Am I just a greedy VC?

My partner Jason has an impassioned post up about the carried interest debate currently taking place in Congress. No matter how you feel about Congress’ efforts to change the tax classification of VC profits from capital gains to ordinary income it’s worth a read (and keeping an open mind).

Obviously this issue is important to me and to all VCs. And while I know there are differences of opinions on the subject (clearly given the intense debate going on right now) I think Jason does a nice job of talking through the personal (this feels overstepping), professional (there are other markets where innovation is taking place where investor are actually being completely exempt from taxes that will draw talent away from the US) and legal (how do you differentiate between a VCs partnership interest from other partnership interests not subject to the proposed tax change?) arguments against the tripling of tax on the long term profits of investors.

While I wouldn’t say that I’m a “fan” of government, I’ve always been of the mind that some level of government safety-net is appropriate. I’m even, generally speaking, ok with a progressive income tax and as a relatively high wage earner understand that I have a certain burden living in our society to pay a much greater share of the overall tax burden. I point this out not to get into a political debate about the benefits of taxes, the proper level of tax  or even the correct taxing system but to be clear that my views on carried interest are not part of some larger agenda around reforming the tax system or eliminating it all together.

I have many of the same concerns that Jason outlines in his blog post about the move to change the tax treatment on carried interest. I’ve even considered whether the change will either shorten or radically change my own career path.

But as a capitalist and a realist I’d simply point out that taxes shape behavior. Our tax code has examples of this everywhere. Want people to buy houses? Allow them to write off their home mortgage (but don’t let them write off credit card debt – we don’t want consumers to have too much of that…). Want people to give to charity? All them to write that off too. Want to encourage longer-term investing? Tax that at a lower rate than short term investing. Need to encourage people to save for retirement? That’s a good one for tax exemption. Invest in education? Check on that one two.

My point is that tax code changes have real world economic and behavioral consequences. And the consequence of tripling the tax on the carried interest of investors will be decreased investment, less innovation and fewer jobs (and I would guess an overall reduction in tax receipts given the 2nd and 3rd order effects of the measure – which completely defeats the purpose of the proposal which is 100% to raise revenue and “fund” the extension of other tax initiatives).

The US currently leads the world in the innovation economy. From our universities, to our entrepreneurial ecosystem, from the belief that it’s ok to step out and try, even if you fail, to our system for nurturing and funding companies, we have a huge global competitive advantage in innovation that has lead to some of the greatest advances in modern society coming from within the US. Venture Capitalists have been an important part of this trend (companies that are or were once VC backed account for 11% of the US workforce and over 20 of US GDP).

The sky is not falling and the day after the tax code is changed (if we’re not successful in convincing lawmakers what a bad idea this is), little will be different in my job or in the jobs of most investors (although no doubt the lawyers will be hard at work figuring out new investment structures). But there is no doubt in my mind that this massive alteration in how we tax the work of a group of people who nurture and fund innovation in the US will radically change the long term trajectory of the our country’s innovation economy. With the focus on job growth and job creation and with countries like China and India knocking at our door trying to be the growth engines for the next millennium’s global economy, is now the time to put shackles around the building blocks of what’s allowed the US to lead the world in technological innovation? I, for one, surely don’t think so.

  • Entrepreneurs have tax problems too…

    I think the AMT treatment of 1202 gains is the bigger offense. I just sold a startup and basically received nothing form the 1202 exemption. When you get done with the AMT it actually cost me money over normal capital gains because of the phase out of deductions. 1202 election is not optional. I can't do 1202 roll over, I need that money to live on.

    Sure I have a giant AMT credit that I can carry forward, but I'm a normal person and it is unlikely that I will ever be able to consume it. Obama's increase of this to 75% or 100% is pointless if it continues to trigger the AMT.

    There are parallels when the company fails. I has a loss carry forward that took me fifteen years to consume. During that time it earns no interest and loses value with inflation.

    Bring back backwards income averaging and remove 1202 from the AMT. Smartest strategy right now is for the entrepreneur to put half his founder's stock into a Roth IRA.

