National Venture Capital Association

Innovation and Carried Interest Tax Policy

Tax fairness and support for the start-up community can work hand in hand.  During the presidential campaign, the Obama-Biden team demonstrated their understanding of critical drivers of economic growth by including in their tax platform a provision for a zero capital gains tax rate for investments in start-up companies.  In building upon this proposal, the new Administration and Congress must balance the goals of tax fairness with support for job growth, innovation and the creation of new, vital industries in the United States.

Background on the Carried Interest Debate

Technically, carry is an agreement among partners to allow one partner (the venture capitalist, or VC) to share in the partnership's profits in a percentage that is disproportionate to its percentage of contributed capital. As a result, a VC is entitled to carried interest only when he or she has successfully built a portfolio of companies that have grown to the point that they can enter the public markets or be sold to a larger corporation (and only to the extent that the profits from those companies exceed the losses and expenses from other less-successful companies).  Never guaranteed, carried interest is based on a meritocracy and provides a VC and the founder of a company with equal economic incentives to build an idea into a viable commercial entity. As such the possibility of receiving carried interest has been a critical and consistent component of the venture incentive paradigm for more than 30 years.

The concept of carried interest only recently became a focus of policymakers when in June of 2007 Congressman Sander Levin introduced legislation that created a new type of “investment advisory” partnership.  For these partnerships, carried interest would no longer qualify for capital gains treatment but would be taxed at ordinary income rates.  While this legislation seems to have resulted from concerns related to managers of hedge funds and private equity firms, venture capital partnerships were swept into this new definition – we believe inadvertently.  Justifications for the proposed changes centered around two themes:  tax fairness and, more technically, the definition of services income.  Common Misconceptions surrounding this debate include:

Misconception:  In the interest of tax fairness, venture capitalists should be charged a regular income tax on their carried interest, like that charged on compensation income.

Reality: When a venture capitalist earns carried interest, it is because he or she was successful in building a business that did not exist before.  If the business is not successful, then (unlike regular jobs) the venture capitalist receives no carried interest. These businesses create jobs and revenues for our economy.  This is the very type of investment Congress has tried to encourage through capital gains tax policy over the years.  Raising the venture capital tax rate on carried interest will discourage investment resulting in fewer companies funded and fewer jobs created.  The new Administration and Congress should look closely at tax fairness and ensure that it doesn’t harm the start-up community.

Misconception:  If a venture capitalist receives capital gains tax treatment on returns generated by his or her own invested capital, any additional returns should be treated as service income.

Reality: The service component of a venture capitalist’s job is captured by the management fee which is taxed as ordinary compensation income.  To the extent that a venture capitalist receives a return that is disproportionate to his or her personal monetary investment, that additional return reflects the intangible value that he or she adds in building the company – just like the intangible value that a founding entrepreneur contributes to that company.  Venture capitalists work side by side with entrepreneurs to create these emerging entities.  The founding entrepreneur also receives capital gain tax treatment upon sale of his or her founder’s stock, which includes a return that is disproportionate to the personal monetary investment made by the entrepreneur.  The outside investors (limited partners) of the venture capital fund want venture capitalists to receive this entrepreneurial reward only in the long-term, when actual economic events (sale or IPO of actual companies) have brought economic value to the entire team – entrepreneurs, investors and VCs.  Carried interest aligns the interests of the company, its founders, the venture capitalists and the outside investors in the venture capital fund.

Misconception:  Venture capital partnerships should not be eligible to receive any preferential capital gains tax rate.

Reality: Capital gains incentives are necessary to encourage long term risk taking in fledgling companies that stimulate the economy.  This type of investing is unique to the venture capital industry.  Of all the asset classes impacted by the proposed changes in carried interest tax policy, the venture industry stands alone in its ability to create entirely new companies, industries and technologies.  Without a long term investment tax incentive, venture capitalists would be compelled to shift to shorter investment horizons and later stage companies. That shift ultimately cuts off the innovation pipeline because seed and early stage companies have runways that are too long for investment consideration.  This dynamic translates to fewer jobs created and fewer new technological advances.

Misconception:  Venture capitalists should be taxed at ordinary income rates, just as professionals in the corporate world who manage funds and engage in the same investment activities.

Reality: Investment firms like Morgan Stanley or JP Morgan that have venture capital arms typically choose to structure them as partnerships so they are taxed just like a “normal” venture capital partnership (that is, they also take advantage of capital gains rate taxation).  Large corporations, like Intel or Pfizer, that engage in corporate venture activities choose NOT to form partnerships because what they seek to accomplish is fundamentally different from venture firms.  Those groups invest in start-up companies to gain early access to strategic technology developments, regardless of whether the investment ever makes money.  If the strategic focus of the parent corporation as a whole changes, the venture arm as a part of the corporation can be easily closed down.  Independent venture firms formed as partnerships must maximize the return on investment for the entrepreneur and any outside investors – i.e. they actually have to build viable, thriving companies to warrant success.

Misconception: Venture capital investment is really the same as private equity or hedge fund activities.

Reality: Venture capital is not designed to maximize capital efficiency from mismanaged or undervalued public companies, nor is it designed to meet short term liquidity needs, invest in public markets, securities or derivatives, take short or long positions or be accessible through brokers. Venture capitalists do not encourage their companies to engage in financial engineering or use leveraged structures. Venture capital returns are achieved by building private companies from the ground up with the goal of bringing innovation to market and creating substantial economic value in technologies, businesses and industries.