Warning: this post is very long and concerns tax policy, and so is likely to suck your soul while you read. However, if you have been or ever will be a highly successful entrepreneur, then I’m talking about matters that mean millions of dollars to you. Enjoy.
We are in a time when the government’s hand in the U.S. economy is heavier than at any time since as least as far back the 1930′s. Makes me wonder who, if anyone, lobbies in D.C. for the benefit of entrepreneurial activity?
The National Venture Capital Association has been in the news of late, as it tries to avoid Congressional and Treasury proposals to regulate “private pools of capital” – a generic term that includes hedge funds as well as venture capital funds. Hedge fund activity in the credit markets may have contributed to the systemic failures in the financial system, but commentators indignantly proclaim that venture capital had nothing to do with the current mess.
The NVCA is the main lobbying organization of the venture capital industry, and in their stated mission and nearly all of their public policy positions, they say they have a broader mandate to “support entrepreneurial activity and innovation.” The NVCA wants Washington to understand the VCs are not merely investors, but part of the lifeblood of the entrepreneurialism that fuels massive portions of the U.S. and world economy.
I suspect that at first the fine folks at the NVCA made this connection to entrepreneurialism because it sounds worthy and friendly to politicians, as compared to being cast as mere financial speculators. But now this connection has become a key conceptual anchor of their argument that venture capital should be treated differently from hedge funds and other private equity funds. Those other guys are pointy-headed number crunchers, see, who move massive amounts of money and credit with extreme disregard for our financial system. VCs are closely involved with startup innovation, heck they are practically entrepreneurs themselves!
This conflation of VCs with entrepreneurs is even more critical in what has become the most important lobbying battle in the history of the NVCA, the fight over carried interest tax policy. I think if more entrepreneurs understood this particular public policy issue, there might someday be better lobbying in DC for related issues that are closer to the hearts and wallets of entrepreneurs.
Briefly, VCs are typically compensated in two ways, with management fees and carried interest. Management fees are a small percentage of the total capital commitment of the fund. For example, a $100 million fund might have a 2% management fee, so the VCs receive $2 million per year for their operating expenses. Carried interest is basically profit sharing on the investment. So for example, if the $100 million fund operates for 10 years, and makes $500 million, a 20% carried interest might be applied on the profit – that would be $500 million less the $100 million of invested capital, less the $20 million of management fees (assuming 2% per year). So 20% of $380 million is $76 million. I’ve smoothed over a lot of variations and complexities, but this is basically how it works.
And how the U.S. tax system works – smoothing over a thousand times more variations and complexities – is that you either pay ordinary income tax of 35%, or long term capital gains tax of 15%. Have you guessed what the carried interest tax policy battle is about? That’s right: carried interest has historically been taxed as capital gain, but many are now calling for it to be taxed as ordinary income. In the example above (which would not be a particularly large or extraordinarily successful fund), the 20% difference in tax rates would mean $15.2 million less for the fund managers. You can see why this is the Battle of the Century for the NVCA.
Now, let’s get back to this point about VCs being practically entreprenuers themselves. In Congressional testimony, the NVCA says that venture capitalists rise above mere “financial engineers” (presumably the hedge funds and private equity guys), contributing sometimes daily management attention and real “sweat equity” into startup companies. Some entrepreneurs may snicker at that testimony, and others may pluck their eyeballs out rather than read it. I can freely admit that I’ve seen VCs who do make invaluable contributions to their portfolio companies, far above merely providing money.
But if the NVCA really wants entrepreneurs to view their efforts to “support entrepreneurial activity” favorably, they ought to extend their views on tax policy to the issues that really and directly affect entrepreneurs. See, although startup founders can readily enjoy capital gains treatment on the value of their equity, some bizarre tax policies in this country often have the practical effect of forcing ordinary income treatment on the equity stakes of many private company employees. The NVCA is fighting tooth and nail so that VCs (who are almost like entrepreneurs, after all) can get capital gains tax treatment, while saying not a single word about the policies that cause millions of startup employees to have their equity gains treated as ordinary income.
There are many ways that the NVCA could advocate tax policy for the benefit of entrepreneurs, but I’ll note the two most obvious ones, one a layup and the other a long ball in difficulty of change:
The layup is the Section 83(b) issue. This is just an utterly bizarre policy that is harmless to entrepreneurs if you file all your paperwork correctly, but it is ruinous to entrepreneurs (and often their companies and lawyers) when there is a mistake in filing. Briefly, founders and very early employees of startups usually receive stock (not options, but the stock itself) that is subject to vesting. The tax code says that ordinary income tax is due as the stock vests, on the spread between the price paid for the stock and the value on the date of vesting.
That’s a real problem, because even as the stock vests, it has no liquid market – meaning that the stock can’t be sold easily. So an entrepreneur who holds this stock in a successful company would get huge tax bills that he or she cannot pay. Fortunately, the IRS allows the stockholder to make a “Section 83(b) election” – this is an election to pay the tax at the time of the initial stock purchase. Since typically the price paid for the stock is the fair market value of the stock at the time of purchase, there is no spread and therefore no tax is due.
So that would be harmless, except that if you don’t file the election in the right way at the right time (30 days after purchase), you have to pay taxes the default way. And that kind of mistake does happen, and it can cost millions – not just for the taxpayer, because ruinous tax issues for company founders and early employees can easily sink the company itself, and also typically results in malpractice suits against the company lawyers.
Why should the default position in the tax law be to pay a ruinous tax that no rational person would ever voluntarily elect to pay? Why not just have a law that says if I don’t do a cartwheel on my lawn every 30 days, then I have to give my house to the IRS? This is just utterly inane, so inane that it should be an easy win for the NVCA if they were to take it up as a lobbying cause.
The long ball would be for the NVCA to go after AMT/ISO reform. This is a very complicated issue, but bear with me, because this problem does routinely affect startup company employees. In a vast, vast oversimplication: the problem is that the Alternative Minimum Tax requires Incentive Stock Option holders to pay a tax on exercise of their options, even though the company is private and there is no liquid market for their shares.
In a successful company, this can mean a tax vastly exceeding the assets of the employee, with no means of paying it. A typical solution for many is to sell their shares at the mercy of the less liquid secondary markets (at severe discounts), in order to be able to pay the taxes. And of course, a sale in that situation is typically taxed at ordinary income rates rather than capital gains rates, because of ISO tax rules. So AMT and ISO rules conspire to mean that startup employees often are forced to sell their stock at discount values, and to add insult to injury the gain is taxed as ordinary income rather than capital gain.
So, NVCA: you need to go after those two issues before any knowledgable person should regard you as an advocate for entrepreneurs and innovation. Not only would you get the cosmic satisfaction of your actions actually conforming with your words, but you would also likely get grateful contributions from entrepreneurs and their lawyers.