Debate around proposed new tax treatment for the general partner’s carried interest in a venture fund has been interesting to say the least. There has been passion, there has been drama, there has been social, political and economic argumentation in blogs, tweets, and comment sections. The upshot: On one side of the aisle, the case is made that carried interest is compensation for what are essentially services provided to limited partners (who are the real investors behind any fund), and should therefore be taxed as ordinary income; on the other side, the argument is that at best this carried interest is deferred compensation (on a multi-year term), that is accompanied by high risk, and that should be treated similarly (i.e., as capital gain) for all fund participants in order to avoid possible conflict.
As an interested observer, there is much about this debate that does not satisfy. First off, there is a self-centeredness in the venture-focused dialogue, that excludes other fund categories in a manner that is not dissimilar to the way in which digital media entrepreneurs often forget that more than 90% of sector revenues still happen outside of the world-wide web. Just as the creators of any new media technology or service will at some point have to learn about the much bigger realities of the mass market and how to make money at large scale, so too their financial backers may need to broaden their perspective beyond Sand Hill Road, just to pick a symbol, or areas generally south of 23rd Street but not as far south as Wall. That is to say, the tax debate as presented will have consequence in many other parts of the capital markets, many of which will directly or indirectly relate back to venture capital in one way or another: because portfolio companies grow, and require additional funding, and venture groups require exits.
Secondly, and what might seem contradictory to the first complaint, the debate underscores that a finance segment that has no business being big and complex, has become big and complex, and institutional. It’s one thing to play with other people’s money en masse, in the institutional sense, in the Wall Street sense, when this is being directed to established businesses and the public or private securities related thereto – that is challenging enough, as we have learned. It’s quite another to do so in the world of startups, and what’s more, startups in a highly volatile field.
The venture segment began as a cottage industry, way back when, and has since blown up to institutional prowess as a reflection of the technology boom. Results, however, show that venture capital does not scale. Results show that venture capital funds that manage more than $100-150 million, (and even that is probably too big), don’t work… and if they do, the investments they make are probably not actually venture capital. There was a time when venture funds, if these were in fact funds and not a loose affiliation of investors, were small enough for the general partner to make a meaningful personal investment and have a meaningfully vested capital stake. There was a time when the management fees of such funds were too small to compensate the general partner in any meaningful way, if at all.
For the venture capital segment to demonstrate viability – and the case is currently murky at best – the segment needs to transform itself in important ways. Just as venture capitalists often advise entrepreneurs that they should learn to think fast, adapt, iterate, re-adapt, and so on, it’s probably time for venture capital sponsors – and the limited partners who back them – to behave in like kind. Important structural and attitude changes need to happen for the venture capital segment to reflect current realities, and for the segment to demonstrate long term profit opportunity. Until this happens, I interpret all discussion about capital or ordinary income treatment of carried interest as academic… the overall gain being more or less zero anyway.
