Rewarding High-Risk Innovation: The Case for Carried Interest

4/15/13

As Washington grapples with the deficit, nothing generates more emotion than tax “loopholes.” A priority “loophole” target in the budget that President Obama sent to Congress last week is the treatment of managers’ carried interest in private equity funds as capital gains, which he characterizes as “unfair” and the key reason for the low tax rate paid by Mitt Romney.

When John Steele Gordon declared “Carried Interest is not a Capital Gain” in a recent commentary for the Wall Street Journal, he drew a slew of comments, most of which supported his view. Some were downright virulent, as in, “These vultures are leaches who will eventually ruin our economy. No way they should get a huge tax break for doing it.”

Before changing the rules in this area, I suggest that we consider the argument for capital gains treatment, particularly in the case of venture capital funds. I have a vested interest in the issue. I am a life sciences venture capitalist.

In the article Gordon explains that “Managers of these funds are compensated for their services in two ways. One is the annual management fee, usually 1 percent or 2 percent of a client’s investment. The other is a share in the net profits of the fund’s long-term investments. …The management fee is taxed as ordinary income, but the long-term profits of investment are taxed as a long-term capital gain, for both clients (the investors in a venture fund) and…managers.”

Gordon contends that fund managers should not be entitled to a break, because they “share in the gains but not the losses. They do not put their own money at risk; the reality is that the compensation for their services is income and should be taxed as such.”

Gordon agrees that an entrepreneur should be entitled to capital gains treatment, because “he invests his time and his sweat equity… He is risking a lot: a substantial portion of his working life, his reputation, his potential current income, etc.” All a fund manager provides is advice, like a lawyer.” (That last analogy is particularly painful.)

Mr. Gordon’s descriptions of a founder pretty well describe the contributions of an early stage venture capitalist. These fund managers go through the same process as any founder, starting with an idea, organizing the company, raising funds and recruiting managers.

Venture capitalists clearly meet Mr. Gordon’s two principal requirements for capital gains treatment: Sweat equity and returns at risk. However, a venture capitalist faces an additional level of risk. Before he can take a share of the profits from any one investment, he has to repay the costs of all the other investments in his fund, plus all of the fees he has received. In fact, if the venture team had received options to purchase a 20 percent interest in the fund instead of a carried interest, they would be in exactly the same position as a management team granted stock options, which all agree qualify for capital gains treatment.

John Carey, senior editor at CNBC.com, points out that managers of private equity funds rightly expect to be taxed on the same basis as their investors, because the rate should be based on how the money was made—through investing in long-term assets—and not who received it. “In fact this [discrimination between investors and managers] seems a bit unfair: it rewards those who already possess wealth and punishes those who must raise it from others.”

While meeting the technical requirements is important, an even more compelling argument for capital gains treatment is the benefit to society of incentivizing venture capitalists to pursue the often quixotic task of starting new companies.

Before they can share in 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.

This is not the time to shift money and resources away from venture capital. The industry will create value that will more than compensate tax payers for their forbearance.

Standish Fleming is a co-founder of San Diego’s Forward Ventures, and a 24-year veteran of early-stage, life sciences investing. He has helped raise and manage six venture funds totaling more than $500 million and served on the boards of 19 venture-backed companies, including Nereus Pharmaceuticals, Ambit Biosciences, Triangle Pharmaceuticals (acquired by Gilead Sciences) and Actigen/Corixa (now part of GSK). Follow @

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  • Tom P.

    Mr. Fleming’s assertion that VC carried interest is equivalent to a 20% option position neglects to note a critical detail: option holders need to exercise their options and hold the shares for a year to gain long-term capital gains treatment. If they don’t, proceeds are taxed as ordinary income. In exercising their options early, company entrepreneurs and teams put their own capital at risk, just like fund LPs, and these risks can be significant.

    If Mr Fleming were honestly willing to take options in his fund rather than carried interest, and to really put himself in “exactly the same position as a management team granted stock options,” nobody would contest his right to pay long-term capital gains. But he’s not, and that fact actually helps highlight a core point of Mr. Gordon’s challenge – that fund managers are unfairly getting long term capital gains treatment without ever putting their own capital at risk.

  • Tom P.

    Mr. Fleming proposes “an even more compelling argument for capital gains treatment is the benefit to society of incentivizing venture capitalists to pursue the often quixotic task of starting new companies.”

    Let’s consider which is scarcer: financiers willing to raise and manage VC funds under 2 and 20 terms with probably 50% odds of success and a very nice living whether they succeed or fail; or entrepreneurs and teams willing to found and build companies with probably 10% chance of success, and a discounted living standard in the meantime? Which of these is the more “quixotic” pursuit, and who is really at the heart of starting these new companies, the founders or the investors?

    • Standish Fleming

      At the Rock Stars of Innovation conference in San Diego recently one of the panelists quoted estimates that by the time industry completes
      the current contraction cycle, only 1/3 of the funds and less than ¼ of the
      partners would remain. Losses on that scale should be sufficient to place any industry on the endangered-species list.

      With its long and painstaking apprentice system, the industry took almost 30 years to reach the peak last decade. To rebuild, we will need to attract the brightest and the best. Fair treatment of carried interest as capital gains will not guaranty we can get the talent we need, but at least it will not place the industry at an obvious disadvantage.

      The biggest threat to the entrepreneurial ecosystem is not catastrophic regulation, but the incremental degradation of environment to the point that we find ourselves compromised across a broad front. The US does not have a monopoly on new business formation or entrepreneurial initiative. Many of the stars of the start-up world come here from elsewhere. We cannot afford to limit the opportunities for our managers, our companies and our communities when we compete for the resources we need to create and sustain the innovation economy.

