CMM December 10th, 2009
Over the past few days, President Obama has turned up the rhetoric on small business growth. He’s held summits (we won’t mention the attendees and who wasn’t invited), he’s included a new laundry list of talking points, and issued a round of encouraging statements. This past Tuesday, December 8, the president even went so far as to suggest “a complete elimination of capital gains taxes on small business investment” for one year.
Unfortunately, members of his own party were not listening. Or, maybe they were but they chose to disregard the president’s guidance. Yesterday, without a public hearing or committee vote, the Democratic controlled House of Representatives voted to raise the tax rate on carried interest paid to equity fund managers to 35% from 15%. This 133% increase was accomplished by reclassifying carried interest from a capital gain to ordinary income. That’s why today’s headlines should read “House of Representatives Loves High Unemployment, Punishes Job Creators.”
How Does Venture Capital Work?
While this bill applies to many investment groups—including broader private equity, real-estate partnerships, and oil-and-gas partnerships—my perspective is focused on the affect of small business growth resulting from venture capital investment. Venture capital is high risk portfolio style investing that utilizes equity and equity-like investment tools for the purposes of providing development and growth capital for start-up companies. Companies fitting this profile typically have a curve-jumping quality, focus on an underserved and growing market, and have all kinds of risk due to their infancy, sensitivity to the overall economy, and dynamic change factors. As a result, most venture investing is done with a portfolio approach and with a significant return-on-investment expectation.
Investment capital is typically raised from institutional partners such as endowments and pensions, with the occasional inclusion of a high net worth individual. These investment partners compensate a staff, led by fund managers, to manage the investment capital and the portfolio investment. This staff has two methods of compensation, through an annual management fee and with a carried interest bonus upon liquidation of the fund. The management fee goes to pay all expenses, including salaries of the fund, for the life of the fund—typically around 10 years. In my experience, staff members have lower salaries than they could find in other industries, with the majority of their compensation coming in the form of the carried interest bonus. For purposes of this conversation, these salaries are taxed as normal income.
Over ten years, the fund may invest in a handful of companies. Some of those companies may fail, some may break even, and a small number will make a significant return. At the end of the fund, the goal is to return all investment capital to the investment partners, plus the additional money made off the fund. A portion of this additional profit is set-aside as a carried interest bonus to the management team. Traditionally, this bonus has been taxed as a capital gain because of the nature of its source—the money comes from a successful investment and is not a guaranteed return. The money occurs after many years of tedious and patient management of investments.
Changing the tax structure on carried interest changes the economics of incentive for the people that work in venture capital. As financiers, we’re very sensitive to the idea that there is a cost to the capital we deploy. If we fail to meet that hurdle, our investors will look for other investment opportunities. Likewise, there is a cost to the time and resources we commit to managing that capital. If our compensation doesn’t justify the stress and commitment necessary, we’re likely look for alternatives. Ultimately, less potential carried interest return to the management team leads to increasing salary compensation, which results in less capital available for deployment. The other alternative is that we run the risk of venture capitalists seeking careers in other industries. While there are arguably too many funds active today, the mind set and culture of the venture capitalist is a rare animal. Run too many of them off, and you’ll find this to be an endangered species and industry.
Why Should I Care?
To put it bluntly, venture capital provides a unique and critical service to our economy—capital and guidance for start-up companies. According to U.S. Census Bureau data, companies less than 5 years old created nearly two-thirds of net new jobs in 2007. While not all of those companies were candidates for venture capital, a substantial number of them were rapidly growing businesses serving unique market needs. These companies often lack the assets or history to secure debt, making an equity investment like venture capital a lone source of financing. Without access to capital, those companies grow at much slower rates or even close down completely. Our small business economy isn’t a recent phenomenon; it’s been the staple of our economy for the past fifty years. The small business economy and innovation spurred companies like Microsoft, Apple, Oracle, and Amazon to name a few.
Tinkering with the economics of venture capital is playing a dangerous game. While the short term intent may be to supplement incentives in other areas of the economy, the long-term effects may be regression of small business growth and capital deployment. Why punish a critical piece of the mechanism responsible for two-thirds of business growth?
I know it’s a little stale (seeing as it’s now August 2009), but
