Carried interest taxation and new fund formation
There is a ton of chatter about the US Government’s new plan to tax venture capital funds’ carried interest at ordinary income (instead of at the lower capital gains tax rate where they are currently taxed.) Some pretty thoughtful people have been suggesting that this will either not be a big deal at all or will be pretty damaging to new company formation in the United States. (Or that VCs will just hire good lawyers and figure it out how to avoid taxes anyways.)
I tend to be of the belief that tax policy does pretty often drive many rational people to certain outcomes. (In other words, taxes do influence behavior for a lot of people.) I also think that a lot of venture capital firms are started by successful entrepreneurs who really don’t have a great plan as to how they are actually going to make money as investors. (In other words, many first time VCs who start funds may not be acting completely rationally.)
So, my initial gut reaction to new fund formation would be that if an entrepreneur really thinks he or she can be a great VC, then they are going to go ahead and start a new fund. This is in spite of any tax policy impacting their decision.
But as I thought a little bit more, I did realize that there was another group that gets carried interest in a number of new funds – the anchor LP. As I understand it, when a wanna-be VC group is raising capital, they often “sell” a piece of the initial firm to the first, big investor(s). These initial investors get both a piece of the GP and a piece of the LP, while the rest of the fund’s LPs are only limited partners. The GP gets the carried interest, and is thus currently taxed at capital gains rates. I believe that a lot of these anchor investors are big banks, funds of funds and very high net-worth individuals who would benefit from lower taxes (I also think that pension funds are pretty active in this marketplace, but they would not have the same tax interests.)
If these initial anchor-new-fund-tenants are negatively impacted by a higher capital gains rate, then we may see a lower new venture capital firm formation in the coming years. I do believe that the venture business could benefit from some real business model innovation, and I’m not sure this innovation is going to come from existing funds.
So it is possible that this tax change could hurt venture capital in the US if it makes it harder for new, innovative funds to get off the ground. And this would then make it harder for entrepreneurs to get their startups funded. (Of course, there is also the angle that there are too many venture capitalists in the US and fewer new entrants would drive up returns for the industry… but I’m not going to go there in this post!)
Looking for the historical impact of capital gains on venture capital fund formation
However… we have had a period of lower capital gains tax for the past several years. And, in theory, if my above reasoning is correct, this should have driven a higher number of new fund formation during the period when the capital gains tax rate was lower. In May 2003 the long term capital gains tax rate fell 25% (to 15% from 20%). So one would have expected more funds to be formed during this time. But I did a little digging around on the NVCA’s web site and was able to find the number of new venture firms by year. I plotted them against the capital gains tax rate and I didn’t really see anything that isn’t probably totally explained by the overall economy/NASDAQ.
Am I missing something? It looks like capital gains didn’t really have any impact on the venture capital fund formation. Of course, this is not enough data to make any real statistical take-away. I think it’s pretty clear that the stock market is driving venture capital fund creation.
Note that I’m not a tax expert, and that I’m also no longer an venture capitalist! Please let me know if I am leaving out some sort of a huge piece of info. Another piece of data that would be really helpful is if anyone knows what % of new funds have to sell part of the GP to get the first fund off the ground. Finally, I’m only really trying to talk about new fund formation in this post. Taxation could have an impact on other parts of the venture capital landscape beyond new fund formation.