Calling the Carried Interest Bluff
The National Venture Capital Association just released a report suggesting that the business of investing money in fast-growing start-ups is on the ropes:
The uncertainty and potential impact around many of the policies that have been discussed in Congress in recent months has contributed to an investment climate that is viewed as increasingly unfavorable by a majority of the venture capital industry. This course must change if we wish to remain competitive with other nations over the long term.
That's from Mark Heesen, the NVCA's president, and he is referring, among other things, to the taxation of carried interest, which has been heating up lately. In brief, carried interest is a fee that VCs charge their investors, calculated as a percentage of how much money they make. Today, those fees are taxed at the lower capital gains rate of 15 percent, rather than the rate for ordinary income, which tops out at 35 percent. The NVCA is in full court press right now to try to stop Congress from removing the tax break and has posted a giant link about the issue on its homepage.
I have a lot of respect for Mark, the NVCA, and the right of every venture capitalist to get filthy freaking rich. VCs do good work and they've helped create many an innovative company. But I'm skeptical of the NVCA's argument that treating venture capitalists like regular wage earners (that is, by making them pay income tax on their income) would somehow destroy the start-up economy.
The NVCA's position on carried interest goes something like this: Venture capitalists need tax breaks because start-ups are good for the economy. Taking these tax breaks away "effectively removes any meaningful tax incentive for long term investment in new companies," according to a recent press release.
But there's a problem with this. A tax exemption for VCs doesn't create an incentive for investment in start-up companies; it simply creates an incentive for going to work at a venture capital firm. Here's Fred Wilson, a venture capitalist who supports the change:
We have witnessed financial services (think asset management, hedge funds, buyout funds, private equity, and venture capital) grow as a percentage of GNP for the past thirty years. The best and brightest don't go into engineering, science, manufacturing, general management, or entrepreneurship, they go to wall street where they will get paid more. And on top of that, we have been giving these jobs a tax break. That seems like bad policy. If we force hedge funds and the like to compete for talent on a more level playing field, then maybe we'll see our best and brightest minds go to more productive activities than moving money around and taking a cut of the action.
Fred points out that folks who invest their own money in venture-backed start-ups--that is, university endowments, pension funds, and wealthy people--will not pay higher taxes; they'll still pay capital gains rates. And VCs who invest their own money will not see their tax bill go up either.
So why do VCs deserve to have their income taxed differently from that of regular people? I called Emily Mendell at the NVCA who argued that a VC's contribution to a start-up is "akin to that of a founder" who contributes sweat equity. Since founders who sell their companies are taxed at the capital gains rate, she said, VCs should receive the same treatment when they sell a company.
That's an interesting point, but VCs aren't founders; they're extremely well-paid professional investors. Moreover this isn't a debate about start-up creation; it's a debate about VCs' take-home pay.
That's fine by me. I can see why the average venture capitalist wouldn't want his tax bill to go up. And it's perfectly reasonable for a VC trade group to try to protect its members from tax increases. But let's not get all high and mighty about it.
I'm curious to hear what people reading this think--and I'd love to see someone make a convincing case that treating carried interest as income hurts start-ups. I haven't seen it yet.