    VCs have a giant advantage. You can diversify and you are partially shielded from the risk. You don't get stuck with big losses when the business fails. You're better off than the entrepreneur.

    • i couldn't agree with you more and i don't believe in taxing "phantom" gains until they turn out to be real (this happens all over our tax code and often drives the wrong behavior) . we actually have this problem as a partnership as well – we're taxed on the profits from our fund before we actually see any of the gain.

      while i agree with your diversification argument (diversity is good), i don't know that we're "better off" than entrepreneurs. the same factors that mitigate our risk also limit our upside. while we clearly don't work as directly on an individual business as the entrepreneurs in whom we invest, we also don't see anywhere near the direct benefit of the work that we do put in. so it cuts both ways. interestingly on this point a few vc firms have created stock option pools that allow their senior portfolio execs to trade some option in their own business for a basket of options that reflect the overall portfolio – hedging the downside risk of their putting all of their eggs in one basket.

  • Brian

    I'm ready to be convinced that you're right, but here are a few thoughts that I would like to see a response to first.

    First, I'm always a little skeptical of the threat that someone will start doing business in another country if their taxes are increased. If there are other countries that don't tax VCs at all, why are the US VCs still here? Presumably, if the tax rate had gone from 0 to the current 15%, you would make the same argument even more vociferously, right? Why is it always the very next tax increase that will cause people to finally leave or 'go galt' (especially given that overall taxes are relatively low)?

    Second, there are other factors that influence job creation much more than VCs. According to this report less than 1% of new businesses in the US have VC backing and only 16% of the 500 fastest growing companies do (http://www.kauffman.org/newsroom/venture-capital-industry-must-shrink-to-be-an-economic-force-kauffman-foundation-study-finds.aspx). So is the theoretical drain of VCs to other countries really going to have a huge effect on job growth? And shouldn't we focus on the other 99% of new businesses to get more bang for the buck?

    Third, how do we know that by raising the tax, VCs won't invest even more money rather than take the profits? The whole point is to take a small amount of money and turn it into a bigger amount, so why not reinvest and try to make so much that the tax change doesn't leave you any worse off? If that were an option, it would spur even more growth.

    I'm sure there are some good arguments to be made in terms of innovation, new technologies, etc, but I have to believe there are efficient ways to spur innovation without ignoring what some would say is a loophole in the tax code.

    Thanks,
    Brian

    • i’ll take your third point first as i think it makes the most sense. this already happens – as vc’s run successful funds (and therefore have the capital to invest) they typically do increase what’s called their gp stake (general partnership) in their fund. i think this is great and of course there’s been no question that the gains made on this investment will continue to be taxed at long term rates.

      as for whether there will be a capital or talent flight to other countries (or other industries), only time will tell for sure. but there’s no question that more than doubling the tax rate on an activity will change the landscape. i’m not aware of any countries that have had long term tax holidays for venture capitalists – only a few now that are trying to jumpstart their innovation economies by starting up these programs. i point it out as an example of the fact that tax policy effects the choices people make (these countries are implementing these tax policies to drive more talent to their markets). i think back on my own career and a choice i made when i was about 23 to stay in the states rather than move to asia where i had a job offer. while i’m not saying that in the very short term there will be a massive flight of talent away from the us (for example i’m not going anywhere), i’m saying that over time people will make choices based on things like tax rate. i very well may have made a different choice 15 years ago had i been faced with the current landscape.

      as for the importance of vc to the economy, there are a number of studies that show the impact of venture backed companies to the overall economy (check out thehttp://www.nvca.org for links to many of them). a large % of current jobs are because of once venture backed companies. taking a snapshot at a single point in time isn’t the way to look at it – you need to look at the ongoing and long term impact of venture investing on our economy.

      appreciate the thoughtful comments.

      seth

  • Being in Europe, I can't comment on the details of how this change in taxation will affect the VCs in the US.
    However, I think we're a far cry from seeing talent moving outside the US, towards markets where innovation is taking place.

    As a matter of fact, I'm not convinced there are such markets. Let me explain: I am a CEO, based in Finland. Most of the VCs there don't even appear on TheFunded and have a deal flow of <3 deals / year. If you look at VC in France, UK, Germany, you will find very few of the same caliber as in the US.

