By James Kwak
The House of Representatives is considering a bill that would change the tax treatment of venture capitalists’ income (and that of private equity fund managers as well). Currently, VCs typically are paid “2 and 20” — that is, an annual fee of 2 percent of assets, plus 20 percent of profits. For example, let’s say a fund starts out with $200 million. Most of that money is invested by the fund’s limited partners — pension funds, endowments, insurance companies, the usual suspects. After ten years (roughly the average life of a VC fund), the investments made by the fund are now worth $400 million — a pretty humdrum return of 7 percent per year (before fees). The venture capitalists themselves will earn about $14 million ($200 million x 2% x 7 years)* plus $40 million (20% x ($400 million – $200 million)) equals $54 million. (Note that they earn that $40 million even for doing worse than the stock market’s long-term average return.) The limited partners get what’s left over after those fees. And before you start crying for the VCs, remember that a typical VC firm will have multiple VC funds going at once.
Right now, the $14 million is taxed as ordinary income, but the $40 million is taxed as capital gains — that is, at a tax rate of 15%. The bill would tax the $40 million as ordinary income (actually, 75% as ordinary income and 25% as capital gains), for an effective tax rate of about 35%.
The current tax treatment has never made sense to me. The lower rate on capital gains is supposed to provide an incentive for capital investment.** This is why, if you buy stock and sell it more than a year later, you pay tax on your gains at a lower rate. So clearly the actual investment returns on money invested in the VC fund should be treated as capital gains — but not the VCs’ 20 percent fee, since that’s compensation for fund management services, not returns on their investment. (VCs typically invest their own money in a fund, but it is only a small fraction of the whole, and no one is debating how that money should be treated.)
One argument I’ve heard is that the 20 percent comes out of the capital gains of the fund itself, so it should be treated as capital gains. But that’s nonsense. If the limited partners got to keep it, it would be capital gains. Once they pay it to the VCs, it becomes an investment expense for the limited partners and a performance bonus for the VCs.
Gerry Langeler, a venture capitalist, made a valiant effort to defend his tax break in the New York Times, but his arguments are so full of holes I wonder if even he believes them.
He starts off trying to equate the VCs’ 20 percent to the profit a homeowner makes on the sale of his house.
“If you buy a house and take out a mortgage, you usually put a small percentage down, with the bank carrying the balance. To keep the math simple, say the house costs $200,000 and you put down $20,000. Ten years later, if you sell the house for $300,000, you have a gain of $100,000 on that $20,000 investment. It is taxed as a capital gain because your capital was locked up for a prolonged time, there was a material risk of loss and the gain was not ‘guaranteed’ to you for just showing up every day, the way a salary is. You used the bank’s capital as leverage on your $20,000 investment, but that does not matter from a tax standpoint. Neither does the fact that you worked around the house over those 10 years to improve its value.
“Now, let’s compare that with carried interest in a venture capital partnership. We in the industry invest a small percentage of the total dollars in our partnerships, like the house purchase above, with our limited partners investing the rest. Our investments are locked up for prolonged periods of time, often five to 10 years before we see any return. There is a real, material risk of loss of capital. In fact, many venture funds in the bubble lost money, including partners’ capital. Like the house situation, our downside loss potential is ‘fixed’ by what we invested, while our upside is unbounded.
“We do a lot of work ‘around the house’ to help our start-up companies grow. Our investors get their return on the profits we make. For those investors that are taxpaying entities, they pay tax on the gain at capital gains rates, just as they would if they had invested in a home. No one is proposing to change that tax treatment.
“If there is a profit on the entire partnership, then and only then do we as managers of those partnerships get our carried interest — usually about 20 percent of the total profit. That carried interest is delivered in the form of stock in those start-ups, stock that has been held for 5 to 10 years. Unlike our salaries (rightly taxed as ordinary income), the carried interest is not guaranteed by our just showing up, and it is only delivered if a long-term gain in the form of capital is created.
“Carried interest in a partnership bears a striking resemblance to our personal ‘carried interest’ in our homes.”
