VentureBeat

Mitt Romney, a leading Republican presidential candidate, was a founder of Bain Capital, a private equity firm. So you’d think he’d understand the basics of the VC tax legislation being fiercely debated in Washington. But in an interview with TechCrunch, he shows he doesn’t understand it.

When asked what he thought of the VC tax proposal he says:

“…with regard to carried interest associated with venture capital, real estate, private equity, I do not believe in raising taxes. And it is a capital gain because those individuals do make an investment, it’s a small investment, but they make an investment of their own capital and I would treat capital gains as capital gains instead of trying to re-categorize them as normal income.”

The emphasis is ours. He is flat out wrong. The VC tax legislation governs only the “carried interest,” or the profits made by VCs and other investors from investing other peoples’ money, i.e, the money they get from the big institutions that provide the money to their firms. As we explained in our earlier story about the VC tax issue, the profits VCs make from investing their own capital remains at the low capital gains rate of 15 percent. For Romney to mix this up shows that he’s either purposefully trying to obfuscate this fact — like much of the rest of the industry is trying to do — or that he just doesn’t understand the issue, which would be troubling indeed. Too bad TechCrunch didn’t call him on it.

Romney’s comments, notably, come as the US House of Representatives Ways and Means Committee voted today to increase the tax to the regular personal income tax rate of 35 percent. The venture capital lobby, meanwhile, sent out a note saying it was “alarmed” at the move. The Senate, however, appears to have stalled on voting for the tax, so we don’t expect it to pass any time soon.

Senate Majority Leader Harry M. Reid (D-Nev.) has reportedly told venture capital and private equity firms that the carried interest tax-hike bill won’t get get through the Senate this year.

Venture capitalists and private equity mangers deserve to be paying the higher rates, because they’re not taking any risks with the investments they’re making. The tax they’re paying now is the very low capital gains rate, and is paid on profits they’re making from investing other peoples’ money. Capital gains was designed only to encourage risk taking.

The report, carried in the Washington Post, suggests the fight by Democratic lawmakers, including some presidential candidates, for the higher tax has come to an end, at least for this year. These advocates wanted to raise the low 15 percent capital gains tax most VCs and private equity managers pay on their earnings, to the full income tax of 35 percent.

However, in the UK, the government has decided otherwise, and is unveiling new taxes on the industry.

Millions of dollars were spent by lobbyists to attack the bill. However, Reid implied the reason for the bill no passing has to do with the jammed Senate schedule. But tax hikes are difficult in presidential election years, so it’s not clear whether the bill will be back with more support next year.
Notably, the Post says the lobby attack on the proposal generated business for more than 20 lobbying firms, including the capital’s two largest, Patton Boggs and Akin Gump Strauss Hauer & Feld. A single private-equity firm, Blackstone Group, paid Ogilvy Government Relations $3.74 million this year, one of the largest recorded fees to any lobbying firm during a six-month period. According to the Post:

Some of the most prominent executives in the industry have made the rounds of senior lawmakers in recent months. Among those seen on Capitol Hill were former commerce secretary Peter G. Peterson of Blackstone Group and David M. Rubenstein of Carlyle Group. The financiers have benefited from cooperation with the real estate industry and the broad business groups like the U.S. Chamber of Commerce. Trade groups such as the Real Estate Roundtable have sent letters to lawmakers and testified before congressional committees against the tax increase because it would also impact the managing partners of their developers.

President Bush said he is against making venture capital and private equity firms pay income tax of 35 percent on their “carried” profits.

We wrote about why VCs and other investment professionals should be paying the higher tax than the 25 percent capital gains rate they currently pay — namely, they are already getting capital gains privileges on the personal money they are risking on these ventures.

We don’t entirely understand Bush’s logic on the matter, because his comments were expressed only vaguely, in reporting by the New York Times (see Bush’s comments lower down in this story, which is mainly about the stock market slide caused by sub-prime lending habits):

Noting that partnerships are a common structure among small businesses, Mr. Bush said he was satisfied with the current tax structure. “We are very, very hesitant about trying to target one aspect of limited partnerships,” he said, “for fear of it affecting small business growth.”