  • Tom P.

    All of the benefits of new business formation Mr. Fleming cites are compelling. But let’s get real: the growth of our innovation economy is more constrained by a limited supply of viable new ventures led by strong, seasoned management teams than by any lack of investment capital or people to put that money to work. Indeed, the weak performance of the VC industry over the past decade helps makes this case – too much money pursuing too few deals. And that weak performance – by the very same talent that’s attracted by the incentives that Mr. Fleming supports – is leading investors to look elsewhere for market-beating returns.

    If we’re going to take the leap that it makes sense for the government to invest in incentivizing business formation at all, let’s start from scratch. Shouldn’t we focus every dollar on supporting the constrained side of the equation, and help encourage entrepreneurs to launch new companies? What if we set the income tax rate to zero for anyone involved in the first two years of a company start-up? Wouldn’t that be a better investment with broader impact and a larger benefit to society than helping a few already-wealthy people try their luck in what is already an overcrowded VC space?

    While there’s little or no evidence to suggest that leveling the tax playing field would dissuade VCs from playing the game, if such a policy helped accelerate the contraction of the VC industry to a point where the remaining players could deliver more compelling returns to their LPs, wouldn’t that tend to help keep the capital flowing to this industry, and provide further social benefit along the lines Mr. Fleming advocates? What if some VCs actually were compelled to start companies on their own (and take the options packages that Mr. Fleming finds so attractive); why wouldn’t that represent a positive reallocation of human capital?

    • Standish Fleming

      The innovation economy is constrained by many factors, first and foremost by capital and experience, and the venture industry is a major
      provider of both.

      Venture has made substantial contributions to the US entrepreneurial
      community. According to Ernst and Young venture capitalists have invested nearly $220 billion, largely raised from institutional investors since 2006. Without professional intermediation that money would have gone elsewhere. The track record of success from Genentech to Google speaks for itself.

      Experience comes from the intensity of the venture process. A venture capitalist will work directly with a few dozen companies in his career and indirectly through his partnership with many tens and even hundreds.
      An institutional investor once told me that when he asked the Kleiner Perkins management team why he should invest with them, he was told, “Because we have made more mistakes than the others.” There is no substitute for experience in a start-up and venture capitalists have it.

  • http://www.allegiscapital.com Bob Ackerman

    A cogent articulation of the case for Carried Interest. Like Mr. Fleming, I have a vested interest in this discussion as a long time seed and early-stage venture capitalist. His articulation of the mechanics of venture capital carried interest is accurate and resonates with my own experience and perspective. But let me also amplify as it relates to “early-stage” venture capital. We manage small pools of capital where management fees yield “draws” (repayable to the
    investors) that are equivalent to (and sometimes lower) than the salaries in
    the tech sector. We work as partners with our entrepreneurs for years to
    hopefully build successful companies, knowing that the odds are stacked against success. When we are successful – years down the road – we return all
    capital (including the draws on which we paid taxes) to our investors, and only
    then do we participate in the profits which are the subject of carried interest
    taxation. Having been a serial, successful entrepreneur twice before
    starting a venture capital firm, I know first had the value a “good” venture
    capitalist can bring to a new venture. As a venture capitalist, I work as
    hard as I ever did as an entrepreneur to contribute to the success of my
    portfolio companies. It’s personal – for the entrepreneur and for the venture
    capital mentor.

    Tax policy in many cases is intended to encourage behavior – tax-free municipal bonds, home mortgage interest and charitable donation deductions, R & D tax credits, , etc.. I can make this case for early-stage venture capital where there is in fact a shortage of capital and expertise to support entrepreneurs. We need more of both! Others have made the argument based on partnership accounting. While taxing carried interest from venture capital would generate some level of additional tax revenues (the VC numbers are estimated in the range of $100M to $200M per year), the unintended consequences of shifting investment dollars to later stage, larger pools of capital may very well have a chilling impact on the innovation ecosystem which is dependent on access to experienced, high-risk
    capital. This is the seed corn upon which jobs representing more than 20%
    of today’s US GDP was built. At a time when we are in critical need of
    innovation to reshape and rebuild our economy, do we want to make it harder to
    launch and build successful start-up companies? Around the world,
    governments and entrepreneurs are taking a page from the US Innovation Playbook and emulating the policies and practices that have powered our economy to the global technology powerhouse that we are today.
    Here it home, we appear to be heading in exactly the opposite
    direction. I can’t speak to Private Equity, Hedge Funds or Real Estate partnerships and their long term value to the US economy. I can reinforce, based on a career of experience as an entrepreneur and a venture capital mentor investor, venture capital is about creating value (and jobs) from ideas. Personally, I don’t think we have enough of either in the US.

  • Mickey Askins

    You are endorsing a better deal for higher income persons at the expense of lower others. What part of that helps you sleep better at night besides the money under your pillow?

    • Standish Fleming

      Though disappointed, I guess that I should not be surprised by the hostile tone, since it is one popularized the president during his recent campaign. The idea that somehow entrepreneurs benefit by taking away carried interest from their venture colleagues makes no sense to me. I am talking about improving the environment for company formation and early development for everyone. Early stage business is particularly dependent on a healthy ecosystem, because start-ups rely on external sources for virtually every element of their business.

      If Silicon Valley has demonstrated one thing, it is that start-up success is contagious. Unlike many other areas of business, launching new companies is not a zero-sum game. Early stage entrepreneurs make money by creating value, not by taking it away from others. The more capital, resources, people and prosperity in the community; the more opportunity for all.