Tax Story: VC Carry vs Founder Equity

Readers regularly email to pick apart my support for changing the tax treatment of carried interest from capital gains to ordinary income. Almost all of the correspondance now relates to venture capital, as buyout and hedge fund managers seem to have accepted that their loophole is closing.

Here’s a recent email from reader Bill:

“One can argue whether or not preferential capital gains tax treatment, in general, is a good idea, but to split hairs and say that one set of managers (entrepreneurs) deserve it, but another set of managers (VC, PE guys) do not, evidences not just a fundamental lack of appreciation for what financial managers do within the context of a modern economy but also a willingness to sustain a clearly illogical and contradictory position in order to maintain some romantic, populist and dated notions about the relative social value of different kinds of labor.

Therefore I challenge you: If you truly believe that investment GPs should have their carried interest taxed, then take the next logical step and declare your opposition to the favorable tax treatment for corporate managers’ equity stakes.”

Bill articulates the single stickiest wicket in my argument for changing carried interest tax treatment. And it’s one I’ve wrestled with a bit this morning. Here’s what I’ve come up with so far:

VCs often argue that while they aren’t investing their own money, they are investing their time just like entrepreneurs are. Both typically receive some form of cash salary on which they pay ordinary income (management fees for VCs, payroll for entrepreneurs).

From a directional perspective, however, the VCs are investing their time on behalf of someone else’s investment. Entrepreneurs, on the other hand, are investing their time on behalf of their own investment (assuming they had to pay something, even reduced salary, to get their options). I’m not saying it’s a distinction with an ocean-length of difference, but at least a small pond.

Second, the risk taken on by an entrepreneur is usually much higher than the risk taken on by a venture capitalist. An entrepreneur typically puts all of his or her eggs – at least from a time perspective – into a single incorporated basket. VCs, on the other hand, split their time among a variety of baskets. If a single company fails, then the entrepreneur has lost far more than has the venture capitalist (particularly since, again, the VC didn’t put in any money).

I’m not basing my argument on the relative romanticism of entrepreneurs and VCs, but rather on the relative level of risk. I’m also not basing it on the “relative social value of different kinds of labor” or on a “lack of appreciation for what financial managers do.”

I appreciate what financial managers do for the economy, but don’t tell me for a moment than they do more than do, say, teachers or police officers (both of whom pay ordinary income).

Every profession should begin from a place of ordinary income, and then be required to argue their way out of it. Not the other way around. I believe that entrepreneurs can make the case, based on their level of skin in the game of economic growth (although just barely). I do not believe that venture capitalists can do the same.

Now feel free to rip apart my tortured logic…