 of the most prominent companies in the world. Data is readilly available starting October 1, 1928 in its modern form, although the report was first published on May 26, 1896 with a recorded close of 40.94. For more information, visit Wikipedia’s Dow Jones Industrial Average article.

On October 1, 1928 the Dow closed at 240.01.  Using this basis for comparison, the Dow grew at an average of 3.02% per year until January 8, 1987. On that fateful day, almost 60 years after that 240 point close, the Dow broke through the ceiling and closed at 2,002.25. A closing above 2,000 was an incredible testament to the American economy. This achievement reinforced that while the economy may flux between “good” years and “bad” years, long-term the economy grew. From a financial planning perspective, this also enforced that money saved for retirement and invested in something like the Dow could be a low-risk way to save and grow money. After all, $1 accumulating growth at 3.02% is worth almost $76 forty years later.

What happened after the 2,000 mark is a phenomenon that I’ve never really had adequately explained. Over the next twenty years, the Dow grew at an incredible pace averaging 7.92%. This caused the Dow to break through ceiling after ceiling as the index shot up from 2k. The Dow topped out on October 9, 2007 at 14,164. While it took 60 years to reach 2k, twenty years later the Dow broke 14k, a 7x increase. There are some potentially convincing arguments for why this happened– my favorite being that advancements in technology increased the access and flow of information, therefore improving the accuracy of the Dow– but no one outside of academics and certain regulators seemed concerned. Most investors, industrialist, and politicians have been punch drunk on the gains that rolled in with this growing economy.

While I don’t really have the necessary data or analytical skills to prove my theory, I think the economy became overheated during this period and economic growth exceeded capacity. Certain elements of the economy became exhausted due to over stimulation and manipulation (dotcom’s in the late ’90s, real estate in ’07, credit and banking in ’08). If you look at the graph below, you’ll see that I’ve taken the historical monthly averages from the Dow starting in October ’27 and going through January ’87. I’ve added a trend line assuming exponential growth through the end of ’08. The results are astonishing. Based on this trend line and previous growth in the economy, the trend line shows the Dow breaking 4,500 at some point in ’08.

In reality, what actually happened was something like this:

Now, I know the math here is a little weak, but it doesn’t take a statistician to see that growth over the last twenty years has far exceeded historical trends. Our trend in the first graph forecasted reaching almost 5,000 by the end of 2008. We actually saw an all time high of around 14,00 in October of 2007. That is 9,000 points or 280% of the forecast.

The core assumption of economic growth is that the economy grows as a function of supply and demand. There are a number of functions that effect supply and demand (population growth, opportunity cost, the free exchange of information, etc), but 280% of the trend forecast means that something major must have changed inside the supply and demand function.

I could keep writing about this for the rest of my life, but I’m no economist. I’m a capitalist, and I want to get back to the profit side of this study (i.e. my job). I will say that I think the economy became over inflated in the last twenty years and bloated with the activities of greed from both Wall St. and Main St. Looking back, we all know the culprits– they’re the same investments and financial systems that we “blame” for the current problem.

I think it is reasonable to expect the market to grow at a rate higher than the trend lines forecasted 5,000. I accredit this assumption to our increasing understanding of the “digital age” and its effect on the flow of information. With the Internet, 24 hour news cycles, and the ever growing rank of academics and professionals in this area, it is no surprise that the market should become more efficient. I also think the market will grow at a rate less than the trend line in the second graph, forecasted at 8,000 at year end. Based on these two models, I assume the Dow to restablish an equilibrium somewhere between 5,000 and 8,000.

In just a few minutes, the Dow is scheduled to open at 8,070 and trade up. I don’t know where the bottom lies, and no one really does with all the tinkering and “market psychology” babble going on in Congress, the White House, and on Wall St. I think a realistic low is somewhere between 6,500 and 7,500 if left to its own devises. This isn’t technical analysis; call it a gut feeling. And my gut says we’re getting very close.