Friday, October 12, 2007

Who's the entrepreneur?

I wrote this on an impulse because I was enraged by an article in The New York Times about VCs posturing as entrepreneurs. Of course, the Times didn't print it (they get a thousand submissions for everything they publish), so enjoy.

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As an entrepreneur, I was surprised to read the title "Entrepreneurs Defend a Tax Benefit Despite a Dubious Congress" (V. C. Nation, Sept. 21), and offended to learn that venture capitalists are posing as entrepreneurs in order to protect their anomalous tax treatment. VCs, as we call them, may like to think of themselves as entrepreneurs, but they are no such thing. Even associates fresh out of business school make six-figure salaries, and partners' base salaries are considerably higher - funded, of course, by the 2% asset management fee they charge their investors.

The ongoing debate, of course, concerns the "carry," or the share of investment gains that they keep for themselves, and whether it should be taxed as ordinary income or a capital gain. On the face of it, I fail to see how anyone could argue that this constitutes a capital gain, since the capital at risk is not theirs to begin with. A sophist might argue that the carry is deducted from the investors' capital gains, and hence should be treated that way for tax purposes ... but that's the same as arguing that when you sell stock for a gain, your broker should pay capital gains tax on his commission, because it comes out of your gain.

But leaving aside that well-trodden ground, the claim that VCs deserve their tax break because of the "sweat equity" that they invest in their portfolio companies, and the jobs that those companies create, is a bit much. VCs do play an important role in allocating capital - my company would not exist without them - but so do research analysts, mutual fund managers, equity underwriters, and traders, all of whom pay ordinary income tax.

Once the capital is allocated, many successful entrepreneurs - who no longer need to play nice with VCs - would describe the ongoing assistance they receive as ... well, "incidental" would be a nice way to put it. (One of the most candid VC partners I met once said, when asked what his role was, "we provide the money.") But even in the cases where they do provide valuable assistance, why should that work be taxed at a lower rate than the work done by every employee who helps the company grow and succeed?

On September 14, 2001, I quit my job to found a software company with five friends. We earned nothing for six months until we acquired funding, and then took large pay cuts from our previous salaries until the company was self-sustaining. Today, our company has more than 350 highly skilled, highly paid employees (the vast majority in the United States), and has created hundreds more jobs among our partners and customers.

It is true that those jobs would not exist without the initial backing we received from VC firms. But aside from the function of allocating other people's capital, which does not in itself merit capital gains treatment, I would defy any VC to argue that he played a greater role in creating those jobs than did I, or any other founder, or any one of fifty other important people in the company - and all of us pay ordinary income tax on our salaries.

In general, I fail to see why the contributions of capital toward growth and job creation are more valuable than the contributions of labor. As a result, although the lower tax rate on capital gains benefits me as a part-owner of my company, I don't see why it should exist. But given that it does exist, for VCs to argue that the labor they put into their portfolio companies is so much more valuable than the labor of the employees that their labor (and not ours) should be taxed as if it were capital is both nonsensical (should firefighters pay capital gains tax on their salaries because they are crucial to society? should teachers?) and insulting to the people who really build those companies.

1 comment:

David said...

So I wonder if this means that VC's will be willing to take on common stock instead of preferred stock in return for their investments?