Venture Summit East... and VC's, FinReg, Taxes and Whining

On Wednesday, I headed to HarvardBS to panelize on angel investing in a segment named "The Seed Council", a rather unusual title yielding thoughts of fertility.. or infertility.  I spent some time thinking how that applied to investing, but was fortunately interrupted by my fellow panelists. AlwaysOn does a good job of gathering interesting people and ideas and this panel was no exception. Unfortunately, we didn't have much of an audience since it was perhaps fittingly, the dead-last panel wrapping up a three day VC conference agenda. 

The panel line up included friend and moderator Gabor Garai, new friend and fellow traveler Elon Boms, and two other guys doing micro-cap funds who I had not previously met -- Tony from NYC and David from SF.  Here's the agenda item:

Early stage investors play a crucial role in the VC ecosystem. What are they looking for now?
Gabor Garai, Partner and Chair of Private Equity & Venture Capital Practice and Co-Chair of Life Sciences Team, Foley & Lardner
Elon Boms, Managing Director, LaunchCapital
John Landry, Managing Director, Lead Dog Ventures
Tony Tjan, General Partner, The Cue Ball Group
David Blumberg, Managing Partner, Blumberg Capital

Gabor did a fine job of herding the cats with some tantalizing questions about the state of venture capital and its impact on angel investing.  I'll leave my thoughts on that hot topic for another post, but what really struck me was David Blumberg's visible irritation about the impact of possible/probable Washington FinReg policies regarding VC income taxes and the alleged impact of same on innovation in this country. 

Although I don't want to pay any more taxes than next guy, I find the argument that the sky will fall if VCs now have to pay ordinary income rates (adjusted down in fact) on "carried interest" vs. keeping the status quo of paying capital gains rates to be highly specious and unfortunately, predictably arrogant.  Though the opportunity to engage David was there, I decided to hold back -- I'd much rather debate people I'm friends with than people I just met.. it's more sporting!

It would appear that thus far, this is a far more passionate issue on the left coast but I've heard a lot of gnashing of teeth here too!  During our panel, it was certainly reinforced by the hyperbolic statements from Blumberg virtually predicting that the entire innovation infrastructure will risk collapse if the VCs have to pay ordinary income rates on the 'carry'.  Unfortunately AlwaysOn has not posted the video so I'm depending on my feeble memory to support that claim, but frankly I was taken aback.  When they post the video, I'll update this post.

What really stuck in my craw is the ludicrous suggestion that the VCs are the guys taking the risk and therefore they need to be treated 'special' for it.  They're vociferously arguing that the VC partners 20% share of the 'excess returns' after fund capital is paid back (the 'carry') should continue to be treated as capital gains for tax purposes, at a dramatically lower tax rate compared to the FinReg proposal to treat it as ordinary income.  

Huh? For starters, VC's are NOT investing their money, or if they are it's a very small percentage of the fund size that WILL be treated as capital gains on their K-1's. Instead, they're investing OPM.. other peoples money!  So help me out with that 'investment risk' argument -- it's their investors that are taking the investment risk, not the VC fund managers.

What these fund  managers get as 'carry'  is what's called a 'BONUS' everywhere else -- if they do well they get paid for doing well! Bonuses for the 'little people' are ALWAYS treated as ordinary income not capital gains.  So the VC's comp plan isn't really much different from other industries.  They derive their salaries from the 2% fee income on committed capital, and the 'carry' is their performance bonus.  It's ordinary 'fee' income and that's not capital gains. If the argument is that their bonus is at risk, I'll be glad to introduce them to every other executive with a comp plan and who pay ordinary income rates on that bonus.  A bonus is a bonus... it's that simple.

If we really wanted to support innovation, then the management teams of the VC portfolio companies should be the folks taxed at preferential rates for exceeding their performance, not the VC's. These entrepreneurs are they guys and gals that took the REAL risk, yet they have to pay ordinary income rates on bonuses just like the rest of the working stiffs in this country.  Unfortunately, the VC argument implies that they've done more to make that innovation happen, a conclusion that's not only incorrect, but indicative of the chutzpah that still pervades an industry that needs (and is getting!) a serious injection of reality.  Ironically, it's a moot point anyway today - the industry as a whole hasn't experienced 'carry' income in ten years!  But I share their optimism about the future!

To be clear, I'm highly supportive of capital gains treatment for real investment gains (and losses).. the money kind, not the time kind!  The VC Fund's INVESTORS are entitled to pay capital gains rates because they INVESTED their money for the long term and took the investment risk, but the logic of claiming that a 'carry bonus' is somehow tied to investment risk of the VC partners defies logic.  And I should state that many VC's agree with my line of thinking here.  Even Union Square's Uber-VC Fred Wilson is in disbelief that his colleagues can actually look at themselves in the mirror after making these arguments.  He argues that if this causes VC partners to INVEST more of their own money, maybe they'll provide better governance and commitment than they do currently investing other peoples money -- but he concludes that 'carry' is nothing more than fee income.


So my VC friends... Despite the fact that I know, respect and appreciate what you do, I think it's time to pay your fair share, to stop the whining and to quit the 'Zombie lies' about how you're taking the risk and innovation is doomed if you have to pay more taxes.  It's getting increasingly pathetic and I know you can do better.  It was a loophole and now it's closing.. live with it.. and let's get on with re-building this economy.