Investing In Penny Stocks Online Brokers…

Specifically, I wonder whether an entrepreneur should receive capital gains treatment in the following scenario:

- Seed investors (VCs or angels) invest $500k in your idea, allowing you to get started. You take no salary for the first 9 months, spending the money on R&D. Essentially, you are getting paid to manage their investment, because in many cases that founder’s stock you hold wouldn’t even have been issued without the startup capital that paid the lawyers to file your incorporation.

- You introduce the product, and it doesn’t quite work. You run out of money a few times along the way, but your investors keep funding you, and the combination of your enthusiasm, large market potential, and progress on the science allow you to keep going. You have started taking a small salary, and you pay your employees below market wages.

- You get some good traction in the marketplace and over time raise a modest total of $20M on your way to profitability. Every time you raise a larger round, your salary gets more in line with market rates, and as the company develops a strong position in the marketplace, employee salaries become very competitive. Your company is known as a great place to work, and as you inch towards an IPO, there is in fact very little risk in working at your company compared to the startup phase.

- As you prepare for an IPO, you get bought by Google for $500M (after M&A fees, etc.) instead. You still own 8% of the company and you get long-term capital gains treatment on $40M.

I’m not sure how the scenario above is substantially different from your Credit Suisse example. You can argue over the definition of whether the entrepreneur is managing someone else’s money, but that’s purely semantics. Someone else has put up the money (all of the money, in fact). It was risky, because things could have gone well or poorly. Should it matter who put up the money? If that’s the key issue, then the legislature should wipe away capital gains treatment for all entrepreneurs, too, except to the extent that they self-fund. It seems that the perverse crux of most arguments against VCs receiving long-term capital gains treatment is that only those who put up the money should receive a benefit. Ironically, this would shift the favor heavily towards only those who already have money. You can decide for yourself whether you are being philosophically consistent to believe that entrepreneurs and not VCs should receive preference when someone else puts up the money, but it is beyond debate that it would be poor policy to remove incentive for entrepreneurs to take risk. What entrepreneurs do is very difficult, and it should be nurtured and supported.

Personally, I think the real issue is the definition of long-term. When a VC makes a bundle in 13 months, maybe it isn’t what the long-term capital gains law really contemplates. Perhaps we should make the criterion 2 years, or 3 years, or even 5 years. Some European countries even have a graduated step down on their capital gains tax that goes to zero over a long enough period! This sounds complicated to me, but maybe a 2-3 year definition of “long-term” would be a more appropriate barometer of how the industry really works.

Ultimately, this law says that if you hold a share of stock over a certain period of time, you can receive long-term capital gains. If you start changing what it means to “hold a share of stock” saying that some stocks qualify and some don’t arbitrarily, you are headed down a slippery slope of shoddy intellect. We are already doing enough to diminish our country’s ability to compete in the global marketplace, let’s not compound the problem by reducing the incentives for those who are taking risks to produce jobs and new products and wealth for our economy.

It’s becoming increasingly difficult for VCs to make money now since there are too many funds chasing too few ideas. Investment horizons are getting longer and >5x returns are getting fewer. In the end, after setting off losses most VCs are getting little by way of `carried’ interest. It’s just the management fees/salary they are living on and that’s subjected to Income tax. The occasional carry that they may get, while getting distributed will qualify as *capital gains* only to the extent that relates to their personal savings invested in the fund. Not that portion of the gain that accrues on investments made by other limited partners – which when distributed to VCs as carried interest, IMO, should be treated as `income’ and not as capital gain.

If not, it is abuse of the legislative intention behind the tax statute and shapes up as “Tax Avoidance” (a quirky device used to avoid taxes by twisted interpretation of the law, less culpable than “Evasion” but still unethical if not illegal)and not as legitimate as “Tax Planning” – which is full use of the framework provided by the statute to save taxes.

STOP BEING SUCH A LEFTY, MATT!!!

If her share of the $100M IPO was distributed to her, and she paid $2.7M in taxes on her $18M take, she would have the use of $15.3M for the remaining term of the VC fund. Because most funds have 5,7, or 10 year terms, she would have the use of $15.3M for between 4-9 years. Assuming a savvy investor like a VC GP could get a 10% return on this capital, she would still have a $6M after-tax gain. Even after returning the $18M to the under-performing fund she’d be left with $3.33M. Since the $2.7M tax had already been paid, this $3.33M would be hers to keep.

Not too shabby for an under-performing fund, even before taking into account the management fees.