The Carried Interest Debate – Down to the Wire

Unless you have been living under a rock, you’ve no doubt read about the debate in Congress going on regarding carried interests for venture capitalists. Many in Congress, in order to continue to fund their agenda, are looking to change the tax classification of VC profits from capital gains to ordinary income.

It looks like the next 48 hours will determine how this debate works out. The finance folks on the Hill are in full swing deciding on a number of issues, including the good news today about leaving angel Investors alone and allowing at least that part of the startup ecosystem to remain unscathed.

As for the carried interests issue, it’s been overly-politicized in a myriad of ways including those who like to frame this as class warfare, those who see this issue as just a bunch of winey VCs who don’t want their taxes increased or those who claim that VCs make money off of services and should be taxed accordingly.

I don’t think any of these are accurate. What this is really about is the future health of the innovation economy in the United States. It’s really that simple.

Now don’t get me wrong. I understand the political rhetoric. Every time a new tax is proposed, some group of politicians rise up claim the sky is falling and that the new tax will “kill” an industry. The fact that it usually doesn’t means that when there are real concerns, they fall upon deaf and / or suspicious ears.

I’m not one of those folks. I don’t like taxes (like most folks), but understand that in many new tax cases the markets adapt and life goes on. I honestly feel, however, that this is not one of those cases.

Whatever you believe about VCs, their wealth, they way they earn their income, etc., one thing that is apparent is that VCs partner with great entrepreneurs to create jobs. And we create a lot of them. In fact, we risk our personal wealth and reputations to invest money in highly risky startups that take 5 to 10 years to mature in these efforts.

Most of our investments do not work out as we plan. The ones that do, create sustainable, long-lasting jobs that benefit the job market today and for future generations.

And for this, Congress is thinking of effectively tripling the tax rate on our risky efforts. This at a time where job creation is the single most important issue our country faces. This at a time when countries like China and Russia are considering EXEMPTING VCs from taxes that invest in startups. This is simply stunning to me.

We’ve already seen a lot of investment capital (from both VCs funding startups and those that invest in VCs) go overseas to places like India and China. Anyone who is active in our ecosystem knows that money available to U.S.-based startups is less than it has been in 15-20 years. I guess that i could argue that 2009 might have been a bit worse, but go ask most entrepreneurs or VCs what it is like to raise money these days and they won’t wax poetically.

And the Congress is saying: “hey, we don’t care. Take more of your money overseas. In fact, let’s move all the VC activity offshore.” What’s left of our long-term economic viability if we give other countries the ability to compete better than we can?

Nice. Really nice.

Another argument that I love is that “VCs haven’t returned profits in the last decade to their investors, therefore they shouldn’t get incentive-based tax treatment.” This makes no sense on a number of levels.

1. It’s arguably true if you look at the entire industry, but says nothing about many funds who are successful making their investors money. We cannot assume the successful VCs will continue to want to work hard if their taxes are tripled; and
2. And, if true, this just proves my point about how risky all of this activity is, further supporting the point that incentives need to exist.

And remember, VCs do pay normal income taxes on management fees (salary) that they receive. And many VCs return all the management fees to their investors before they take profits, so effectively they are paying normal income tax rates on money loaned to them.

But what worries me the most is the slippery slope that we are going down. Even if you believe that VC profits should be taxed as services/income, then how on earth do you distinguish this from the cheap equity that founders allocate to themselves when starting a company? Isn’t all of their success based on the labor and services as well? While VCs may be using other people’s money to invest, so are entrepreneurs.

So how do you distinguish? Answer: you can’t. Entrepreneurs, you are next.

Bottom line, the Congress is going down an irreversible path that threatens to undermine the innovation economy in this country. I hope that logic, instead of politics, prevail. We’ll know shortly the answer.

Jason Mendelson is a managing director at Boulder-based VC firm Foundry Group. He also sits on the board of the NVCA, and blogs at www.jasonmendelson.com.