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.
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