Proposed tax hike threatens Ann Arbor venture capital industry, investors warn
Michigan's economy needs to attract investment in startups and new technology, and Ann Arbor-based research and development is a key component of that.
But now local investors are concerned that a tax bill passed Friday by the U.S. House of Representatives could repel Michigan’s venture capital industry from funding the types of companies that have defined recent success in the region.
The so-called “carried interest” bill would implement a tax hike on venture capital fund managers who reap gains from long-term investments in startup companies.
Local venture capitalists and Ann Arbor-based Michigan Venture Capital Association are actively seeking to block the changes as the Senate is expected to consider the bill next week.
“It could drive people out of the business,” said Tim Petersen, managing director of Ann Arbor-based Arboretum Ventures, the state’s most prominent venture capital firm. “It’s the wrong time to be (discouraging) people from doing venture activities.”
Arboretum Ventures managing directors Tim Petersen and Jan Garfinkle are among the Ann Arbor investors who could be impacted by a new tax hike proposed in Washington.
File photo | AnnArbor.com
Under a typical structure of a venture capital firm, most profits reaped from an investment in a startup company are distributed to the firm’s institutional investors and a smaller percentage of the profits are distributed to the fund’s day-to-day managers.
Since those investments can take five to 10 years to mature, the profits distributed to VC managers historically have been taxed as capital gains income, which is taxed at a rate of 15 percent. Under the proposal making its way through Congress, however, those profits would be taxed as ordinary income, which could equal a rate as high as 35 percent for wealthy investors.
“It’s going to remove the incentive for venture capitalists to stay in deals over the long term,” said LeAnn Auer, MVCA’s executive director. “They would move to invest more in the later stage. That takes away much of the funding that would be available for these early-stage entrepreneurs.”
Venture capitalists funneled $131 million into 25 Michigan companies in 2009, according to the MVCA. The 16 venture capital firms headquartered in Michigan manage an average of $76 million in capital. Another six firms headquartered out of state maintain an active presence in Michigan.
Venture capitalists argue that their investment activities play a vital role in providing financing to hot startup companies, including local firms such as ForeSee Results, Accuri Cytometers, Sakti3, Esperion Therapeutics, QuatRx Pharmaceuticals, Lycera, NanoBio, Johnson & Johnson’s HealthMedia and Becton, Dickinson and Co.’s HandyLab.
But supporters of the proposal, including U.S. Rep. Sander Levin, D-Michigan and chairman of the Ways and Means Committee, argue that the gains reaped by venture capital firms and distributed to the fund managers should be treated as ordinary income since the managers are usually investing someone else’s money. Congress designed the bill to target wealthy investors who manage hedge funds, private equity companies and venture capital firms.
Those fund managers also receive a regular salary for their services, “so it’s fair that they would pay the same rates as others who perform services,” University of Colorado professor Victor Fleischer told the New York Times.
“This is a basic issue of fairness,” said Rep. Levin.
Levin said in a statement provided to AnnArbor.com: “Venture capital partners play an important role in managing venture capital investments and to the extent that their own money is at risk, income from investment should be taxed at the capital gains rate. However, the compensation they receive for carrying out their job should be taxed as ordinary income - just as it is for other service providers including corporate executives who receive a considerable portion of their pay in stock options subject, if and when exercised, to ordinary income tax rates.”
Proponents say that, under the bill, private individuals who invest their own money will still be taxed at the capital gains rate.
Auer said the MVCA has been working with the National Venture Capital Association for the last few years in an effort to convince lawmakers in Washington to protect venture capitalists from higher taxes. She said the tax increase especially threatens Michigan’s venture capital industry because many funds in the state are already operating on a shoestring budget.
“Taking a tax like this is going to make it hard for those firms to survive and it’s going to disincentivize anybody going into the business in the first place,” she said. “Why go into business if there’s really no carrot at the end of it?”
Chris Rizik, an Ann Arbor venture capitalist who manages the Renaissance Venture Capital Fund, said he fears that talented investors will flock to traditional financial firms instead of trying their hand at venture capital.