Here’s why we think venture capitalists and other investment professionals should pay income tax rates on “carried” profits, as proposed by legislation in Washington.

The lower capital gains tax rate of 15 percent, which VCs are now paying, is meant to encourage people to take risks, to investment money long-term with a business in hopes of generating superior profits. Encouraging such risks is good for all of us, because it fuels economic expansion and job growth too.

However, the carry doesn’t fall into that category of risk-taking. We’ve come to our conclusion after consulting with Kate Mitchell (see our previous post), a venture capitalist who represents the National Venture Capital Association in Washington hearings, who opposes the tax change. We’ve also talked at length with the tax attorney Mary Kuusisto, of law-firm Proskauer Rose and who is advising the NVCA.

Mitchell, you’ll recall, argued she has invested her own life’s savings into her endeavor as a venture capitalist. She placed her hard-gained cash into her venture fund, alongside the cash invested in by other institutional investors (folks like Credit Suisse, Liberty Mutual, Pantheon Ventures), and argued it was tied up for ten years before she saw any returns. That’s highly risky.

However, the personal money she invests, it turns out, will still get capital gains treatment. The legislation being considering in Washington wouldn’t touch her portion. Rather, it would change the tax treatment on returns from a very different pile of money — that money given to her invest by the other institutional investors (Credit Suisse et al).

Under the contract with these investors, Mitchell and her other general partners at Scale Venture Partners get 20 percent of the profits produced by the firm’s investments. The profits are called “carry.” By giving Mitchell and her other partners at Scale this money to invest, they’re asking her to perform a service. They’re paying her fees, too, in order to render that service — in the millions of dollars. In other words, this part of the bargain is not a risky activity for Mitchell to engage in, even if she argues differently. In our view, then, it is no different from the job performed by the elevator man, a janitor or cab driver, all of whom must pay income tax.

Let’s take an example: Assume, for sake of argument that Mitchell invests $4 million of her own money alongside the money of other investors in a $400 million fund. Assume she is the only general partner. The institutional investors (Credit Suisse, et al.) invest $396 million, and agree she will lay claim to 20 percent of the fund’s profits for managing their money.

A. The good scenario.

Let’s assume things work out great at the firm. The firm makes makes all its money back, and then an additional 50 percent, or $200 million. First, Mitchell gets her own $4 million back, plus $1.6 million as her portion of rightful profits (as an investor, remember, she gets 80 percent of the $2 million profit on her money). Here, capital gains works as it should. It gave her a tax break to encourage her to take risks, and she walks away with $1.6 million more, and that is be taxed at 15 percent, leaving her with $1.36 million after taxes. Moreover, as general partner, she claims 20 percent of the $200 million in profits made on the rest of the $400 million. That’s $40 million before taxes. That’s the carry that Congress is thinking about taxing. If the bill passes, instead of walking away with $34 million, she’ll walk away with only $26.

[Note: She'll have paid income tax on the 2 percent fee she gets in management fees before she realized the carry. However, they're factored out of the profits for determining the carry amount, so this is not an extra tax. The VC lobby does have a quibble, however. The fees are not deductible, resulting in a slightly higher effective tax rate on the carry (yes, this gets complicated). But the legislation won't change any of this, or least that's our understanding of the tax proposal right now, so this is really just a footnote.]