    I think the advantages of being based in SF, Boston, and nowadays Boulder as so great for the entrepreneurs that it would be too difficult to look abroad.

    • it's a helpful perspective ramine and i agree that the entrepreneurial ecosystem is vibrant in the US – more so than in any other country – it's a huge advantage and one that we should continue to leverage, not squander. however history tells us that the nexus for innovation can move around over time (ask italy, great brittan, etc how they feel about this). and while i don't think the day after the tax is enacted we'll see a flight of talent and capital, huge structural shifts to the incentive system here in the states will have meaningful long term impacts on our entrepreneurial ecosystem.

      i'll use myself as an example. in 1996 i had the choice to move to asia or stay here in the states (i had job offers in both places). i chose to stay here. today i'm not sure i'd do the same thing given the overall landscape. my point is that people make individual choices that may change with a new taxing scheme here in the states and these choices may lead to the erosion of the advantages that you describe.

  • This is not a comment for or against the carried interest debate. From an outsider perspective – I am a Canadian – I thought it worth affirming your opinion on how a strong VC community drives much of the US innovation economy and the economy in general.

    Innovation funding needs to come from some place – public or private? Here in Canada we have a weak VC community but continue to produce a high rate of quality innovation because the government supports early stage R&D through a very attractive Income Tax Credit (42% of expenditures are returned up to $2 million annually with no other project or company limitations) and an excellent public education system.

    Thats good. However…without a risk taking equity driven culture, once a company goes from R&D to commercialization, there is very little support. Most Canadian innovations fail commercially or are gobbled up by US firms. I believe that intellectual property is your most significant exportable asset. Its not labour, not energy, not automobiles, etc. I am fairly certain that, beyond innovation that is driven by defence budgets (your government R&D program), without a strong VC community, the US economy would lose its entire foundation.

    Better to reward it than to punish it. I think this is your argument Seth, and I agree.

    • great perspective. i'm familiar with the canadian tax credits (several canadian companies have used it in pitching me as a reason to invest in canada).

      i definitely believe that a large portion of innovation in the US economy is driven by private investment (certainly not all VC, of course). it would be a real shame (and significantly detrimental to our economy) to lose that.

  • Paul Kedrosky's post was amusing:http://paul.kedrosky.com/archives/2010/05/carried

    • paul does a good job of making fun of the NVCA position, although with little in the way of facts (other than his opinion that taxing VC partner distributions differently from all other partner distributions eliminates the "sweetheart" deal we now how by being taxed just like every other partnership under the tax code). i understand that we're easy targets (mostly white, mostly men, mostly relatively wealthy) and i guess that's how politics works. in this case there will be real, long term ramifications to the change in policy…

  • Yawn. Trickle-down theory redux. Look, you're right that at the margin it will likely reduce invesment. But in the main the current structure is: Simply. Not. Fair.

    As a member of an LLC I pay a shitload more taxes than you, not to mention more than my employees and investors. And guess what? I went out and did it anyway despite the tax consequences.

    And while you're worried that your overall fund size may be smaller, you DON'T have to worry about being able to spread your risk across multiple investments. Me? I've only get to place one bet at a time.

    So while it's all well & good to offer appeals to innovation and the future of the economy, get back to me when you have something more persuasive than "privatize gains, socialize losses." Or at least convince the greatest investor in history (Warren Buffet) to go along with you.

    • sethlevine

      i know we’re never going to agree on this one, Derek. the truth is that your founders shares (which you didn’t “pay” for) get taxed at long terms gains rates (whether they are membership interests or shares). mine don’t. and that’s simply not fair.

    • i know we’re never going to agree on this one, Derek. the truth is that your founders shares (which you didn’t “pay” for) get taxed at long terms gains rates (whether they are membership interests or shares). mine don’t. and that’s simply not fair.

      • Those shares were worth zero when I bought them, and I sure had a hell of time getting investors to think otherwise. But eventually I did – by creating a business that kicks off cash flow. And I still pay a much higher tax rate than my investors on that cash flow.

