Overshooting and Undershooting: Scale Venture Partners’ Kate Mitchell and Rory O’Driscoll on the VC Pendulum Swing

7/29/10Follow @wroush

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making sure that some far-ranging potential changes that would have made it more difficult for these angels to invest did not go through.

X: You’re talking about the SEC registration issue.

KM: It was accreditation. The SEC was threatening to raise the level of a “qualified investor” and what kinds of assets it took so high that it would have aced out a lot of angels. We helped them come back down. The ACA was very happy with the result of that.

X: Speaking of legislation, the NVCA was also working this year to head off changes in the way venture partners are taxed on their income from carried interest, the money they make on venture exits when portfolio accompanies get acquired or go public. The question was how much of carried interest income should be taxed as regular income, and how much under the lower capital-gains rate. Where does that issue stand now—is it off the table?

KM: What happened was that the changes got lumped into the R&D tax credit extender bill, then into a bill for unemployment insurance. The question was how do you pay for the goodies, and we became associated with that—”we” meaning, broadly defined, the private equity industry, including partnership taxes for hedge funds, real estate firms, private equity firms, and then the little teeny-tiny venture capital industry. The tax extender bill failed for other political reasons, and unemployment insurance sailed through this week on its own.

Does the tax extender get reinvigorated before the election, or in a lame-duck session after the election? That’s tough to know at this stage. It’s not a zero likelihood. We have delayed it, but we haven’t solved it by any stretch of the imagination. We had worked out a compromise under which [carried interest] would be treated as some blend of ordinary income and capital gains for investments held over 5 years. Will the compromise hold if it does come up again, when more goodies need to be paid for? We’ve kicked the can down the road, on the one hand. On the other hand, a lot of entrepreneurs and VCs and ultimately professors—including Phil Sharp at MIT—signed a letter to President Obama saying “Who do you think is going to help take things out of my lab at MIT if it’s not the VCs?”

X: Can you explain why venture partners shouldn’t be asked to pay somewhat higher taxes on their windfalls from venture exits? I also wonder how this issue affects innovation more generally. I would think that the way limited partners are taxed would be much more significant for the venture industry and its customers, in the end, than the way general partners are taxed.

KM: The NVCA was founded 40 years ago around legislative changes to get capital-gains treatment for profits from long-term investing. So that is a structure that has existed for a long time. I think there is ultimately an issue of how you are going to incent people. If you get taxed on ordinary income for a deal that takes two or three years, and you get taxed in the same way on a deal that takes 10 years, are you going to want to do the 10-year deal? There would be no incentive to … Next Page »

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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