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Higher Taxes Will Kill VC Investing: Kneale

Journalists love clichés (especially TV journos), which live on for decades (or centuries) because they often are so apt.

And so it is that we invoke Dickens to describe the state of venture capital in Silicon Valley with that worn intro from “Tale of Two Cities”: “It was the best of times, it was the worst of times . . .” It would have been a great opening line had it stopped there, but it runs on in a single sentence spanning 118 words.

Bill and cash
Bill and cash

And yet, published in 1859, it perfectly describes these times of 2010: “it was the age of wisdom, it was the age of foolishness...the noisiest authorities insisted on being received, for good or for evil, in the superlative degree of comparison only.” Sounds like President Obama, to me. Or Goldman Sachs .

The best of times: Silicon Valley should be humming with new deals. A plethora of new product platforms beckons, ecosystems that should draw hordes of gleeful developers of new software apps, hardware gadgets and services. The new 4G Apple iPhone unveiled this week will inspire thousands of apps-designers; so will the ever-proliferating Google Android system, and Facebook with its 450 million reachable, registered members.

Yet it looks like the worst of times, and that owes to taxes—a ton of ’em. It threatens to damage venture investing and to derail a key source of job growth. And no one in Congress, in either party, seems intent on doing much of anything to stop it.

At first glance it looks like the venture-capital business is doing just fine. In the first quarter of 2010 VC’s did 681 deals worth $4.73 billion—up 41 percent in dollars from a year ago, when 635 deals were hatched.

But for the most recent 12-month period, total VC investing is down 36 percent from the year before, to $19 billion pumped into 2,900 deals. And that full-year total itself is less than one-fifth of the sum in the boom/bubble/bust year of 2000, when a massive $100 billion was invested in almost 8,000 deals. (Source: PricewaterhouseCoopers and the National Venture Capital Association.)

One reason: It’s far more difficult now for a startup to make it all the way to a stock offering. In 1994, a startup took less than five years to get to the IPO stage; that wait now lasts almost ten years, the venture trade group says.

In the 1990s a total of 1,776 VC-funded companies went public during the decade (56 percent of all venture startups). But in the “uh-oh” decade that began in 2000, only 392 IPOs occurred for VC startups—a mere 13 percent of the funded firms; the other 87 percent got bought by existing companies. The VC association blames burdensome regulations such as Sarbanes-Oxley and a dearth of bankers willing to handle tiny stock offerings of $50 million or less.

The tax picture will make this Dickensian diorama even worse. We already know the tax rate on investment gains is going up by one-third at year-end, from 15 percent to 20 percent. And we know that, for people earning over $200,000, Obamacare will add an extra tax of 3.8 percent on top of the cap-gains rate to fund Medicare. So the top cap-gains rate will rise from 15 percent to 23.8 percent—a jump of 58%!

Just think of it: crimping new investment to fund an utterly bankrupt government program. Brilliant.

But the biggest tax hit, the most pernicious one, is yet to come, on “carried interest,” the upside returns earned by VC funds, REITs and most other partnerships in American business. Congress looks likely to roughly double that tax rate.

VC lead partners now pay only the 15 percent cap-gains rate on their funds’ annual profit payouts, and Congress wants to tax them at far higher personal income tax rates that will approach 40 precent. The latest proposals try a tiered approach that would tax, say, 65 precent of the profit at the far higher personal rate and the other 35 percent at the (soon-to-rise) cap-gains rate.

CNBC.com

So VC firms’ outside investors will continue to pay capital-gains, rather than personal, rates; so will startup founders and entrepreneurs. Yet the actual principals who run the fund and decide where to invest—the real risk-takers—would have their upside slashed.

“It cuts the risk-reward ratio for them significantly,” says Emily Mandell of the National Venture Capital Association. “When you double the taxes on a certain type of investment, you discourage that investment. Some people won’t even go into the industry. Why bother to invest for ten years in a company when you can go work on Wall Street and get guaranteed bonuses at ordinary-income rates?”

Then again, the Wall Street guys’ taxes are going way up, too. But whatever.

No doubt the Democrats will paint this as a fat-cat issue: Only the rich invest in venture funds, so the hoi polloi need not worry. But for many of us, our pension funds invest in VC funds, and our mutual funds own the stocks of big tech companies that grow by acquiring startup technologies.

And all of us should worry about job creation. VC-funded firms create jobs at more than twice that rate of companies that weren’t venture-backed: 3.6 percent job growth annually from 2003 to 2006, compared with only 1.4 percent growth at all companies, the NVCA says. And the IPO logjam further hurts, because 92 percent of all job growth at VC-backed firms occurs after the shops go public, the trade group says.

In Silicon Valley, I’d bet that billions of dollars already are being pulled off the table because of this swelling tax burden. One venture guy tells me his marginal tax rate could rise to 59 percent. So why create a new fund at all?

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