CMM June 14th, 2010
My friend Jonathan Patrick of 898 Enterprises asked me to do a guest blog on the topic of venture capital. I’ve written a brief, albeit non-exhaustive, history of venture capital that includes Doriot and his 6 principles of venture capital investing. Check it out here.
Check it out.
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.
CMM April 15th, 2010
Awesome presentation from Steve Blank, a professor at UC Berkley. Invest 5 minutes and flips through these slides:
My thoughts–
I’m passionate about education, and this set of slides really captures some issues I’ve voiced about formal business education around the idea of entrepreneurship. To sum it up, you can’t use traditional pedagogy and expect to get entrepreneurs. While they need to know 80% of the material that a traditional business person knows, the other 20% is the “secret sauce” that doesn’t necessarily apply to big business. This presentation captures this critique, hitting a home run around slide 38. While managerial accounting and operational strategy are key to success as an entrepreneur, that isn’t the “secret sauce” that drives entrepreneurial success. As I’ve come to understand, while traditional business acumen is necessary for entrepreneurship, it isn’t sufficient without the other 20%–the secret sauce.
I once heard a Dale Carnegie trainer describe successful leadership as a pyramid, with attitude, skills, and knowledge as the three sides. While attitude tends to be the base of the pyramid–after all, nobody cares what you know until they know you care–the sides are interconnected and rely on one another for support. I don’t believe that business schools can teach attitude, although they can encourage the right attitudes and discourage the wrong ones. They can manage expectations, assisting students with identifying their passion and lifestyle preference. Ultimately, those individual have to pull the trigger on a career. It has to be their passion, their idea, and their attitude that drives the business, particularly in the earlier stages of entrepreneurship, although I’d argue that is true for any business career.
The other two pieces of the pyramid are knowledge and skills. I consider knowledge to be the collected acumen for business and skill to be the ability to sift through that acumen and derive the relevant model/practice/content for making and implementing a decision. Business schools can expose students to this material around an entrepreneurial framework, but they need to do more. While big business may revolve around a relatively consistent set of best practices, almost every start-up is unique and requires unique skills. You need hypothesis testing, customer development, operational scaling, and an understanding of the appropriate and accurate performance metrics. All of these are, to some extent, unique to the start-up opportunity. Start-ups don’t have years of retained earnings to rely upon. There is no writing off bad and costly decisions as learning experiences. The loss of time and capital from bad decision making can forever alter the future of a start-up company, potentially causing it to cease operations. In my observations, successful entrepreneurs have an instinct for survival and paranoia that drives them to avoid those costly learning experiences. In contrast, those same entrepreneurs rely on data to understand the risk and appropriate approach for major business decisions. They see under-served markets, and if the opportunity is risk-reward appropriate, they develop a plan for attacking that market. The key is understanding if the risk-reward is appropriate and if a capital appropriate model can be developed. When you’re neck deep in accounting, logistics, etc, it’s difficult to step back and look at the big picture and get perspective around those types of questions. But, you have to know the accounting, logistics, etc to be able to address those types of issues.
To use a sports analogy, business schools make great athletes, but athletes need to find the sport that fits their talent and the position. Not all athletes are football players, let alone quarterbacks. Not all business school graduates are entrepreneurs, let alone high growth entrepreneurs.
Their are lots of folks in the East Tennessee area that are wrestling with this idea right now. The University of Tennessee has innovation/entrepreneurship programs in its business college for both undergraduates and graduate students. Out of the Garage is a blogging and learning platform under development by the guys at the Center for Entrepreneurial Growth.
CMM August 7th, 2009
This comes from Tim Draper‘s article at Communications of the ACM. If you don’t know, Tim Draper is the founder of Draper Fisher Jurveston (DFJ), one of the most influential VC funds. Draper was also an investor in Hotmail, and created “viral marketing” as a tool for signing up beta users. The man is a legend, basically. I’ve had the chance to be in the audience for one of his speeches, and I loved it. He was funny, savvy, controversial, and very personable. Plus, he plays guitar and wears tacky ties.
Draper’s article is all about how now is the perfect time to be an entrepreneur. I couldn’t agree more! Frankly, I think we’re in the kind of trouble that stimulus and government spending can’t get us out of. And forget about big corporate. If they’ve got deep enough pockets, they’ll take the turtle approach… tuck in to their shell, don’t take risks, and hope to weather the storm. Who can really get us back on track? The entrepreneurs!
Is there evidence to support the claim that a recession is a good time to be an entrepreneur? Sure! GE, IBM, Microsoft, Shell Oil, AT&T, Merck, J&J, Sun, Skype, Kodak, Polaroid, HP, and Adobe…. all companies started during an economic downturn! What is it about starting during a recession that is a blessing in disguise? Draper says the following:
CMM August 5th, 2009
Yes…. Yes they can. And with the way things are going, we better hope they do.
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