This argument ignores the difference between equity and debt. When you buy a house, your mortgage is debt. You are in the first loss position. When a VC puts some of his own money in his fund, that’s equity; it’s on an equal footing with the limited partners’ money, and they share losses proportionally. Investment gains on that money — the VCs’ actual investment in the fund — are already treated as capital gains; it’s the 20 percent we’re talking about here. Saying that a VC is “leveraging up” his investment in his fund with LPs’ money is nonsense. If Gerry Langeler really wants to put in all the equity in his VC fund and borrow the rest from investors — well, good luck trying to find people who will lend 90 or 95 percent of the money in a VC fund. If that’s what he’s doing, he’s getting 100 percent of the profits after servicing his debt, not 20 percent; that’s what owning all the equity means.
More fundamentally, even if the return profile of carried interest has a resemblance to the return profile of buying a house, that doesn’t make it capital gains. The fact that there’s risk involved doesn’t make something capital gains; if that were the case, then banks could start paying long-term bonuses (based on multiple years’ work) and calling that capital gains. The fact that the upside is unlimited doesn’t make something capital gains; if that were the case, then sales commissions would be capital gains. The fact that there’s downside . . . wait, there is no downside. If the fund loses money, the VCs don’t make up 20 percent of the losses to the limited partners. Their downside is restricted to their direct investment in the fund.
The second argument attempts to equate VCs to founders.
“In another example, closer to home, say an entrepreneurial team starts a business and raises money from venture capitalists. Those entrepreneurs pay ordinary income taxes on their salary (of course), but any gains on their stock — generated by leveraging our money and our help, as well as their hard work — are taxed as capital gains.
“The powers in Washington say that one rationale for taxing venture capitalists’ carried interest as ordinary income is that this is a ‘fee for service’ situation. But how is that different from an entrepreneur’s founders stock? He or she is being compensated based on the wealth created by direct labor. If ours is now a fee for service, then so is that of the entrepreneur. Can you imagine the uproar about stifling company formation and job growth if Congress suddenly chose to double the tax on entrepreneurs in this country?”
Again, Langeler can’t tell the difference between a founder and an investor. To start off, what does it mean to say that founders are “leveraging our money”? The concept of leverage only applies to debt. VCs invest by buying convertible preferred shares, which are a form of equity, not debt.*** They are buying a share of the company, and they get all the upside on that share. That’s not leverage. Seen purely from the standpoint of the capital structure, VC investments dilute the founders. Granted, the company is getting something valuable — cash — in exchange for that dilution. But it’s giving up some of the upside. That’s the opposite of leverage.
And if Langeler doesn’t know how VCs’ carried interest is different from founder stock, he doesn’t know how his business works. It typically works like this. At time zero, the founders decide to start a company and do some work. At time one, which could be the next day, they actually create the company and they invest all of the capital. At this point, they own the whole thing. And they keep working. From that point forward, the founders are compensated for their labor through their salaries, which are taxed as ordinary income. (And in most cases, the founders either pay themselves no salary or a considerably below-market salary for several years.) Someday they may sell their founder stock for a large gain, but they got that stock because they owned the company to begin with.
At time two, the VC fund comes along and buys a piece of the company. As part of that deal, one of the VCs gets a seat on the board of directors. At that point, he has a fiduciary obligation to act in the best interests of all of the shareholders. Any work he does for the company is in that capacity. He is working for the investors in the company. The limited partners want this, because if they’re going to put their money in a company, they want someone they trust (the venture capitalist) watching over that company. So the VC on the board is acting directly as a fiduciary for the shareholders and indirectly as an agent of the limited partners. That is why the LPs are willing to pay him 20 percent of the profits. The fact that it’s 20 percent of profits, rather than an amount that’s fixed up front, makes it a bonus, and bonuses are always taxed as ordinary income; it doesn’t make it a capital gain.
The compensation for both the work Langeler does as a board member and the work the founders do as employees should be taxed as ordinary income. Langeler wants the compensation for his work as a board member to be taxed the same way as the appreciation on the founders’ initial ownership share in the company. That’s not apples and oranges; that’s apples and chartreuse.
Langeler continues:
“The gains of the limited partner investors in the stock owned by venture capital partnerships are taxed as capital gains. The gains by entrepreneurs on their stock holdings are taxed as capital gains. Under the new proposal, the only people taxed as ordinary income on the capital wealth created in that start-up would be the venture capital partners themselves.”
Um, right. That’s because the VC partners didn’t invest any of the capital.****
And it’s worse than that. The last sentence in that excerpt is an insult to anyone who ever worked at a startup company but who was not a founder. Many early stage employees contribute much, much more to the “capital wealth created in that start-up” than any VC. For Langeler, they don’t even exist.
