This article appeared in Venture Beat today. I’ve been meaning to write about this topic for a while, but waited to see how it would develop. As it turns out, Obama, who received a lot of support from several prominent venture capitalists on Sand Hill Road, thought it would be a good idea to tax carried interest as ordinary income. He believes, wrongly, that this would bring in billion of tax revenues each year. Umm… he’s got to be kidding, right? Sure, maybe it works in theory, but whoever advised him on this clearly has no understanding of how carried interest works. His proposal applies to both buyout firms and venture capital firms, but I’ll focus mostly on VCs.
First of all, with the economy the way it is now, only a fraction of VCs will receive carried interest. If that’s the case, President Obama is not going to see billions of tax dollars flowing into government coffers like he hoped he would.
Secondly, carried interest is what motivates these guys to take big bets and invest in world-changing ideas. If you are a post-MBA associate at a prominent venture firm whose working her tail off to make partner, would you still want to put in all that hard work if you found out that the government was going to tax your shirt off? Management fees just pay salary and bonuses. No venture capitalist works for that. They want carry so they can make bank when they get 5x return on their fund.
Thirdly, private equity investments are long-term investments, especially in venture. It’s not as though VCs invest in a company one day and sell it the next day. It takes as many as 7 to 10 years to invest, grow, and harvest a company. This means that it may take as long as 7-10 years before they get their money back. Mark Heesen, the president of National Venture Capital Association, makes a great point when he says that carried interest works as a buffer to weather failures while waiting for the next home runs.
Yes, I do realize there is a difference between angel investors who invest their own money and VCs who invest institutional capital. But if, for that reason, the government taxes the VCs’ carried interest as ordinary income, then those who can will just start investing their own money. And those who can’t wouldn’t have made much money anyway so taxing their carry as ordinary income wouldn’t have been an effective move anyway.
Entrepreneurs and investors, who risk their money and time in an attempt to create new (or almost new) businesses and employee hundreds of thousands of people (here’s where VCs and PE shops differ in a major way) and make life more convenient, should be awarded.
Maybe Mr. Obama is right. Maybe his system will bring in more tax money. But think of the opportunity cost of killing the next google or ebay. That would have been a shame wouldn’t it?
By: Jonathan Lee