B. The bad scenario

Let’s assume the negative scenario. Let’s argue that the fund gets an early success from one of the companies it invests in, say $100 million in IPO returns a year after investing only $10 million on the company. Mitchell would have to pay a 15 federal tax on her 20 percent portion ($18 million) of the profit of $90 million she locks into. So she pays $2.7 million in federal taxes. However, assume that the firm later losses a total 90 million on its other investments. Mitchell deserves no profits from carry, because the firm hasn’t made any money. So she must give her $18 million back to the firm, setting her back to square one. But she still has paid the $2.7 million, so at the end of it all, she is $2.7 million in the hole. There may be no tax relief on that loss, she says, because losses can only be offset by gains in the future. Mitchell argues this potential loss means she’s taking risk, because of her overall ownership in the firm, justifying she deserves capital gains treatment. However, we disagree with that argument because she didn’t need to lock into that profit early on by selling. That’s a right afforded her by an agreement with her limited partners.

Final note about the WSJ’s math — The WSJ has a piece estimating the total proceeds produced by the tax would be “just” $2 billion, noting it is tiny when compared to the nation’s overall budget. However, we’d argue that is a significant amount, and should be taken seriously given that we’ve got huge budget deficits. Update: A comment below suggests are deficits aren’t so bad. Fair enough. I should add, however, that one group, the Economic Policy Institute, estimates the expected tax proceeds at $6 billion.

The Congressional debate about a new tax (see our coverage) on investors kicks off tomorrow (Wednesday) with U.S. Senate hearings.

Venture capitalists are represented by Kate Mitchell (pictured here), a managing director at San Francisco’s Scale Venture Partner. Mitchell called us from Washington, to explain what she’ll tell the U.S. Senate, and then later at the U.S. House of Rep. in a briefing: That VCs like her have invested substantial amount of their personal savings into small companies, alongside the capital they manage for so-called limited partners. As such, VCs put their own money at risk. Moreover, they also work hard with portfolio companies over a ten-year life of a venture capital firm.

In other words, that risk and hard work means the returns on the investments should continue to be taxed as “capital gains”, or at 15 percent, not as income, which is much higher, she explained.

She’ll be going up against Mark Gergen, a University of Texas Law School professor, who will argue the opposite. He considers the VC profits part of regular income, and told PE Wire he will urge the panel to adopt a “simple fix” to 702(b)—the relevant part of the tax code—that would encompass not just buyout firms and venture capitalists, but also real estate partnerships and oil and gas partnerships.

Mitchell, by the way, is about as coherent a spokesperson the VC industry could hope for. She speaks well, is engaging and comes across as credible. The National Venture Capital Association made a smart move to offer her up as a spokesperson (it presented a list of people to Congressional staffers, who picked her from the list).

She argues that the so-called “carry,” or profit obtained by investors from their investments is not guaranteed until the end of a ten-year fund cycle. She wants to make that clear to Congressional staffers and others who don’t seem to understand how VC investing works. She said VCs pay ordinary income tax on the interim fees they get from their limited partners — fees which are used for salary, rent and other costs of doing business. But a VC’s profit is only sorted out at the end of the fund’s life time, once the VC returns the principal investment and fees to the limited partners.

If a VC firm sees one of its companies go public or get sold for a big profit early on, she said, the venture capitalists at the firm pay a 20 percent tax on those gains, but those gains are never fully realized by the VC until the initial principal is first returned to limited partners. She’ll also talk about the jobs and economic growth that VC-funded companies create, and contrast that with other forms of investing, such as leveraged buyout activity, where firms like Blackstone have drawn the attention of legislators for throwing lavish banquets featuring $300-stone crabs. The Senate has even called its bill the “Blackstone Bill.”

Mitchell uses the example of a VC fund that her firm started investing in 2004. Mitchell be working on that until between 2011 and 2014 and won’t see any returns until then. “I took the savings I have, and money I’ve made from my career, and invested,” she said. “I’m hoping to get carried interest. I haven’t seen it yet.”

Private Equity Week’s Dan Primack has a good follow-up on the debate about the new tax for venture capitalists and other investors.

A public backlash against these investors is encouraging politicians: The extravagant ways of Blackstone, the buyout firm that that just went public and where leaders were feasting on $300 stone crabs, haven’t helped. The tax proposal is gathering momentum.