(There’s a similar but better argument made by Bill Burnham a few years ago: that the 20 percent is compensation for the venture capitalist’s “sweat equity” for helping the company. But if you’re going to make that argument, I don’t see how you avoid acknowledging that founders also invest “sweat equity” beyond their actual capital contributions. Like the VCs, they own stock that everyone agrees should be treated as capital gains, and then they do some work. Why is the VCs’ work any different from the founders’ work? Especially when you consider that founders–and most early employees–are making considerably less than their opportunity costs, and hence their risk extends beyond their initial capital investments.)
There’s more, but I’ll stop there. Really, I have nothing against the VC industry. I regularly cite venture capital as one of the best parts of the financial system (and one that does not rely on anything that could be called “financial innovation”), my former company would not exist without VCs, and many of them are smart, hardworking people who have contributed greatly to the economy. Some VCs (well, one at least) are even in favor of the proposed tax change. The treatment of carried interest as capital gains is by no means the biggest problem with our tax code. I might be able to live with it if the argument were simply, “VCs are good, and this special perk is intended to provide an incentive for them to do what they do” (Daniel Shaviro thought about this line of argument, but wasn’t particularly impressed).
In short, I wouldn’t even have bothered with this post. Except that duty called.
* This isn’t quite right, because the $200 million is a capital commitment that gets drawn down, and the 2% fee is probably assessed on current asset value, not initial fund size, but this we’re not discussing this part of the fee here.
** I don’t actually this is a good idea to start with. The premise is that people are irrationally conservative when it comes to preservation of capital. and hence you have to provide an incentive for them to put their capital at risk. But even if you accept that premise, the better solution is allow full refundability of losses — meaning that you get to take a tax deduction for all of your capital losses. That solves the problem more directly, since it provides a benefit in the state of the world that people want to be protected against, and it is less distorting. In any case, the effect of the lower capital gains tax rate is to lower taxes for rich people, since they are the ones with capital gains. But for the purposes of this post, let’s just assume that capital gains are taxed at a lower rate than ordinary income.
*** Convertible preferred has debt-like features, but they only matter in a bad outcome (they give the VCs a disproportionate share of whatever value is left in the company). So from the founders’ perspective, a VC investment provides the downside of debt, but not the upside.
**** Again, you can debate whether labor should pay higher taxes than capital — my instinct is that it shouldn’t — but everyone, including Langeler, is taking that as a starting point for this debate.
The Baseline Scenario 
He has a point about founder’s stock, but not the one he intended. Just like options or stock grants, that is not an investment; it is compensation. And thus it should be taxed as income, too, not as capital gains.
Oh, one nitpick. “The concept of leverage applies only to debt” is not true. Options are levered to the underlying stock. Profits are leveraged to sales. These are not metaphors. By definition, “leverage” refers to a small change in one thing resulting in (or from) a large change in something else. You can leverage an investment by taking on debt, but you can also leverage it in many other ways.
The Internal Revenue Code is several thousand pages long. One page contains the tax rates; the remaining pages contain loopholes for special interests, none of which makes any economic sense but all of which cooperate in preserving a system in which only working people pay significant taxes. If enough people really understood the operation of the tax system, there would be a revolution tomorrow morning.
It doesn’t help that nearly all the money collected is wasted and most of it is diverted to the pockets of those whose income is minimized by the loopholes.
Perhaps your next post should examine the fact that the average multinational corporation pays income tax at an effective rate of less than 7%.
Excellent post.
People who earn too much money, too easily get obsessed with greed, instead of being obsessed by their job. Thus VCs, by bathing in money less, will be able to do their job better.
PA
I believe that PE and VC taxation was a big change in Bush’s 2001 tax cuts. It is my understanding that before those tax cuts, the profits were taxed as ord. income. This tax change contributed to PE boom of the 9 years or so.
Excellent post. This is a subject that is of not much interest to me, but your detailed analysis and wit made makes it a pleasure to read. Loved the XKCD reference :)
Amen!
Some of that XKCD stuff is absolutely hilarious, not just the one above. Actually this reminds me I should have included XKCD as a link on my site a long time ago. I’m gonna do that later today. I’m surprised more bigname bloggers don’t have it on their permanent blogroll.
