Increased Taxes on VC Profits – Catastrophe in the Making?
Washington is talking again about increasing taxes on private equity firms, including VC firms, and this could easily be a catastrophe in the making. Such a policy may be OK for hedge funds, but not for VC funds, which are already struggling and which, more importantly, might close shop if they had to fork over a big piece of their diminishing profits to the government. As it is, investment profits at most firms have been mighty lean for a decade.
The biggest issue is not what a big tax hike would do to venture firms themselves but to the US. economy. Historically, venture-backed startups have generated a disproportionately large share of good American jobs, especially if these startups ultimately go public, because they help create or expand important industries. This is no time to undermine that trend.
The only way for the U.S. to avoid following Greece (and we already are right behind them) is to create new leading-edge industries with highly differentiated and high-paying jobs. This is the key not only to re-invigorating the sagging U.S. standard of living but also tackling the sticky issues related to our massive national debt. These jobs are the output of the venture ecosystem. U.S. tax and other economic policies should be focused on stimulating as much innovation as possible in America. Venture capital is a crucial element of this process, and tax rates have a significant impact on the risk/reward appetite of the venture capital industry.
Some say venture capital firms should pay markedly higher taxes on their profits, or carried interest, because it is a matter of “fairness.” This misses the point entirely. Our tax code has always been primarily a tool to achieve economic and social objectives. I would put high -paying job growth at or near the top of the priority list, especially given America’s lingering economic woes.
For the small minority who think that venture capitalists are being singled out for special treatment, consider a few rhetorical questions:
- Why is interest on home loans deductible when rent is not?
- Why do we have a long history of tax breaks for investment in research and development or for purchases of capital equipment?
- Why are donations to non-profit organizations tax-deductible?
Our tax favors these activities because they are deemed to be beneficial to our economy and our society. Isn’t this also true for American job creation in America, especially the higher paying jobs that sprout from the venture ecosystem?
Bear in mind, too, that venture capitalists are already investing more of their capital off-shore in countries such as India and China, where tax treatment is more favorable. And it’s not just about taxes. The capital is also following the foreign-born entrepreneurial talent that once dreamed of building lives in America. These entrepreneurs are still coming to America to be educated, but they are then returning to their homelands because good opportunities there are growing briskly. This includes startup creation, and these startups are creating jobs that do not employ Americans or pay US taxes.
Everybody who has a stake in this issue should write their congressman and lobby hard to take the possibility of venture capital tax increase off the table. If Washington policy makers don’t wake up, all Americans — not just venture capitalists and startup entrepreneurs — will pay a terrible price. Our already faltering innovation engine, if not resurrected, will turn America into a second-rate economy with second-rate jobs and reduced standard of living for all.
Bob Ackerman is the founder and managing director of Allegis Capital (www.allegiscapital.com), a seed and early-stage venture firm headquartered in Palo Alto, California. Ackerman has worked with more than 50 corporate investment partners over the past 20 years as both a venture capitalist and a startup executive. Read his past peHUB posts here
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Georges van Hoegaerden said on May 21, 2010
Bob,
The real point is not whether Venture Capital requires special treatment (plus or minus), we can debate the difference between the value and potential of venture capital versus innovation elsewhere. We all know by now Venture Capital as a financial instrument to ignite and deploy groundbreaking innovation is dead.
But the real issue is whether a tinkering with regulations on a financial instrument that is not a free-market system makes any sense at all. Without a free-market system in Venture, regardless of the mountains of regulations one could deploy, innovation in our country will be surpassed by others who understand that the theorem of the financial system determines the detection and growth of innovation.
So, if you want to see any support in defending this specific regulation, we should elevate the discussion to real financial reform in Venture (by way of a new system), because politically Venture today has no political leg to stand on to claim any social economic value but a distant memory.
Best,
Georges
Miguel said on May 21, 2010
Those examples seem somewhat specious. Regardsless, Here are some off-the-cuff thoughts:
1. Why is interest on home loans deductible when rent is not?
- Because “interest” on rent is deducted from the property owner’s income instead. The net effect should be similar.
