Tag: venture capital

How VCs Are like Colleges

By James Kwak

College application essays? They’re all the same. That’s according to Rick Clark, the head of admissions at Georgia Tech, who kicks off this past weekend’s episode of This American Life by, in part, mocking the tired trope of “idealistic teenager goes to Central America to help the people there but becomes transformed by the experience.” Clark, however, is self-aware enough to realize that the colleges are equally bad: the glossy brochures they send out to high school students, trying to attract their application fees if not their tuition checks, are all exactly the same in virtually every respect.

This reminded me of what it’s like trying to raise money from venture capitalists. The number one thing they care about is your sustainable competitive advantage (unless you’ve already started a successful company, in which case they’ll write you a check to deliver peanut butter sandwiches by text message, but you don’t need their money anyway). Why, if your idea is so good, won’t big company X (in our case, SAP or Oracle) just copy you and crush you? It’s like they all took the same class in business school and only paid attention for the first fifteen minutes.

Then, at the end of the meeting (occasionally at the beginning), they talk about themselves and why you should want their money as opposed to the equally green money of the identical-looking, khakis-wearing, bicycle-riding people on the other side of Sand Hill Road. They really focus on improving operations; they sit on a small number of boards; they care about developing entrepreneurs; blah blah blah. They all have exactly the same pitch. But they can get away with it because they have the thing that matters: money. The one VC I liked the most was the only one who said, “Basically, we’re the money, and we try not to mess things up too much.”

(The rest of that TAL episode is a fantastic story about Emir Kamenica and how he made it from being shot at in Bosnia to going to Harvard—so good I almost took the wrong exit on the way to work yesterday.)

Private Equity and “Job Creation”

By James Kwak

The phrase “job creation” always makes me a little queasy. The personal computer has probably contributed to the elimination of tens of millions of clerical jobs, yet I think most of us feel that computers are a good thing: they make people more productive, meaning more goods and services for everyone . . . and hopefully the people who lost those jobs will find work doing something else. In boom periods, like the 1990s, it seems to work, at least for most people, but I doubt that there’s any proof that productivity-increasing innovation always increases employment. But this line of thinking quickly leads to questions like whether the invention of the automatic toll booth is a good thing (because it eliminates what must be a pretty unpleasant job) or a bad thing (because it results in the layoff of people who may not have good alternatives), and those questions are above my pay grade.

Anyway, job creation these days usually refers to growing companies, making stuff people want, which tend to hire new workers—leaving aside the question of whether the products they make are causing other people to lose their jobs. This is the kind of job creation that Mitt Romney (and the private equity industry, at least publicly) wants to be associated with.

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Wall Street and Silicon Valley

By James Kwak

Whenever someone criticizes “Wall Street,” someone else tries to defend Wall Street by saying that without it we wouldn’t have Silicon Valley and all of its wonders. Most recently, A.S. at Free Exchange says this:

“What would Silicon Valley have been without venture capital and private equity? Apple’s spectacular growth was made possible by the capital it raised in financial markets (it is a public company).

“Much of Apple’s initial investment came from an angel investor (a relative or friend who provides the start-up capital). But most new companies rely on formal capital markets. In a 2009 working paper, Alicia Robb and David Robinson investigated the capital structure of start-up firms, and found that 75% primarily relied on external financing from formal capital markets, usually credit cards and bank loans in their first year. They also found that firms that used formal credit were more successful.”

As critics of Wall Street go, I probably find this more annoying than most because, well, I worked in Silicon Valley. Most of these comments are obvious, but here goes anyway.

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Steve Jobs and Me

By James Kwak

I took a short break from fiscal and monetary policy to write an Atlantic column about Steve Jobs’s retirement and what it means for the eternal debate over whether and when founder CEOs should be replaced by experienced outsiders. Along the way, I read some interesting papers on the relationship between founder CEOs and stock market returns or company valuations.

I should clarify that I’m no Apple fanboy. I use a MacBook Pro, which I consider almost a necessity given how much time I spend with my computer and the abominable state of Windows. But I don’t like the “my way or the highway approach” when it comes to hardware; I wish it had a Backspace key and a deeper keyboard, among other things.

I understand that controlling the hardware ensures a more consistent user experience and less customer dissatisfaction, but allowing hardware manufacturers to compete certainly has its advantages. Look at Android, for example: I use an Android phone, and even if the iPhone is still the best phone for the median customer (a highly debatable point), the proliferation of Android models means that for most people, there is an Android phone that is a better fit. Although I was an early iPad adopter, I’m generally disappointed with it. It’s great for playing Plants vs. Zombies, checking the weather, or watching a TV episode, but it’s too slow and the browser is too weak to do anything serious. And the fact that you can’t swap out the default Apple keyboard (as far as I know) is a classic example of the problem with the Apple approach: the thing doesn’t even have arrow keys (yes, I know how to use the magnifying glass), and every Android keyboard does a better job with special characters.

Still, there’s no question Steve Jobs is a genius, and nothing like the empty suits who parade through the Times‘s Corner Office column who talk about nothing but hiring, motivation, and teamwork.

Update: Sorry, I meant to say Delete key, not Backspace key.

The VC Tax Break

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.)

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