I’m not saying that crazy guy who crashed the plane in Austin Texas and committed suicide was right. I think suicide is morally wrong and he endangered and meant to cause death to others which is extremely wrong, and no excuse for. But if you look at parts of the tax code he made reference to in his suicide note about independent contractors, he did seem to have some good points there.
Enjoyed the article! As I pointed out my post that your referenced, I am not opposed to changes in carried interest taxation that ensure VCs are in fact taking a real risk, but eliminating capital gains treatment solely on carried interest, as opposed to all equity, is bad tax policy that is based on romantic and dated views of the relative value of different kinds of labor/assets.
VCs get carry not as a “bonus”, but as upfront equity because they contribute intangible assets (reputation, deal flow, connections) to a partnership that the LPs would not have access to otherwise.
To demonstrate this, I have a question for you:
If a VC did not draw a salary but spent all their time and energy and leveraged all their professional connections and experiences to help build a business do you think they should get capital gains treatment on any investment gains?
Aye, long time fan of XKCD, the more references the better! Great post James, something I wouldn’t have even thought about had I not read this.
Sometimes I think they just need to burn the current tax code and start anew. It’s such a loop-hole jumbled mess, mostly in favor of those who don’t have trouble making money in the first place..
This is not correct. The basis for capital gains treatment for carried interest was established over 50 years ago when the US Congress authorized the creation of partnerships under the tax code and subsequently refined in a series of IRS rulings over the last 40 years. VC/PE partnerships have had capital gains treatment of carried interest since the creation of those industries in the 1960s and 1970s. Carried interest is a concept used in a wide variety of industries outside of venture capital and private equity, such as real estate, agriculture, retail.
Ah, you’re right. But it’s still true that accepting a VC investment is not leverage — it’s reducing your share of the total upside, not magnifying it.
Apply the duck test. Accepting ordinary income in the form of equity is ordinary income deferred.
Converting ordinary income to capital gain for the purpose of evading taxes is theft by conversion.
I’m confused by your question, but I think my answer would be “no.”
What investment gains are you talking about? If I start a company, and my best friend agrees to help me out by using his connections, but he declines compensation for his services because, say, he’s already wealthy, then he doesn’t have any money to pay tax on.
If my best friend also put in some capital, then of course he gets capital gains treatment on his investment gains. And, as no one is contesting, VCs get capital gains treatment on the money that they personally put into their funds.
But here we’re talking about the VC’s compensation for gains on *other people’s* investments (in this case, the limited partners). If he gets no compensation for his work, then the tax treatment issue doesn’t come up at all. As it is, he gets 20 percent of the profits, and he’s entitled to it — no one is saying that VCs’ work doesn’t have value. But I don’t see how the fact that you’re not drawing a fixed salary makes your work the equivalent of a capital investment. If you put in a lot of work for the company, you should get compensation — and that’s why you get 2 and 20. The fact that your work is worthwhile doesn’t mean that it should be treated as capital gains.
If that’s what you want, then you should negotiate a deal up front where, in exchange for services you will render to the company, you get real equity. That is, in an A round, the founders bring the company, the VC fund brings cash, and the VC general partner brings his future services, and each party gets equity. If you could negotiate such a deal, then fine. But I would have a hard time justifying more options for a VC for sitting on the board and making some phone calls than for, say, the first engineer. The fact that the engineer draws a salary doesn’t settle the issue, because that engineer could probably make six figures *more* working at Oracle, or even more than that working as an independent contractor.
In short, I don’t buy the alchemy that makes a VC’s compensation for fund management and board service into capital gains. If you want to make a pure policy-based argument that we want to encourage VCs and hence we should have this illogic in the tax code, that’s fine, but that’s a different question.
This is a very simple issue – hard to see how a smart guy like you doesn’t get it. The founders/GPs of a VC/PE fund are no different than the “founders” of any company. They provide money out of their pockets to establish the firm, hire the team, rent office space, run the business, etc. Then they raise capital from investors (LPs) at a stepped up valuation which splits ultimate profits from the liquidation of the fund in an agreed upon fashion. Identical to any start-up raising capital from VCs in any up round and splitting the profits in an agreed upon fashion upon liquidation of the company. Someone please explain to me the difference??? If you can’t, please stop opining on what you don’t understand. People’s livelihoods are at stake.
This strikes me as roughly correct. If there is an income event, it needs to be taxed as income. If there is a gains event, it needs to be taxed as gains. Here, there are both. Treat the initial 20% like any other deferred income. Treat the gains like any other realized gains.
