Right now, there is a bill before the US Government that looks to remove a preferential tax treatment for Venture Capitalists and Hedge Fund Managers. People like Chris Dixon (@cdixon on Twitter or http://cdixon.org) and Fred Wilson (@fredwilson on Twitter or http://avc.com) have come out in favour of changing the tax treatment whereas Jeffrey Bussbang (@bussbang on Twitter or http://bostonvcblog.typepad.com) has come out against the change.
By way of background, here is the issue at hand: VCs raise funds from Limited Partners (investors on behalf of individuals, large funds, pensions, etc) and the VC invests the money strategically according to the funds goals. This money is “funds under management” so NORMALLY the VCs charge a management fee of ~2.5% from which they pay themselves a salary and keep the day-to-day administration of the fund running. Finally, when the VCs realise a return on their investment they get what is called “carry”. Basically, “carry” is a percentage of the profit on the investment and is usually, from what I understand 20%. Now under US Tax Law, for the investors, they’ve made a long term investment and their return falls under the capital gains tax regime which means they pay a lower rate of tax on their profit. The rub is that the VC is also getting the capital gains tax treatment on their “carry”. For a really good explanation of this go to Fred Wilson’s blog: http://www.avc.com/a_vc/2010/05/why-taxing-carried-interest-as-ordinary-incom… The part of this debate that I’m starting to find surprising is how the people who are against the changes are trying to justify their lower tax rate. It is nothing but FUD (fear, uncertainty and doubt). The main arguments are: – less funds will be employed in startups because LPs will have lower returns as VCs pass on this additional cost;– smart people will go into industries other than VC where they can make more money and pay less taxes;
– VCs will become risk averse; and,
– Smart people will find other tax loopholes. What an absolute load of crap. This kind of drivel is consistent when you shine the spotlight on something unfair, those who’ve been taking advantage never have a tangible argument as to why they should get preferential treatment. The current situation is entirely unfair for the average American taxpayer. A VC or Hedge Fund Manager gets PAID a salary to invest money on behalf of other people. They get paid to do it “SUCCESSFULLY”! The meaning of success is to get the highest return possible. The VC or Hedge Fund Manager is not taking ANY capital risk whatsoever by turning up for work and doing their job, they are getting paid a salary. To then try an argue that they deserve the same tax treatment as the people taking the risk (the startup entrepreneur and the LP) is disingenuous. The idea that VCs will become more risk averse or effectively pass on their personal taxes as a cost to the LPs is also laughable. VCs are in the business of getting higher than ordinary return on higher risk asset classes. If they stop taking risk, then they will overpay for assets and see lower returns. If they pass on their taxes as a cost to the LPs then this will lower the return. In my opinion, this will separate the men from the boys – the VCs like Fred Wilson and Chris Dixon who are killing it right now will see no change in their returns and may see higher quality deal flow while “risk averse” VCs overpay for shares in the next round of Facebook and Zynga. I encourage a shakeup of people in the VC industry. If some of them want to leave to go be M&A bankers, go crazy. The newer generation of VCs who are becoming the successors to Ron Conway and John Doerr aren’t the Harvard MBA clique who’ve been running the show, but they are former entrepreneurs like Chris Dixon, Caterina Fake, Reid Hoffman, Jason Calacanis, Kevin Rose and Mark Suster. Then there are guys like Fred Wilson, who LOVE what they do, they want to add value to the companies they invest in, look at what Jack Dorsey (@jack) has to say about Fred Wilson. These people aren’t in it for a tax dodge and I doubt they’d leave the industry because they had to pay a fair amount of tax – in fact they’d probably look at it like a challenge to go make more money. My favourite argument is the one about “smart people finding other loopholes”. For me, that’s what’s become so wrong about the current economic system. You get all of these analysts and accountants spending inordinate amounts of time trying to game the tax system or the markets and they don’t have any ability at all to CREATE something. Far too much time and resources are spent today trying to avoid paying taxes, if only that money and effort were put into creating new businesses or products. We’ve trained too many MBAs to think of tax as a “drain” on a business that should be avoided as opposed to what it really is, a byproduct of success – PROFIT.