And while most investors are upset about the tax, New York venture capitalist Fred Wilson (pictured left) says the tax is justified:

I strongly believe that long term capital gains should be taxed differently than short term capital gains. And I also strongly believe that capital gains should be taxed differently than ordinary income. The counter argument is that the economic incentives to take risk with your capital should be enough and you don’t need additional tax incentives. I don’t buy that. Human nature being what it is, most people are going to want to be conservative with their capital. Taking a risk with your capital, particularly on new business initiatives (whether its a new restaurant in the neighborhood or a cure for cancer), is something we need to encourage. And many of the developed countries in the world agree. In some countries, capital gains are not taxed at all. I don’t think we need to take the economic incentives that far.

But, and this is a big but that will annoy most if not all of my colleagues in the VC and private equity businesses, if you are generating those gains with other people’s money (OPM), then that is a fee you are being paid and it should be taxed as ordinary income. I really don’t see how anyone can argue otherwise with a straight face.

If congress is successful in taxing carried interest as ordinary income, it will massively increase the amount of taxes I pay. So be it. Someone has to pay the taxes to keep our troops equipped, our borders secured, our schools modernized, and our children healthy. It might as well be me and my wife.

Meanwhile, here’s the statement by Mark Heesen, president of the National Venture Capital Association (NVCA), which represents 480 venture capital and private equity firms:

The Bill proposed today by House Democrats to change the taxation of carried interest from a capital gains rate to an ordinary income rate is extremely concerning to the venture capital community. We assert that carried interest in the venture capital business model is a true capital gain and should continue to be taxed at that appropriate level. This proposed legislation could have far reaching, negative implications for the start-up community, venture capital investment, and the US economy. It is critical that legislators identify and fully comprehend the unintended consequences of this proposal as it could impact one of the country’s most important economic engines. We look forward to continuing a dialogue with members of Congress on this issue as the legislative process continues.

Another concern is how these VC and other partnerships will respond to such a tax. Some may try to exploit loopholes that let them move their entities offshore but continue to invest here, for example. Experience has shown that you can’t just levy a tax and expect a corresponding increase in receipts. Congress should keep this in mind, and raise taxes only in a way that doesn’t mean a decline in tax revenues as a result.

U.S. Congressman Sandy Levin (D-Michigan) has finally introduced the bill that venture capitalists were dreading: A higher tax on their profits.

If it passes, and there’s a possibility it may, it will change the tax treatment of “carried interest,” or profit that VCs and other investment professionals get from their investments. The change would tax that profit at a much higher rate — by treating it as ordinary income, rather than as capital gains, which draws a mere 15 percent tax rate.

Here’s Levin’s statement. The jargon can be tough for the uninitiated. Basically, the legislation would apply to any investment professional active in “alternative investments,” which refers to most forms of investment outside of stocks and bonds.

Here’s a PDF of the proposal.

Robert E. Rubin, the former Treasury secretary in President Bill Clinton’s administration and now Citigroup exec, has come out in favor of the private equity tax.

“It seems to me what is happening is people are performing a service, managing peoples’ money in a private equity form, and fees for that service would ordinarily be thought of as ordinary income,” Mr. Rubin was cited saying by the NYT. He said he he was not a tax expert but that issue should be looked at “with great seriousness” by the appropriate tax committees in Congress.

The NYT has the story.

Here’s the latest action:

Amazon’s odd and scary patent — First, Amazon rolled out a product called Mechancial Turk (image left), where people do tasks for you that a machine couldn’t perform. Strange name, we thought, but nicely couched in history, and the people still ruled. But the latest Amazon patent puts the machine in charge, breaking down tasks, and commanding the human to do them. According to the patent, just awarded, “the humans perform the subtasks and provide the results back to the server.” Note that the inventors are the guys who have since left Amazon and launched Kosmix, a search engine.