“We’re competing for people like every other industry is,” said Rizik, who formerly managed Ann Arbor VC firms Avalon Investments and Ardesta alongside Michigan gubernatorial candidate Rick Snyder. “If somebody has a choice of going to venture capital or Wall Street to be an investor, I can guarantee they’re going to make more money on Wall Street.”
Rizik said the anti-Wall Street sentiment should not be directed at VC firms.
“We’re the ones creating the jobs, we’re not just churning paper,” he said. “Why would you want to punish us by doing this?”
Contact AnnArbor.com's Nathan Bomey at (734) 623-2587 or nathanbomey@annarbor.com. You can also follow him on Twitter or subscribe to AnnArbor.com's newsletters.
Comments
AnnArBo
Sun, Jun 6, 2010 : 7:55 a.m.
This is just the start of what the future is going to look like. You start with the "rich" as they are portrayed as being able to afford it, then it trickles down to everyone. Huge government spending requires huge revenue sources, in the end everything is on the table because once you start these public entitlement programs, they can't be stopped or scaled back and must be funded. Our government is going to eat us alive with tax increases.
Mick52
Fri, Jun 4, 2010 : 10:07 a.m.
Another foolish attempt to increase taxes that will hinder Michigan's recovery. And I suggest anyone promoting a flat tax, like Techno, should include how to convince non profit organizations that rely on tax deductible contributions this is good for them. If flat tax rate is passed, will the govt be able to finance their survival?
braggslaw
Thu, Jun 3, 2010 : 7:48 p.m.
With the exodus of 100's of thousands of people out of the state we cannot afford to drive other productive/tax-paying enterprises out of the state. Who else will pay taxes to support all the social services and state workers.
Michigan Reader
Thu, Jun 3, 2010 : 5:24 p.m.
"This is a basic issue of fairness", said Rep. Levin. No, it's an issue of closing the federal deficit.
braggslaw
Thu, Jun 3, 2010 : 1:42 p.m.
I am not going to pretend to understand the tax codes. I will say that any new tax that drives jobs away from Michigan is not a good idea.
MDVH
Thu, Jun 3, 2010 : 12:44 p.m.
Somewhat Concerned, I'm not sure I understand your math. At issue is whether the (non-investment portion of the) carried interest is taxed at the 15% cap gains rate or the likely higher ordinary income rate ("as high as 35%"}. While the tax rate may (on average) double, this doesn't equate to a "50% cut" in the cash earned, right? More generally, whether that incrementally higher tax hit will push qualified managers out of this niche will be a function of market forces (like supply/demand and deal term negotiations) more that tax rates, IMHO.
Somewhat Concerned
Thu, Jun 3, 2010 : 11:17 a.m.
Not only are venture capital firms very different from private equity and hedge funds, they differ among themselves in a way that is important to the future of Michigan. A large vc fund of the sort most likely found in Boston or Silicon Valley that invests a billion dollars will receive a management fee of $20 million. A vc fund of the sort most likely found in Michigan that invests $80 million will receive a management fee of $1.6 million. After the expenses of running the fund, there is very little reward for the vc fund managing partners. Their reward is in the carried interest. If that reward is taxed at the higher rate, that reward is cut in half. That's a big change. In the big funds on either coast, the rewards might still make sense, but in the small funds that fuel Michigan's future economy, rewards being cut in half means that people who have the ability to run the funds will go elsewhere. It's a 50% cut, and the managers have alternatives. If even a quarter of them go to other fields of finance or entrepreneurship or to large coastal funds that do not lead venture financing rounds in Michigan, the effects on our state economy and the job opportunities for our young will be felt for an entire generation. Just when Michigan's new economy is getting some good news, one of our own members of Congress leads an effort that could tear the guts out of it and concentrate the new economy even more on the coasts. We just keep shooting ourselves in our feet.
blueplatespecial
Thu, Jun 3, 2010 : 10:45 a.m.
