The “carried interest” earned by venture capitalists is no different from the equity earned by entrepreneurs or hired CEOs who run our companies. They have all their eggs in one basket — whereas we have our upside spread over many companies — but the analogy is strong.
A CEO who joins a venture-backed company gets stock options or restricted stock at FMV. Typically this is common stock with a price per share 20% or so of the preferred. Through the hard work and management skills of the executive, he or she contributes to the stock value growing over time and at time of sale or IPO (with some delay) he or she cashes out and earns capital gains on that compensation. Note that he or she also earns a current salary and typically a bonus taxed as ordinary income. He or she puts up little or no money up front, but has an “option” to put up the money if things look good later.
Likewise, the venture capitalist takes an early risk to put some of his or her time, reputation, and board skills into an early-stage company. Instead of getting options in that company, he or she gets ownership indirectly through a partnership. He or she likewise puts up little money relative to the LP’s but does invest a substantial amount of money spread over 20 or so companies. The VC’s contribution is less for each company, but in aggregate is like the CEO who invests his or her time into one company.
For the life of me, I can’t see how you can tax carried interest as ordinary income without also concluding that capital gains should be taxed the same as ordinary income. We have had times in our relatively recent history when there was no “capital gain differential.” The National Venture Capital Association convinced a Democratic Congress and Democratic President (Carter) that America would be better off with such a differential, that risk taking should be encouraged because it produces the lion share of new jobs in America.
History has proven the NVCA correct, to the benefit of all stratums of American socioeconomic life. The risk-taking by VC’s (again, spread over several companies) is the same as management’s risk taking on a single company.
This fundamental analogy is the reason we should not proceed down the path of taxing risk-based capital gains as ordinary income for the participants in the venture process. It is the golden goose that funds the social safety net. In California, it represents the largest single source of revenue for the state, outside of property taxes.
Craig Jones is the Managing Partner of Ticonderoga Capital, and has 23 years of venture capital experience focused on technology-enabled services with a strong emphasis on healthcare business services. Jones was previously the Managing Partner of Dillon Read Venture Capital, a Partner with Advent International and an Associate with Centennial Ventures.