I consider myself fairly well-versed in the differences between debt and equity, balance sheets, and tax policy, but I still had a hard time following this post. Therefore, I think any legislation on the topic is going to be a tough slog for anyone seeking to be re-elected.
Nonetheless, I do think that the tax treatment of carried interest, like many features of the tax code, is a mechanism designed at the outset to provide an advantage to the already rich at the expense of everyone else. However, even though I don’t agree with those features of the tax code, as long as they are there I think we should all use them when we can. For example: take a long position in your favorite security, then trade option spreads on that underlying; all your gains and losses can be accounted as changes to your cost basis, so all your earnings become capital gains. Hold the long position for 12 months, and it’s long-term, even though you didn’t hold any of the other positions longer than 6 weeks.
If only I could engineer a way to eliminate the downside risk altogether, I’d have my own little Private Equity empire.
Perhaps the VC should treat the up-front equity as ordinary income. Any appreciation from that basis would then be capital gains — but there would be risk of loss as well.
There would certainly be attempts to game such a system — by imputing a very low value to the original equity grant. But disclosure would help, since the partners would complain about overpaying for their stakes.
Exactly. GPs should be treated exactly the same. When they provide money out of their pockets, they get equity. If they sell it later, they pay gains tax. When they raise capital, they sell equity AND they charge a 20% fee. That 20% is income, so they pay income tax. The providers of the capital require that they invest that fee alongside them. If that fee later generates more gains, the GPs should pay gains tax. If the GPs don’t like that, they can negotiate another compensation structure.
If a start-up raises capital in traditional fashion, there is no taxable event for the founder. If the founder, however, sells his own equity, there is. There is no difference between this treatment and the mooted one our host proposes.
For the record, nobody’s livelihood is at stake if Silly Valley VCs start paying higher taxes.
I’ve posted a couple of entries on carried interest on my blog. There is no economic reason for this treatment of carried interest, and every time a VC tried to defend it he/she comes across as a greedy person trying to rationalize their greed. James, I agree with you that the only legitimate argument (although not one I agree with) is “venture capital is good and so we are giving it a tax break.” Let’s have that discussion on its face, rather than making all kinds of spurious arguments that try to equate carry with capital gains.
If the GPs were to sell stock in the management company, your parallel would work. But instead, they are getting a share of profits from a partnership in which they put no capital at risk.
Sorry, I don’t think your first paragraph is correct. The GP’s 20% ownership in their fund is identical to an entrepreneur raising $80 at a $20 million pre-money value. The entrepreneur doesn’t have to invest $20 to raise money at a $20 value, does he? There is no set relationship between ownership and dollars invested in any financial market.
Also, not all GPs are rich. Most run very small funds that have been structured based on 40 years of tax law.
Sorry, that’s not correct. Each Limited Partnership is a separate entity into which GPs do invest capital. If helpful, think of each Limited Partnership like an LLC that makes acquisitions. Just like there are serial entrepreneurs that start new companies every 5-7 years, there are GPs that start new funds (LPs or LLCs) every 5-7 years.
The management company receives management fees on which its members pay ordinary income taxes.
So let’s let them keep the cap gains treatment but raise the cap gains rate to 25%,the “middle class” tax bracket. And raise all the top brackets to the pre-Bush tax cut level, and add a new 42% bracket for people with taxable imcomes of over $1 million. And end the preferential rate for dividends.
The entrepreneur doesn’t have to invest because he starts out with 100% of the equity. The GP starts out with 0% of the equity. His 20% carried interest is compensation provided by the LP. I am surprised I have to explain this to you.
As for tax law, it changes all the time. Stupid, unfair tax law would seem especially precarious. What makes this stupid, unfair tax law so inviolable?
Wrong, you are arguing semantics. The GP could just as easily form the Limited Partnership (or LLC if you like) and own 100% of the equity (just like the entrepreneur) and then raise capital. All that matters is that the LPs agree to the splits. No difference.
I’m pretty sure he’s using the term “leverage” here to mean “to take advantage of”, as in “I leveraged our business contacts to make a sale.” I read the statement as meaning the entrepreneur is taking advantage of the VC cash to build his company. It’s clearly an example of finance/business speak leading to confusion, but I don’t think it’s an example of him not understanding how actual leverage works.