I am not convinced this is unjust or a bad thing. As I understand it, VCs get a management fee from their limited partners that funds investment activities and salaries. These salaries are taxed as normal income. The VC partners also have a small percentage of the invested capital in the fund. Any proceeds from this would be taxed at the capital gains rate. In addition, VCs have a carried interest in the fund that is a percentage of the profits that are made from an investment they made with other peoples money. The VCs are not putting their capital (with the exception of the small % mentioned above) to work or at riskthey are risking the money from their limited partners. If the VCs do a good job (i.e. make smart investments that make money for their partners), they get a piece of the upside. This sure sounds like a performance bonus to me. Every job I have ever held, the performance bonus was taxed as regular income. It is also at risk; if I dont perform, I dont get it. I dont see how the VC carried interest is substantively different from a performance bonus and thus VCs should be treated and taxed the same way. Also I dont buy Ms Auers contention that this would drive people out or early investing. If there is money to be made in the space, VCs will be there investing. To offset the income hit they may need to increase their management fees or carried interest, or far more likely, price it into the investment (i.e. have the entrepreneur bear the cost through decreased valuation). As a side note, I would like to know if the management fee is guaranteed for the life of a fund (usually 10 years). Do VCs have a contract with their limited partners that commit the LPs to the management fee and the investment cash calls. Is the management fee performance linked?
Corey
Thu, Jun 3, 2010 : 9:29 a.m.
There are many things wrong with the bill that the House just recently passed. However, I must admit, after reading the code sections affected by the bill that a couple things must be addressed when properly talking about this 'loophole'. First, only interest that is not a return of invested capital will be taxed at ordinary income rates. Here the burden of proof of what is and what is not a return of invested capital is on the taxpayer. Seriously, if you do your accounting correctly you shouldn't see carried interest taxed at ordinary income rates that shouldn't be already taxed at ordinary income rates, under standard at-risk provisions of the tax code. Secondly, for tax years beginning on or after January 1, 2011, and before January 1, 2013, only 50% of carried interest in excess of a return of capital will be taxed at ordinary income rates. After January 1, 2013, it will be 75%. Thirdly, lets not forget that this is a federal tax issue so all venture capitalists will have to follow this rule no matter what state they operate in. In order to generate business in this state we need to look at the awful tax environment we have here for businesses. The best thing to do in this state would be to repeal the MBT.
StartupGeek
Thu, Jun 3, 2010 : 9:02 a.m.
As an entrepreneur who has dealt with VC's here and in Silicon Valley, I do not support a change to tax on "Carried Interest" for VC's (Hedge Funds, perhaps, yes). While the VC is not investing capital, but rather their time, their time is completely at risk and the time horizon is long. If they are unsuccessful in their portfolio, no carried interest. And many are not successful. How many of those proposing a change in the tax structure have a significant portion of their income completely at risk with the compensation 5-10 years out? Additionally, Michigan needs more VC's - especially more high quality VC's - we do not want to discourage new entrants at a time when they are needed more than ever. The majority of new jobs come from growth companies and growth companies often are funded by VC's. The future of the state depends on a vibrant entrepreneurial ecosystem and the VC's are a key player in that community.
Nathan Bomey
Thu, Jun 3, 2010 : 8:30 a.m.
Without taking sides on the debate here, I wanted to clarify, just to be clear, that venture capital fund managers *do* indeed get taxed at normal rates for their regular salaries. This bill addresses additional profits distributed to fund managers as a result of the success of companies the VC funds invested in. For example, local firms that invested in University of Michigan spinoff success HandyLab reaped significant returns when the company was sold last year to Becton, Dickinson and Co. for $275 million. Most of those profits were distributed to the funds' investors and then the remainder was split among the fund managers. It's those profits that would be subject to ordinary tax rates under this bill.
Technojunkie
Thu, Jun 3, 2010 : 8:18 a.m.
Tell you what Sen. Levin, pass the Flat Income Tax plan that wipes out loopholes in exchange for a "low" 17% flat rate and we can compromise on taxing capital gains as ordinary income. Of course, the Democratic Party won't be able to sell tax loopholes anymore but it's a sacrifice worth making, right? Just think of the tax money you'll get to play with if we commoners are busy doing productive work instead of complying with your bleepin' tax code! And don't even try to pretend not to notice the Flat Tax's personal and dependent deductions that shelter the low income workers you claim to care so much about. Some of us can do math.