2. Why do we have a long history of tax breaks for investment in research and development or for purchases of capital equipment?
- To encourage the _owners_ of capital to allocate it to specific, as opposed to simply rewarding those who implement the mechanics of allocation (e.g. VC). That’s why there’s a capital gains tax rate as well
3. Why are donations to non-profit organizations tax-deductible? See point #2. I’m having a hard time coming up with an example of for-profit organization that allocate donations to non-profits, charge a fee for their services, and then treat that fee as a capital gain.
Sorry I can’t give this more time; I have get back to work. Work that is clearly less-valuable than a VC’s because it’s taxed as ordinary income
JH said on May 21, 2010
“venture-backed startups have generated a disproportionately large share of good American jobs, especially if these startups ultimately go public, because they help create or expand important industries.”
Absolutely true, but now let’s think about that on a deeper level for a minute. In early going, VCs provide the very important seed capital that enables entrepreneurs to create jobs, but make no mistake, it’s the entrepreneurs, not the VCs, who actually create those jobs. In the event of a sale, the entrepreneur’s gains are treated as ordinary income. Remind me why VCs deserve better tax treatment than those who actually build the companies and create the jobs day after day?
But wait there’s more…In the event the company goes public, it is the public investors, not the VCs, who fund the vast majority of those jobs.
Take credit where due my friends, but recognize that all the self-congratulatory hyperbole about deserving special tax treatment for single-handedly saving innovation and the world paints you as self-enamored whiners, completely disconnected from reality.
Opening Statement said on May 21, 2010
Vinny Gambini: Uh… everything that guy (Bob Ackerman) just said is bullshit… Thank you.
Peter Mullen said on May 21, 2010
This is what you get for electing a radical socialist to the Presidency, one with absolutely zero experience in the business world, absolutely no perspective on how the market works. You asked for it, you got it. Like the speech? Don’t like the result? Look in the mirror and thank yourself for this disaster in the making.
JoeK said on May 21, 2010
JH,
perhaps you can tell us how entrepreneurs would get started without capital??
Lee said on May 21, 2010
The core issue is whether carried interest should be treated as ordinary income. The rest of these points are an obfuscation.
VC’s are NOT RISKING THEIR OWN CAPITAL. VC’s who risk their capital get the same treatment as LP’s as it should be treated as capital gains.
No where in this argument is any salient point made that this will drive less investment. As LP’s are still getting the same tax treatment and they are the sources of capital.
Tell me what VC is quitting his job that pays him/her $200k – $1mm annually from management fees because the taxes got raised on their potential share of carried interest. No one is quitting the Venture Industry will not shrink because of this.
If I am wrong please let me know how the Venture industry will shrink because of this.
Finally how does this shift investment to other countries? The LP’s who invested the capital are still getting treated the same. I assume VC’s who are residing in the US and or US Citizens will still be paying the same taxes on their income to the US no matter where is was earned in the world.
Another self serving argument trying to classify ordinary income as capital gains.
Capital Gain said on May 22, 2010
Carried interest represents a share of profits on comeone wlse’s capital. That is income, beyond any argument whatever. Now if the VC and PE guys would bother to invest any of their OWN money in their companies, those gains would of course be capital gains. They got away with murder for decades.
Cornelius Diamond said on May 27, 2010
The only catastrophe is the easy lifestyle a select few have maintained. It is income, no doubt about it. They are lucky they got away with it for so long. And one thing. VCs DO NOT CREATE IEEAS, JOBS OR EXPLOIT OPPORTUNITIES. ENTREPRENEURS CREATE JOBS, IDEAS, AND EXPLOIT OPPORTUNITIES. They have for thousands of years, with or without VCs. Remember, only less than 1% of start-ups are funded by VCs. Thus they cannot even make a bogus claim that they are responsible for job creation.