It doesn’t take much analysis really. VC’s put virtually no personal capital at risk. They play with other peoples money. If they are right, they are compensated insanely well. If they are wrong, they are paid extremely well. Little risk except they may not raise the next fund if they don’t perform and the gravy train ends.
As to the argument that this will restrict investment capital in the system. If they think they can get paid any more for what they do with their time, I think they are sadly mistaken. I say take your ball and go home, but you won’t be able to afford the jet, the extra homes, etc.
if taxes are increased on them they will still invest the money they raise and it won’t impact the number of people who want to raise a venture fund or seek to invest in start up companies. It’s red herring thrown out there to scare people and regulators.
They should pay ordinary income carried interest and salary except for the small slice that they contribute, which should be capital gains.
End of story, there is no debate.
The “carried interest” is simply profit. We tax profit either at the corporate rate or, if a pass-through vehicle, at the individual rate. Dan, the fact that VC’s may be “founders” of their own funds, with a modest amount of capital at risk is immaterial. The way they make money is from the split with their pigeons. If Scott Boras (who is at least on a 0/15) pays full freight, VC’s should too.
Dan, I’ve forgotten who, but a successful financier once said, “Fine with me that the American People want to tax 50% of my income. I got 100% of it from them.”
Support transparency and apply the duck test to your tax returns.
I know many financial people promote complexity. Complexity is always the first line of defense to an allegation of fraud and/or theft.
Warren Buffett has noted many times (when he is doing his “I’m your saintly, cozy, warm-fuzzy, sodie pop drinking Uncle” routine), that his secretary pays a higher percentage of her income in taxes than he does.
Amen, again, Jake Chase.
Your comment has given me a chance to bring up something I’ve been thinking about:
Does anybody ever wonder why the costs of at-source taxation are accepted so meekly by business? Why isn’t it screaming about the “intolerable burden” of collecting taxes for the government? Yelling at the government to get out of its face, and collect its own damned taxes?
My suspicion is that business actually likes the arrangement. It knows that what goes out the front door (expenses related to tax collection) will soon come in the back, in the form of tax breaks, subsidies, regulatory leniency, etc. Furthermore, at-source taxation helps to keep many workers living pay-cheque to pay-cheque. A financially insecure worker tends to be a more reliable, docile worker, the kind who won’t complain about workplace safety, labor law violations, etc. In other words, the kind of worker business likes.
Man, you need to spend a few hours reading about partnership taxation. The problem is there are hundreds of years of precedent here. Try working through your ideas in the case of a young guy with no dough working with and old guy and lots of dough to bu an apartment house. The old guy puts in all the money, the young guy works the property, and they agree to split the gains after a few years when they sell it. How can you tax these guys the way you want to? I think you’ll find changing the way current taxation works is impossible, but I’ll be following your comments.
Not if the upside was large enough that the founders used VC money to give them more than they would’ve got with their undiluted investment…
Isn’t 2 and 20 the case for HEDGE FUND managers?
Cheers.
As I wrote to Dan, tax law changes all the time. Fund me one third the headcount a House committee can muster, and I’ll get you the necessary legislative changes in a neat little bundle next month.
FD: my charter was awarded in 2000, back when it was still conferred by AIMR.
Is this math right ? Looks like 28 Million to me.
$14 million ($200 million x 2% x 7 years)
200 * .02 * 7 is 200 * .14 which is 28, right?
Having worked at 5 startups and been through 3 liquidity events I would beg to differ with Nemo. founders equity and the equity of employees is an investment. It has a cost and must be purchased. It is not just “given” to you like restricted stock and there is a value assigned to that stock for tax purposes. The founder or employee has to hold that until it is liquid if they want to unlock the value of that investment. The investment is also tied to their sweat equity and personal capital to make those shares worth something. I would say that Foundef and employee shares are the ultimate investment and they absolutely meet all the criteria of equity investing and there are very strict tax rules around this equity. The VCs just pay more for their options because they put none to very little actual sweat equity or human capital in the company. They usually just provide cash.
Exactly James! Most VCs really overestimate the “value” of their contributions and connections and I have seen many top, well-known VCs actually hurt companies and lower the return to their funds through not funding a company at the appropriate time or other poor decisions. Decisions that were later proven wrong and proven to have cost them money when the company was acquired for a low amount and then became a HUGE success as part of a larger company. If the VCs/investors had done their job they would have recouped 10x instead of 2x. There are also many VCs and big name investors who put their own money into a startup directly or one they are managing. That is investing! It happens so often that it really contradicts the idea of carry as investment. The carry interest is a bonus and the PE and VC people are deluded if they think otherwise.
Dan, this is cut and dried. The investment a GP makes in his own fund is taxed as cap gains when and if he cashes that out. The 2% mgmt fee paid by his investment and that of the LPs is regular income. The 20% only comes on any gains when the fund is able to liquidate shares in its investments at a profit. He and all the other LPs will get cap gains on that and from their gains they pay the GP/VC a 20% bonus for his effective stewardship of the fund. That is clearly a bonus and should be taxed as ordinary income. This is clearly a loophole and one that is extremely profitable for PE/VC and actually does not make a difference to those actually putting their capital at risk.
Furthermore, founders usually start a company with only their own money from previous successes or that from friends, family, etc. – sometimes these are called angel investors but there are also angel investors that are VCs, bankers, entrepreneurs that see value in seeding a small amount into many different enterprises. This initial seed money is the most important money a startup gets as they take ALL the risk before most VCs even will be interested in investing the LP money into them. Therefore it is a joke for anyone to suggest that the founder and early stage shares are not from investment capital.
Furthermore, is there anything stopping Bill from starting his next fund and structuring it as a company and selling equity to investors while keeping 20% of the equity for himself for his incredible connections, hard work and deal making ability as well as his ability to pick winning and losing companies. I say he should go for it and see how easy it is to sell this new paradigm to investors and see how it goes. He can report back to us all. There were many “incubators” during the tech bubble that I believe did just this. Some made a lot of money and it was probably considered cap gains.
BTW, is there anything stopping Bill or any VC from investing his own personal wealth into any startup that is willing to take it? Certainly not in companies that are not in his fund. I believe that many VCs invest their own money in their portfolio companies but there may be some legalese in LLC agreements that i am unaware of that doesn’t allow this for some reason.
This all sounds like a performance bonus and a commission to me. Why not just give these VC guys shares or options in the venture as compensation instead, like other board of director members?
Some of this reflects an east coast view of venture capital (2 and 20 is standard for PE, but 2.5 and 30 is standard for top tier VCs; participating preferred has upside benefits in 3-5x liquidity events; many deals are funded without founders or their friends or families putting any money into the deals–in two of my startups, the VC invested based on a powerpoint presentation and the company was not even incorporated prior to the investment.)
While I generally agree that carried interest should be taxed like other forms of income, there are some practical problems. Contrary to what’s stated here, GPs do make capital contributions (typically around 1% of a fund’s capital). The GP carry is typically only paid after LP capital has been returned (or sometimes after a hurdle, or with some kind of clawback). Gerry Langeler (who is a good VC–the claim that he doesn’t know his business is ludicrous) is right about the similarity between founders’ stock (which is also purchased for a nominal amount) and carried interest. True, founders (and non-founders) work long and hard, often at lower salaries than they could otherwise earn, but how is that different from VCs shifting some of their compensation from management fees into carried interest?
The ultimate source of the problem is the earned income/capital gains differential. Better to fix this than to argue about what is really investment income and not employment compensation.
I was the young guy once cfaman. I reported mine as ordinary income.
Rule #1: Advise of counsel is not a defense in tax court.
Rule #2: Like lost rent, you never recover lost sleep.
I don’t actually this is a good idea to start with. The premise is that people are irrationally conservative when it comes to preservation of capital. and hence you have to provide an incentive for them to put their capital at risk.
But that premise is obviously false — in real markets people are, if anything, irrationally eager to lever up to buy anything with the remotest prospect of a high return, and have been since tulips were considered a hot investment vehicle (at least).
If we actually had a shortage of investment capital, incentivizing it might make sense, but in reality, we have a glut. (The high failure rate of startups is one indicator: people are starting up businesses even when it does not make economic sense to do so because there is no “hole” in the market; they hope to push out an established competitor, which is a long shot. This is the opposite of leaving money sitting on the table.)
The preferential tax treatment of capital gains is just pure rent-seeking — people with lots of capital gains are rich, so they make campaign contributions in exchange for tax cuts.
James,
Sorry for any confusion, but what I am talking about are the investment gains experienced by the investment partnership (not gains from an individual company investments). So basically if the VC says to its the limited partners “here’s the deal, you invest some cash in the partnership in return I will invest all my time and assorted intangibles into the enterprise in return for a whatever % of the equity we all agree think fair”.
