Nothing ventured, nothing gained

Several friends of mine have recently asked me to explain what Hillary Clinton and Donald Trump mean when they talk about closing the “carried interest loophole.”  Why me?  Because I run a venture capital fund which, like most every other venture capital funds, gives me a share of the profits that we return to our investors.  This profit sharing—earned only after an investment into a startup company becomes successful—is what has become the political football called the “carried interest loophole.”

Recently, some very prominent venture capital investors, many of whom helped pioneer our industry, have come out in favor of “closing the carried interest loophole.”  Setting aside the fact that profit sharing helped these folks create their fortunes over the last 50 years, they do not speak for most of us in the industry.

{mosads}Although tiny, our industry is powerful. Venture capital firms have invested $40 billion into 3,500 private companies, including 1,400 that received their first venture funding, every year, on average, since 2011.  Venture-backed companies account for 42% of U.S. IPOs and 85% of R&D spending among public companies that went public after 1974.  Furthermore, the Kauffman Foundation points out that almost all of the 25 million net U.S. jobs created since 1977 came from young companies less than five years old, many venture-backed. 

I understand the urge to increase taxes on the financial sector when so many are feeling the economic strain of a changing economy.  But doubling the tax rate on successful venture capital investing would be akin to the country’s cutting off its nose to spite its face.  Our job is to partner with entrepreneurs to build the successful companies of the future, and if we succeed, everybody shares in the gains.  Our successes, which can take a decade or longer to build, create new jobs (sometimes even whole new industries), innovative products and medicines, and fuel economic growth.   

We are not “Fat Cat Bankers” as described by President Obama when he lumped us in with Wall Street bankers in 2009, or “Society’s lottery winners” as he described in 2015 when he lumped us in with hedge fund managers.  We are the engine behind the entrepreneurial ecosystem.

Knowing the critical role venture plays in supporting entrepreneurship, why would you ever want to jeopardize it?  In Washington, it’s generally accepted that tax policy should be used to change behavior.  Raise taxes and you get less of something, lower taxes and you get more of something.  If we want less venture capital investment into innovative startups in the U.S., then by all means lets tax it more.

You’d be hard pressed to find a single senator or member of Congress who wants fewer entrepreneurs, fewer jobs or less venture capital investment in their state or district.  Today 50% of venture capital goes to companies in California and 35% is in the Boston-New York-DC I-95 corridor.  That leaves 15% for the rest.  If we want to inspire a new generation of venture capitalists to support businesses in Columbus, San Antonio, Tampa and Phoenix, then we should not make it harder for them to reap the rewards of their investments. 

Some argue that venture capitalists are not investing their own capital in their funds and therefore should not be entitled to capital gains treatment.  Aside from the fact that this is just not true, I would argue that venture investors should be treated just the same as entrepreneurs and other employees at startup companies because in addition to the capital we deploy we also invest sweat equity, side-by-side with founders, to build great businesses.  If we tax the sale of stock from founders who started a company as well as the stock options for employees as capital gains, why not the investors that partnered with them to build the company?

As venture capitalists, we have to take lower salaries today in exchange for the opportunity to make more down the road if the combination of our sweat equity and investment capital creates growing, successful businesses.  Our investors demand that we have a significant level of skin in the game because venture investment is such a high-risk business.  I earn less today in salary than I did 20 years ago running a technology company.  But I do it because I have the potential to earn carried interest if I help my companies achieve success.  If Congress doubles the tax rate on carried interest, it would devastate the economics of venture capital fund formation and the long-term, patient investment model that have been critical to the American entrepreneurial ecosystem. 

Many have said that no venture capitalist out there will quit investing if taxes on carried interest are raised.  While many current VCs will continue their work, what will change most dramatically is the rate by which new entrants get into the venture game, especially those who would launch a fund outside the obvious places of California, Boston, and New York. 

What will also change is how we invest.  If there is no differential economic benefit to outsized success, then we will start making safe bets instead of swinging for the fences.  The net result of all this would be detrimental to the entrepreneurial ecosystem and to the broader economy.  So instead of candidates tripping over themselves to play catch with the carried interest political football, I’d encourage them to think critically about the negative consequences that would result from the elimination of the current tax treatment of carried interest for the venture capital industry. 

Backus is Co-Founder and Managing Partner of the Reston-based NAV and PROOF funds and a member of the board of directors and executive committee of the National Venture Capital Association (NVCA).