        By "mine" you mean… whose shares exactly? Surely not yours. Those shares are your investors', and *they* pay cap gains rates. They even get to write bad investments off agains cap gains. This tax law change will not affect the change in their asset accounting.

        Those other markets without taxes often have other very serious consequences like rules against speed of capital outflow. And the real money in places like China is made on cash flow businesses, not inventing the next Google. Maybe that will change, but let's wait until it actually changes instead of making predictions, which economics really sucks at.

        • derek – my business isn’t set up to make money off of cash flows. i think it’s great that yours is – i assume you’re dividending out the profits and paying the (currently very attractive) dividend tax rates. in my case my equivalent of founders stock is the value i create via carried interest. you create value for your investors and for yourselves through the same mechanism (and when you sell your company you will pay cap gains rates on the founders stock you own). i’m doing the same thing. except now instead of being taxed like you, i’m being penalized because a bunch of hedge fund managers were exploiting this provision to basically avoid paying ordinary income taxes on anything they earned. my carry is the functional equivalent of your founders shares (although i understand that my carry is spread across a number of companies – mitigating some of the downside risk, but also limiting my overall upside since it’s based on the performance of a basket of companies, not just the highest performing one). i work for years for my investors to achieve positive outcomes for them. and now that long term work will be rewarded with a doubling of my tax rate (by the way, this change happened after i signed up for my end of the bargain – the government is significantly changing the rules of the game mid-way through the game itself). and this will over time change the landscape of investing in the US. i didn’t understand the ‘trickle down’ analogy you made in your first comment (i don’t believe much in that theory either). here i’m talking about the government using taxes to change behavior (there are examples of this all over the tax code and i’m sure you know people who have and continue to make decisions because of it). i’m not saying the sky is falling or that this is going to change overnight (or for that matter that there won’t be a creative way to structure around this). but when you more than double the tax rate on an activity, you can expect there to be less of that activity in the future.

          • Only saw this just now. My dividends are taxed as personal income because it's an LLC. And my personal taxes are already double your current rate.

            Since you're not managing for cash flow but for cap gains, that means you can write off those losses against future gains, right? No, you can't. Because those losses aren't yours except for your personal investment. When you have actual personal capital at risk, then I'll be more sympathetic.

            I don't think the government is trying to change behavior. They're just closing a really glaring loophole.

            I do believe double taxation on C Corps should be eliminated. That's one of the few things W tried to do that I supported, but he made it way more complicated than it needed to be.

  • Peter Biro

    Seth –

    You know I love your group but you might be off on this one. You sell a product called "investment returns" for which you want to get paid some after-tax wage. One of your key costs is taxes and it looks like that cost might go up; that "it's not fair" is not the point as this is business and as I'm sure your CEOs will tell you, the business world is frequently not fair. Whether it's fair I think is a 50/50 proposition in your favor at best — I don't think it's fair that you get taxed less than Warren Buffett's secretary and neither does he. So let's call that a wash as serious people disagree.

    Question 1 is whether maximizing your income is the only driver. I would bet since you are at Foundry, the answer is 'no' – you also want to live in Boulder, work for a stud like a Brad, etc. There is some money you probably gave up to do those things vs. working in CA or Dubai. Many people are in the VC industry not only because they can make a lot of money, but because they love what they do and it's fun. That's worth a lot.

    Question 2 is whether your customers are price-sensitive. If you're Kleiner Perkins, the answer is probably 'no' and you can simply charge a higher management fee or keep a higher carry so that you end up with the same after-tax income. Foundry may or may not be in that position – depends on your results and how well you can raise money. But real businesses face this problem all the time.

    I also challenge the notion that taxes always change behavior – economists actually don't say this. The size of the increase is what matters — for example, if you tax soda at 2%, no one will care, but if you taxed it at 100%, a lot of people might care. Given that (1) the scope of the increase isn't enough make VC an unattractive career and (2) good VCs can pass some of the tax along to their 'customers', it's hard to come to any conclusion beside being greedy. I wouldn't have chosen that word about you unless you came up with it first — I just struggled to come up with a better one. 🙂

    Also, I assume your "we're white men, it's easy to pick on us" comment was a joke, right?