Source: Bloomberg
Venture Capital

As Clinton and Trump Call for Tax Reform, Silicon Valley Must Prove VCs Are Special

Venture capitalists will mount a campaign to show Washington why they’re different from hedge funds and private equity.

Venture capitalists are now the ones making a pitch. As both major presidential candidates promote U.S. tax policies aimed at ending special tax treatment for investment managers' income, Silicon Valley is girding itself for potential reforms. Venture investors, facing the possibility of bigger tax bills, are trying to convince Washington that they’re special and should be exempt.

At issue is a decades-old tax rule on carried interest, which is the share of profit awarded to fund managers when selling their stakes, or when companies are acquired or go public. Investment managers say that paying them in carried interest ties their compensation to the performance of long-term, often riskier, investments. Under current law, their carried-interest income qualifies for being taxed as capital gains at a rate as low as 23.8 percent, compared with the top individual income-tax rate of 43.4 percent on ordinary income.

During their campaigns, Hillary Clinton and Donald Trump have each singled out carried interest, calling it a tax loophole benefiting the rich. It’s likely to be a topic of conversation on Wednesday among attendees at a Clinton fundraiser in Silicon Valley hosted by Apple Inc. Chief Executive Officer Tim Cook. “Outside of this being a populist topic, it doesn’t make any sense,” said Peter Barris, a managing general partner at New Enterprise Associates who has been at the VC firm for more than two decades. “We are playing around with the golden egg.”

VCs will spend the next few months making their case to Washington for why they shouldn’t be lumped together with hedge funds, private equity, and real estate investors. They will argue that higher taxes would lead to a VC brain drain, deter new funds from forming, and discourage risk taking. In other words, the tax proposals threaten American innovation.

For a Quick Take on carried interest, click here.

Carried interest has periodically been a target of scrutiny for at least a decade. It was a flash point during the Occupy Wall Street movement and dogged Mitt Romney, co-founder of private-equity firm Bain Capital, during his failed 2012 presidential run. Over the past decade, some members of Congress have proposed treating carried interest as regular income for tax purposes, but those measure have failed.

In this election cycle, carried interest has become calcified in a larger economic debate. “It’s become the poster child for inequality,” said Matt Gardner, executive director at the Institute on Taxation and Economic Policy, a think tank in Washington. “When you see these tax breaks that aren’t available to the general population of wage earners, it erodes the public's faith in the tax system and in Congress.”

Gardner said eliminating carried interest tax benefits could generate an estimated $25 billion over 10 years. He said the amount is small, but it would be a huge symbolic gesture. And wealthy VCs will have a difficult time convincing the public that they should get a pass: “They all argue they are special.”

The VCs can mount a pretty convincing defense. They’ve helped transform novel business ideas into some of the world’s most valuable companies, including Apple, Alphabet Inc., Amazon.com Inc., Facebook Inc., and Microsoft Corp. According to a 2015 study by Stanford University, 43 percent of public U.S. companies founded since 1979 had raised venture cash. Venture capitalists argue that tax incentives encourage them to prioritize a startup’s long-term success over quick gains. They typically work with their companies for seven to 10 years before seeing a return. Because 4 of every 5 startups fails, investors said they bank on meteoric hits—and the accompanying tax benefits—to make up for losses.

As much as 60 percent of a venture investor’s compensation can comes from carried interest, according to the National Venture Capital Association, a U.S. lobbying and trade group. “It’s basically doubling our tax rate,” said Venky Ganesan, the organization’s chairman. Hiking taxes could make investing a less attractive career for those with high-paying jobs at tech companies, where many VCs come from, he said. The elimination of the carried interest provision would reduce the number of new funds and push the industry to make safer investments in more mature companies instead of gambling on areas such as medicine and clean technology, he said.

Not all VCs are panicking. Fred Wilson, co-founder of Union Square Ventures, has expressed support for taxing carried interest as ordinary income. Sam Altman, the president of business incubator Y Combinator, said in December that it’s “ridiculous” for VCs to pay a lower rate on their returns than Americans do on their salaries. (Y Combinator startups receive backing from Willett Advisors, the investment arm for the personal and philanthropic assets of Michael R. Bloomberg, the founder of Bloomberg LP.)

But there is precedent for VCs to be classified differently from other types of investors, said Ted Schlein, a general partner at Kleiner Perkins Caufield & Byers. The industry was excluded from the 2010 Dodd-Frank law, partly because Americans have a greater understanding of the unique value VC funding provides to the economy, he said. “Eliminating carried interest deductions for VCs either shows an ignorance of the issues, or it means you are truly anti-entrepreneur,” Schlein said. “It’s a much more nuanced topic than politicians give it credit for.”

Fighting to keep the carried interest provision risks creating a bigger problem. Appealing for special treatment could make Silicon Valley financiers appear greedy and out of touch, putting their reputations at risk. Tom Perkins, the late co-founder of Kleiner Perkins, wrote a 2014 op-ed in the Wall Street Journal comparing the treatment of rich Americans with the persecution of Jews in Nazi Germany. The article was thoroughly ridiculed and quickly disavowed by other VCs, including those at his own firm. Perkins later defended his comments on Bloomberg TV: “It’s absurd to demonize the rich for being rich and doing what the rich do, which is get richer by creating opportunity for others.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE