Will VCs really stop funding startups?

May 21, 2010

If the American Jobs and Closing Tax Loopholes Act is passed there will be a lot of unhappy venture capitalists, who say they may stop investing in startups.

The new legislation, co-drafted by democratic senator Max Baucus and democratic congressman Sander Levin, aims to re-classify the returns fund managers and venture capitalists receive as ordinary income and not capital gains, as it has been for much of the last decade. This amounts to a much larger income-tax hit for VCs, jumping from 15 percent to nearly 40 percent.

Proponents of the bill, such as angel investor and blogger Paul Kedrosky, say that since VCs, like hedge fund managers, don’t invest their own money when funding startups, that they should have to pay the same tax rate as the rest of us.

The closing of the tax loophole would appear the expedient thing to do in a political climate where bankers are being besieged over bonuses and the big hand of government is trying to better control the practices of all types of investors.

But VCs are crying foul over a bill that lumps them in with all fund managers and takes away the one incentive they say rewards them for their long-term and high-risk investments in startups.

“If you talk to congressman Levin, who has been the architect of this, he’ll even tell you that what we do is different,” said Mark Heesen, president of the National Venture Capital Association (NVCA). “Does he want to see a distinction? Probably not, because he just wants the revenue, but he does see that what we do, from a job-creation standpoint and just from how we operate, is very different than what these other folks do at the end of the day.”

Heesen’s NVCA colleague Kate Mitchell, who is also a managing partner at Scale Venture Partners, said what she does as a VC is more a labor of love and is not as financially rewarding as many outside the industry may think.

“It’s not a high-flying sort of business,” Mitchell said, adding she hasn’t received any carried interest returns since 2000. “Most people I know in the industry have not gotten carried interest. If that entrepreneur drives a fancy new car, I’m still driving my partner’s used car.”

Both Heesen and Mitchell agreed that by removing the “carrot” for VCs, many of them will flee the industry, choosing to become bankers or entrepreneurs. They also suggested the new tax law will lead to less money for startups, as VCs will invest in companies they can flip more easily.

“It’s hard enough getting folks to go into the venture capital industry, knowing that it’s going to be 10-plus years knowing that you might see something,” said Heesen, noting the average exit takes anywhere form 7-10 years. “If it’s ordinary income, you might as well go work for the banks.”

Dan Primack, the editor for PE Hub (a Thomson Reuters publication), said he has heard this type of argument many times over the last few years on behalf of the VC community, but has yet to have a single VC confirm – on the record – that they would leave the industry over the issue.

“If there are so many venture capitalists who say they’re going to leave the business if the carried interest tax changes – identify yourselves,” Primack told Reuters TV, calling what he said amounts to a poker bluff by VCs. “The NVCA has this petition of 1,700 people opposing this, none of them are saying we’ll leave if this happens.”

Watch Primack’s complete interview with Reuters TV:

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