DeeDee
Thu, Jun 3, 2010 : 8:03 a.m.
Tim is right; VC and hedge funds could not be more different! VCs are creating the job engines of tomorrow - hedge fund managers are headed down to the casino. A decade ago there was a lot of publicity about internet companies that were started and flipped, allowing VC's rapid exits and enormous profits. These may still be driving perceptions that somehow VC is always a get rich quick deal. In the current situation, where much needed clean technologies are costing early stage investors more and taking longer to bring to market than many expected, the last thing needed is to disincentivize patient investors like EDF and Arboretum who stuck with Handylab for example, for a decade. As a founder/co-founder of three local companies, some with venture backing, I think we need to do everything possible to encourage the early stage investment community to take the long view.
Tim Petersen
Thu, Jun 3, 2010 : 7:41 a.m.
Thanks for your interest in the issue, Art. A couple of thoughts, since you addressed your comment directly to me: 1) What a hedge fund manager does and what a venture capitalist does are very different. We hold our investments for many years. Our companies usually create new jobs. 2) Venture capitalists do pay ordinary income taxes on the fees we charge for managing the funds - always have, always will, always should. The issue is the tax on the long-term gains from our investments. 3) The current tax on these potential gains is an incentive to do what we do: to make long-term, often risky bets on emerging companies. I'll leave it to you and others to determine if incenting such behavior is a good thing (there are a tremendous number of incentives in our tax code, obviously). Rep. Levin seems intent on scoring political points through obfuscation - he certainly knows we pay ordinary income taxes (as we should) on our management fees. Best, Tim Petersen
Kafkaland
Thu, Jun 3, 2010 : 7:33 a.m.
The carried interest provision for hedge fund and venture capital firm managers need to go. What they receive is compensation for work, plain and simple. If tax break for this kind of activities are needed to encourage job fgrowth, they should be givin in a targeted way, let's say only for profits related to companies that meed certain job-growth targets over thelifetime fo the investment, or for investments in certain sectors like sustainable energy that we want to encourage, but not for, let's say, a hedge fund investments in CDS, or bets, on banks or oil companies going belly-up, or similar counterproductive and antisocial behavior.
Jim Edwards
Thu, Jun 3, 2010 : 7:25 a.m.
Let's be clear about the dire situation in Michigan... we need jobs, we need investment and we need to grow our way out of this situation. The approach to this is simple blocking and tackling: 1. Create a safe atmosphere for corporations to come to Michigan and invest. 2. Create an atmosphere where better returns than elsewhere can be realized... thus allowing money to flow into our economy. 3. Incent innovation and risk taking on the periphery While these comments will likely get the predictable retorts about the evils of making money and how rich people do bad, bad things, businesses take advantage of workers, etc., let's think about the realities of what happens when government gets in the way. Political activity hidden behind a fairness scheme. Scary. It is simple... if a business can operate and make more money in Michigan than elsewhere, it will come and stay. If individuals can live and prosper in Michigan, they too will come and stay. The end result of the safe operating environment, lower costs of doing business and a better return on investment will mean jobs jobs jobs. If you don't believe that, you've never signed both sides of a paycheck or are in complete denial or ignorance of economics. Whatever the case, relying on government to make things 'fair' or 'nice' is silly. Don't kid yourself... that's not the government's job. Once again... businesses create jobs when they believe that they can make more money here than elsewhere. If Michigan is able to participate and be a part of an active effort to encourage business growth in a way that doesn't coddle to anything but business growth, we will have jobs and consumers with money able to buy goods. It's reality. Deal with it. Jim Edwards
Art Vandelay
Thu, Jun 3, 2010 : 6:14 a.m.
Sorry Tim but this tax loophole needs to be closed. Hedge fund managers and venture capital managers shouldn't get special tax treatment. This is your job and you should pay taxes at the same rate as other money managers and the general public.