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In Defense of Carried Interest
Gerry Langeler, managing partner of OVP Venture Partners in Portland, OR, writes in defense of carried interest in today’s New York Times.
When we’ve written on this subject, we’ve tried to emphasize the adverse impact this proposed tax hike will have on an already distressed economy. In short, we’ve argued that venture capital is critical to economic growth, new job creation, and innovation – and if you tax those things you are certain to get less of them. Furthermore, venture capital is a long-term investment that doesn’t ask for (or need) bail-outs.
Langeler worries that the heated political rhetoric about “punishing Wall Street” is interfering with basic consistency, and draws several parallels to the financing and profitable sale of a typical home:
If you buy a house and take out a mortgage, you usually put a small percentage down, with the bank carrying the balance. To keep the math simple, say the house costs $200,000 and you put down $20,000. Ten years later, if you sell the house for $300,000, you have a gain of $100,000 on that $20,000 investment. It is taxed as a capital gain because your capital was locked up for a prolonged time, there was a material risk of loss and the gain was not “guaranteed” to you for just showing up every day, the way a salary is. You used the bank’s capital as leverage on your $20,000 investment, but that does not matter from a tax standpoint. Neither does the fact that you worked around the house over those 10 years to improve its value. Now, let’s compare that with carried interest in a venture capital partnership. We in the industry invest a small percentage of the total dollars in our partnerships, like the house purchase above, with our limited partners investing the rest. Our investments are locked up for prolonged periods of time, often five to 10 years before we see any return. There is a real, material risk of loss of capital. In fact, many venture funds in the bubble lost money, including partners’ capital. Like the house situation, our downside loss potential is “fixed” by what we invested, while our upside is unbounded. We do a lot of work “around the house” to help our start-up companies grow. Our investors get their return on the profits we make. For those investors that are taxpaying entities, they pay tax on the gain at capital gains rates, just as they would if they had invested in a home. No one is proposing to change that tax treatment. If there is a profit on the entire partnership, then and only then do we as managers of those partnerships get our carried interest — usually about 20 percent of the total profit. That carried interest is delivered in the form of stock in those start-ups, stock that has been held for 5 to 10 years. Unlike our salaries (rightly taxed as ordinary income), the carried interest is not guaranteed by our just showing up, and it is only delivered if a long-term gain in the form of capital is created. Carried interest in a partnership bears a striking resemblance to our personal “carried interest” in our homes.
Langeler closes by pointing out that the venture capital partners would be the only ones in this scenario whose efforts and risk-taking were punished with a higher tax rate. The entrepreneur-founders and the limited partners in the fund would still see their gains taxed as capital gains. The inevitable result? Fewer venture capital partnerships and the benefits such partnerships provide: economic growth, job creation, and innovation.
It is an awful irony that a bill that allows for a temporary extension of unemployment benefits is funded in part by a permanent 150%+ tax increase on the one asset class – venture capital – that has actually created new jobs in the ugly economic times of the last two years. Is Congress really thinking through the ramifications of what it is passing here?