Kicking Venture Capital When It's Down

expected VC returns for June 2010 are negative 5.2%
expected VC returns for June 2010 are negative 5.2%

On Friday, the House of Representatives passed a bill that would do many things, including raising the taxes that venture capitalists pay on capital gains. In so doing, Congress is taking a page from Willie Sutton -- who famously said he robbed banks because that's where the money was -- and turning that page on its side.

Ten years ago venture capital, or VC, was where the money was. But not anymore -- the costs of this tax change will exceed its benefits.

The House-passed bill, dubbed the American Jobs and Closing Tax Loopholes Act of 2010, does other things besides raising taxes on VCs. For example, it stretches out "unemployment benefits and lending and tax relief for small businesses," according to The New York Times.

VCs Put Their Investors' Funds at Risk

But it also raises taxes on the gains that VCs earn on their investments. A typical VC fund takes on limited partners, LPs, such as foundations and endowments with funds to invest, and the fund's general partners, GPs, invest that money -- perhaps along with some of their own -- in startup companies.

The general partners typically receive a management fee of 2% of their assets under management and 20% of the gains they make on selling the startup companies in their portfolios. But since the gains on that so-called carried interest are considered capital gains, they're taxed at 15%. If the carried interest was thought of as ordinary income, those GPs would be paying the top tax rate, 35%, on those gains.

Encouraging Risk-Taking

The reason for treating the carried interest as a capital gain is to encourage risk-taking. But, as I argued on July 13, 2007, on CNBC in reference to private equity funds, most of the money that goes into a portfolio company belongs to the limited partners, not the general partners -- the fund's managers. Therefore, since most of the carried interest doesn't spring from putting the GP's own capital at risk, I thought most of it was ordinary income and should be taxed in a blended fashion.

That is, the portion of the general partners' capital that they put at risk should be taxed as capital gains and the GP's share of the carried interest created by the limited partners' investment should be taxed as ordinary income. The House bill passed on Friday agrees with my logic. It would require that 75% of the GP's carried interest be taxed as ordinary income.

VCs Are Not Where the Money Is Anymore

Unfortunately, Congress is barking up the wrong tree if it thinks this tax increase will help close the budget deficit. That's because VC funds have performed terribly over the last decade. Annualized U.S. venture returns for the decade ended June 30, 2009, were 14.3%, down from 26.2% in the prior quarter and 33.9% a year earlier. The best year for VC funds was 1999 when annual returns were 83.4%. The expected returns for June 2010 are negative 5.2%.

No taxable gains will result from VC funds that lose money. And this means that the provision of the House bill that raises the tax rate on a GP's carried interest won't add to U.S. tax revenues.

Out of the Reach of U.S. Tax Authorities?

Unfortunately, the GP tax issue is the least of venture capitalists' concerns. The biggest is what could be a long process of finding startup companies that actually get to the point where they can go public or be sold to another buyer. Only then is there any hope for the VC fund to generate positive returns for investors.

In the meantime, those VC funds may incorporate themselves in places outside the U.S. that still allow them to pay a 15% rate on whatever investment gains their funds might generate in the future.