Thursday, April 9, 2009

Politicians: You All Look the Same to Us

When wielding a large regulatory hammer, sometimes everything looks like a nail.

In the quest to identify and regulate 'systemic risk' and increase the tax base, our politicians have decided they don't want to be in the business of defining 'what is a hedge fund, what is a private equity fund, what is a vc fund', etc. So they are seeking to apply a broad prophylactic that will only further damage a fragile dynamo of economic activity.

It has been written that venture capitalists, while representing something on the order of .02% of annual US GDP, have backed businesses that now represent nearly 18%. Whether that's a stretch or not I do not know; the point is, this is not about a small 'adjacent' asset-class that is simply collateral damage in the war on systemic risk, as some politicians would have us believe. It is a direct assault on the future industrial outputs of our nation. Competitor countries will not wait for us to discover how misguided these efforts are and reverse them; they will rush in and capitalize on the opportunity, filling the vacuum.

Far more than simply an issue of debt levels and systemic risk, the very nature of the venture business is fundamentally different than that of its 'cousin' enterprises in private equity, leveraged buyouts, and the hedge fund world. VC funds are small (rarely more than low to mid-nine digits and usually quite a bit smaller). Their partners do not get rich off of fees irrespective of ultimate outcomes. Funds do not have meaningful – or even measurable – debt leverage ratios. The companies in which they invest almost never have more than a handful of employees and negligable (or zero) revenue.

In sum, it is an industry that by definition exists on the left side of Schumpeter's curve; that is, the creation part of 'creative destruction', where job growth, tax roll contribution and economic output (including significant positive trade-surplus) curves move up and to the right.

Politicians fretting over falling victim to the 'game theorists' and thus avoiding the ‘definitions' conundrum are doing a great disservice to our country; unfortunately, by the time they realize - and reverse, amend or except - various policies, it may be too late.


Barry Graubsrt said...

I think you do a good job of describing the difference in the role that VCs play, but am not sure I understand it's relevance to the carried interest tax issue. The reason to increase the tax isn't punitive.
Are you saying the VC market won't be lucrative enough if carried interest is taxed as income? I think it may be slightly less lucrative (and may weed out the weak performers) but it will still be a profitable profession.
Tax rates aren't based upon contribution to society.

James D. Robinson said...

The great advantage of long-term gain models in venture capital lies not in remuneration issues for VC's but rather in the alignment of incentives between investors and entrepreneurs. Despite a degree of passionate (though often misguided) hyperbole to the contrary, this system does, in fact, work quite well. Yes, issues exist around the differences between preferred and common shares (and even various classes of preferred); still, ceteris paribus, equity-holders generally succeed - or fail - together. (Things like liquidation preferences may get part or all my money back - but almost never constitute a real 'win' for a VC).

If regulations are enacted that erode the differential between current and deferred compensation, then VC's as a whole will look to alternative compensatory schemes that achieve a similar result, most of which are likely to foster disalignment. For instance, I can easily envision VC's extending 'loans with warrants' that never convert until a transaction; under that sort of scenario, as a creditor a VC's interests and those of the entrepreneur can and will diverge wildly both in short & long-term strategy.

Is that really what we want?

And what of the VC's funding source, the limited partner? If they, too, see no tax advantage for investing in venture capital as an asset class relative to, say, public securities, will they?

James D. Robinson said...


The tax code has already established a carve-out so that individual taxpayers can exclude 50% of any gain from the sale of qualified small business stock (“QSB”) that has been held by the taxpayer-shareholder for more than 5 years.

So, what’s a Qualified small business stock, you might ask? It's stock in a qualified small business that is a domestic C corporation that does not have, at the time of the issuance of stock (i.e the initial investment) assets in excess of $50 million, and whose aggregate gross assets after the issuance of stock do not exceed $50 million (n.b.: this is an asset test, not a valuation test). Aggregate gross assets is the amount of cash and the aggregate adjusted bases of other property held by the corporation. The vast majority of venture-backed companies would qualify. (Incidentally, if a hedge fund, LBO firm, etc., were to invest in such a company, they, too, should qualify, for that deal. Isn't that really the point of encouraging growth in start-up enterprises?)

Back to QSB... The active business requirement is met if at least 80% of the corporation's assets are in the active conduct of one or more qualified trades or businesses. Assets used in start-up activities, research and experimental activities, and in-house research expenses fall within the "active conduct" requirement. What is a qualified trade or business? -- business in engineering, technology, accounting, financial services, banking, insurance, financing, leasing, investing, etc.

So, the government has already classified VC differently and doesn’t have to re-create the wheel – they just have to incorporate this into the new legislation.

Anonymous said...