Steve Jobs: Great artists steal — We can’t confirm this yet, but h Here’s a statement reportedly made by Apple’s Steve Jobs. The transcript is on PBS, and the edited version of the video is still at YouTube (see below), and emphasis is ours: “…I mean Picasso had a saying, he said good artists copy, great artists steal. And we have always been shameless about stealing great ideas and I think part of what made the Macintosh great was that the people working on it were musicians and poets and artists and zoologists and historians who also happened to be the best computer scientists in the world.” This airing of this again is notable, of course, because Apple is also in the midst of sparking a revolution in music copyright, prodding the removal of digital rights from its iTunes offerings — and music labels are sensitive about their music getting ripped off. The original video, meanwhile, has been ordered down. (Udpate: This is apparently a well-known quote by Jobs, as pointed out in comments below, so perhaps only relevant in the context of the take-down order).

Viacom vidoes represent just two percent of views on YouTube — Viacom, the large music and video publisher, sued Google for $1 billion for hosting pirated video on its video property, YouTube. But only two percent of views had Viacom-owned music or video, according to a report. That’s more than the other labels and studios, though. See summary by Henry Blodget.

Topix, the news site, opens up to citizen journalists — Topix has been working on local news for a long time, and yesterday opened itself up for citizens to post and edit stories. Question is, why did it take so long? Chief executive Rich Skrenta explains some of this on his blog. Also, note Topix is partly funded by USA Today parent Gannett, McClatchy and Tribune, and so was trying to serve those masters, and lost focus on its own survival. Meantime, though, several other such sites (Newsvine, Backfence, NowPublic, Outside.in etc) have emerged and make Topix a little late to the game. Helps to have your partial owner, USA Today, the nation’s largest newspaper, announce the news, though.

Something fishy with Technorati traffic? — Odd that Technorati, the search engine for blog material, suddenly announces a spike in traffic as rumors circulate it is searching for a new chief executive. Chief exec David Sifry provides the latest details on traffic: Nine million unique visitors over the last thirty days, up from 3.5 million two months ago. At first, we wondered whether the company had hit the wall, and was looking for publicity as it searches for a sale, or a new round of funding. This comes after we stopped using Technorati for blog searches last year — with the emergence of blog material in other engines such as Google. To be fair, though, others are asking the same question, and hearing that Technorati has simply gotten better. Any thoughts?

MySpace ad revenue disappointing? — The giant social networking site will only make $271 million in ad revenue, says one Wall St. analyst, even though Google was supposed to pay a minimum of $300 million to sell ads on the site!

Capital gains tax on VCs — Venture capitalist Fred Wilson has an good analysis on the debate about the VC tax proposal being weighed in Washington. He criticizes a NYT editorial, which argues the capital gains benefit is excessive. Wilson’s point is that the earlier the stage of investment, the greater the risk, and thus the more justified the tax benefit. Should private equity firms, which invest very late, and take on less risk, enjoy the low taxes they get? Maybe not. But if you tinker too much with VC taxes, the better VCs will leave the industry and become angel investors. The Europeans would love it. They’ve been trying to figure out how to get a vibrant VC industry, and a weaker U.S. industry might push more money over there.

As usual, see latest deals — See our VentureBeat Newswire here.

SustainLane gets $3.5 million for sustainable living site — The funding for the San Francisco company is its second round, according to a regulatory filing cited by PE Week. It ranks US cities by how environmentally friendly they are, and provides animated media about people trying to live green and reviews of eco-products.

FatDoor, secretive social network, to launch soon — The Palo Alto-based start-up, backed by Bill Harris, former CEO of Paypal and Intuit, and Bertram Capital, launches April 15, and describes itself as “a wikipedia of people,” with over 130 million people and business profiles at launch. It wants to let you get to know your neighbors, with “…..search and groups based on pre-seeded politics, religion, ethnicity, age, interests, etc.” The site features “three-dimensional geo-spatial visualization of data” and user-generated community publications and “geo-spatial coupons.” Stay tuned