Given this more specific explanation, I guess the question still stands: Do you think the VC should get capital gains treatment on their share of partnership profits? I’m guessing “no” based on the entirety of your response.
You say “I don’t see how the fact that you’re not drawing a fixed salary makes your work the equivalent of a capital investment”. This is the very definition of sweat equity, i.e. invest time/intangibles for equity that is 100% at risk with no guarantee of return. Such sweat equity represents the bedrock foundation of entrepreneurial activity in the US. I would argue that if you take this position with VC sweat equity you are logically compelled to do so with regards to all other sweat equity.
That said, you seem to be arguing there can never be such thing as sweat equity for VCs because they are investing other people’s money. What exactly then are entrepreneurs who take outside investment doing??? It’s pretty much undeniable that they also are getting equity leverage off of other people’s money. Logically there’s really no distinction between the two. Of course, one might argue that a VC firm is not the same thing as a start-up, but most people that argue that have never tried to start a VC firm.
On one side note, you said that “if that’s what you want, then you should negotiate a deal up front where, in exchange for services you will render to the company, you get real equity.” I highlight this because one of the unintended consequences of this tax change may be that VCs push hard to do exactly this, i.e. to get start-ups to grant equity directly to GPs. Today most partnership agreements either prevent GPs from getting separate compensation from companies for their board services or require the VCs to give back any stock they get to the entire partnership. With the new rules in place I wouldn’t be surprised to see LPs loosen these rules significantly as a way to provide some backdoor capital gains comp to VCs. The losers in this are the entrepreneurs because if the VC asks for 5% of the stock for their board service and the entrepreneur really needs the money, they won’t be able to say “no”.
Net, net, I can see where you are coming from, I just have an honest disagreement with you as I don’t think it’s good tax policy to start playing favorites. I guess time will tell which of us is right.
iTod,
I actually am no longer a VC. The only startup investing I do these days is via my own angel investments, so I don’t really have a dog in this fight beyond trying to get people to see that there will be a lot of unintended consequences that flow from this change. In particular, people that identify with entrepreneurs seem to be supportive of these changes when they don’t consider how these will A) likely increase investment funding costs B) lead to demands for greater equity stakes from VCs, i.e. reduced valuations C) establish a slippery slope towards elimination of capital gains based on all sweat equity, not just VC sweat equity. VCs have lots of lawyers and lot’s of money, so don’t be surprised if someone else ends up ultimately paying the freight on this one.
In terms of VCs overestimating their value, start-ups routinely give up 2-10% to get high quality directors on their boards. I am guessing that a lot of start-ups would give up a lot of equity to get a VC like Mike Moritz or John Doerr on their board. You may not, but I think you’d be in the minority.
Finally, most VCs are prevented by their partnership agreements from making personal private investments in the same industry. This is to prevent GPs from “cherry picking” deal flow for themselves. This is why “deal flow” is one of important intangible assets that the partners collectively contribute to a partnership.
I would love to see them keep the one page of rates and put the rest in the shredder.
As a parent of four, homeowner, and salery-earner ($100k-200k range), I keep hearing about all of the “tax breaks” out there. Unfortunately, nearly all seem to be for people who make less money or much more money. I know that I make just enough to qualify for the AMT which wipes out some of the “normal” tax breaks. An AMT that applies to everyone would be fine with me.
Dan, you’re off the mark here. Each individual fund (eg. NEA XII) doesn’t continually raise money at stepped up valuations. It raises money once, and the carry is a share of the profits which is wholly unrelated to the GP’s actual investment of capital in the fund. No investment of capital means no capital gains treatment.
An important nit about startup compenation: you wrote that this sentence was an insult to early employees, who may contribute more to the success of a company than a VC.
“Under the new proposal, the only people taxed as ordinary income on the capital wealth created in that start-up would be the venture capital partners themselves.”
I assume you meant that those employees’ compensation is taxed as regular income, which is true. But at every startup I’ve been at, most pre-IPO employees are also given Incentive Stock Option (ISO) grants that can, in a successful company, be far more valuable in the long term than their salaries. If those ISO are held for more than a year before being exercised, their gains are also taxed as capital gains, not regular income.
I agree with your basic point about the 20% fee being income, since it doesn’t come with any additional capital being risked by the VC.
Create a company that owns the building, and have the young guy vest shares over time.