Private equity investors got a breather in October when the Senate put on hold the debate over raising taxes on private equity and hedge fund managers. The proposed hike would force private investors, including venture capitalists, to pay the same income tax as that imposed on average workers, about 35 percent. Investors currently pay the capital gains rate of 15 percent. Venture capitalists (VCs) are making the loudest noise over the proposed tax raise, spending more than $6 billion in lobbying efforts and crafting dramatic arguments about the provision’s impact on the VC industry. They claim that the hike would damage the U.S. economy and cost jobs. What’s more, it would send startups abroad looking for financing. Imagine, VCs contend, if Google, Genentech and Ebay had received startup money from, say, Russian and Armenian investors rather than those in the good ol’ U.S.A. “We are not saying the sky is falling,” said Mark Heesen, president of the National Venture Capital Association in Virginia. Even so, Heesen ticked off a list of woeful consequences, including that startup companies would be less likely to get financing because the higher tax rate would put some VC firms, of which there are less than 2,000, out of business. John Dilts, president of Westlake Village’s Maverick Angels, an investment firm that works with venture capitalists, is also against the provision. “Anything the government can do to make it easier for venture capitalists to do what they do, I am fully in support of,” Dilts said. Populist groups jumped aboard the debate to ponder why wealthy private equity investors were getting a tax break as middle-income workers living pay check to pay check paid the going rate. The Senate probably will not broach the issue again until next year. But given the passions on both sides , Senator Hillary Rodham Clinton and Barack Obama strongly favor the hike , and that 2008 is an election year, the issue will not be going away. The tax provision became a bumper sticker issue this summer when the enormous wealth of hedge-fund managers and private-investment partners was spotlighted in features published in major newspapers. When the private-equity group Blackstone went public in June, for example, the firm was valued at an astonishing $7.5 billion. Benefits of VCs The capital-gains tax commonly applies to sold assets, usually property and stocks and bonds. Its purpose is to reward investing, which financial strategists say bolsters the economy. In a house sale, for instance, the homeowner pays the 15 percent tax rate rather than the 35 percent rate on ordinary income. In a market sale, the investor pays capital gains tax on the profit of sold stocks and bonds. In the world of professional finances, private equity investors pay the lower percent on the carried interest, or profit, from their asset sales. VC firms make money by taking companies public and then selling them. The firms came to prominence in Silicon Valley during the dot-com boom of the late 1990s. Raising capital from institutional investors like pension funds, endowments and foundations, firms sprouted in Boston, New York and Los Angeles, which is second only to Silicon Valley in the number of VC firms, according to Heesen. Supporters of the tax increase say private investors are really financial managers who should be taxed at ordinary income for their management duties. VCs disagree, pointing out that they are not financial managers but rather are founders and creative instruments in the startups they back. Moreover, because of their long-term commitment to companies, VCs distinguish themselves from investors whose goal is to simply buy and flip properties. VCs contend that their increased financial risk only about 20 percent of their companies become profitable and the rewards reaped by the U.S. economy when a successful company is created, justify their being shielded from the higher tax rate. Moreover, because most VC-backed companies fail, venture capitalists need a large monetary payoff to make their efforts worthwhile. “We see no cash returns until the company goes public or is acquired,” venture capitalist Jonathan Silver told the House Ways and Means Committee in September. “Even at this point in the life cycle, venture capitalists are not paid from company dollars but by outside parties establishing a fair market value.” Further drawing the line between investment manager and venture capitalist, Andy Funk, head of Funk Ventures in Santa Monica, said compensation for VCs is based on performance. “If the investments by the venture capitalist are no good, there is no carried interest,” he said in an interview. Tax hike inconsequential? Critics counter that VCs make a generous income and should pay the same tax as that of the average worker. “The dirty little secret of the venture business is that VCs can be enormously successful even though most of their portfolio companies may tank in public markets,” investigative journalist Joel Bainerman wrote in a 2003 essay. “This stems from the fact that VCs make money on almost any company that gets to an (initial public offering),” Bainerman wrote, “because as early private-stage investors, they’ve likely bought the stock at a price three or four times lower than the public-offering price.” Some VCs acknowledge that they are getting rich and that the tax hike won’t strangle the industry. “We get ample compensation, financial and psychic, for the work we do and the risks we take,” Denver-based VC William Stanfill told the House committee in September. Brad Jones, of Brentwood Venture Capital in Los Angeles, said a tax hike won’t harm the industry or dramatically impact VCs’ wallets. “That is an absurd argument,” Jones said of the contention that VCs won’t be adequately compensated under the proposed policy. “People in private equity make a lot of money.”
