Rewarding High-Risk Innovation: The Case for Carried Interest
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the profits from their portfolios, venture capitalists have to create a lot of value over a long time that benefits a lot of other people. Taking bio-venture as an example: A four-man team running a medium-sized fund of $200 million—let’s call it Improbable Ventures—must create and/or invest in companies that sell in total for more than $1.3 billion in order to make their first $1 of carried interest.
Since early stage financings are typically syndicated, a single fund might invest in 15-20 companies and expect to own about 15 percent of each. Last year’s crop of biotech companies took an average of nine years from first venture round to exit. A fund hitting .333—i.e. one out of every three startups survives—would have a very good record.
Where does the other $1,299,999 of capital value go? In our example, $200 million of the $1.3 billion (15 percent) would go to the investors in Improbable Ventures—pension funds, endowments, and other institutional investors—to repay their invested capital. The remainder goes to the other investors, founders, and managers of the portfolio companies.
Even more importantly, the pharmaceutical industry gets $1.3 billion worth of new products. All of the people who have worked on those assets paid taxes from property to income, and will pay more in future. Products that make it to the market can provide billions in profits for investors (and the IRS) and alleviate the suffering of millions of patients.
Those new drugs represent real wealth that didn’t previously exist. They will save lives and put people back to work. Each successful product paves the way to the next generation of medicine. As patents expire—$103 billion (44 percent of 2011 sales) of branded drugs in the U.S. will shift to generic through 2016—the cost of medicine falls dramatically and permanently.
The importance of venture capital lies in its role as a catalyst in stimulating commercial innovation and renewal. The fund structure enables experienced managers to leverage their skills across multiple companies (and multiple headaches) and should not be a means of disenfranchising them from the favorable treatment that other startup team members enjoy.
Raising the federal tax on carried interest by more than 2.5 times, from 15 percent to more than 40 percent, would make tax strategy a major factor in maximizing venture capitalists’ take-home pay. When they turn their attention from building new companies to managing their tax problems, they spend more time with attorneys and less with entrepreneurs. Contrary to what people might think, VCs don’t have cadres of lawyers to do this work for them.
If both fees and carried interest are taxed as ordinary income, it makes sense for a manager to focus more on fees than carry, because fees are guaranteed up-front payments, not dependent on the results of risky investments. Carry, if it ever comes, has to be discounted for the time it takes to grow and exit a business.
The best way to insure access to future fees is not to lose investors’ money by sticking to safe investments. The best way to maximize returns from carry is to invest in the most exciting and innovative opportunities a manager can find. Changing the relative value of fees and carry moves venture capital away from risky and toward “safe” investments.
However, the government should encourage aggressive investment, because society benefits disproportionately when managers make risky bets on innovative teams and technologies. The system needs more “Black-Swan” type opportunities. These home-run companies reshape the commercial landscape and take the world in unexpected directions. They change the quality of our lives through the creation of electronic media and break-through medicines.
Higher taxes on private equity and venture capital would be a step in the wrong direction, a disincentive for optimal behavior in a productive industry that is already struggling. The National Venture Capital Association estimates that the number of active venture funds has dropped by over a half since 2000, even more in the life-sciences sector, and the trend is expected to continue.