Destroying Appetites For Risk Taking
The Proposed Biden Tax Plan Will Hurt Entrepreneurship and Risk Capital
There are so many stories in the news, it’s tough to focus on any single one. Inflation, China’s economic problems with Evergrande, Hunter Biden’s emails being validated so we know there is “10% for the Big Guy”, American generals contradicting statements that Biden made in an interview with ABC Democratic lapdog George Stephanopoulos, and the continual fractures and fissures widening between and inside both political parties.
One that I always focus on is economic incentives.
Buried in the proposed tax bill are a couple of provisions that won’t be discussed at length but are very harmful to the American economy and improving the worldwide standard of living.
Let’s face it, America is where cutting-edge innovation happens en masse. Silicon Valley is the straw that stirs the drink, but there are plenty of other places in the US where amazing stuff is happening. It’s in the American DNA and it is cultural. That’s why so many immigrants come to America and build companies here.
Sure, other countries have smart people and entrepreneurial communities and I certainly respect what is going on there. Web 3.0 will unleash innovation and democratize capital to provide more opportunities to places outside of America. But, the simple fact is Web 3.0 potentially can make American innovation go even faster.
Treasury Secretary Janet Yellen, no friend of free-market capitalism, said that she thinks the US ought to tax unrealized gains on assets. For those of you that don’t understand what that means in its simplest form, assume you buy a stock for $1, and it goes up in value and is worth $5. You haven’t sold it. The esteemed salt-water economist Yellen would want you to pay tax on the $4 you “made”. This ignores the fact you still are at risk, and could lose it all. Senator Elizabeth Warren already has endorsed this point of view.
There is no doubt in my mind people like Paul Krugman and Joe Stigler will publish editorials defending her point of view.
Of course, if you look at the economic incentives and how people’s behavior works, the policy is antithetical to both.
But, let’s take it a few steps further.
You bought a piece of art at an art fair. That artist all of a sudden becomes Instagram famous. The piece of art you bought at that neighborhood street fair for $300 all of a sudden is worth $5000. Yellen wants you to pay tax on it.
You are a venture capitalist. You found an early-stage deal and negotiated with the entrepreneurs to invest $700,000 at a post-money valuation of $7MM. You own 10% of the company. The valuation of the company was created in a crystal ball. There is no 409A valuation process that would even value the company at $100,000 let alone the $7MM it is valued at on the term sheet.
The company crushes it. It raises the next round of capital at $150MM. Your 10% stake is now valued at $15MM. Janet Yellen would have you pay tax on the gain, or $14.3MM. The company you invested in has only around 20 employees and while growing fast isn’t a lock to be successful. It could still go broke.
By the way, that is roughly the story of Facebook’s first two rounds of capital. Worked out for those investors and they paid taxes on their gains when realized. They also reinvested those gains into new companies and entrepreneurs that brought jobs, opportunities, and higher standards of living to more people across the world.
The flip side can also happen. I invested in a company that did similar rounds of funding. It went out of business and I lost everything. Sure, I got to write that loss off against my taxes, but I sure would have rather had the gain. You don’t get rich losing money.
In my case, the company raised money at the $150MM valuation, then raised its next round at a $20MM valuation. Would Yellen let me take the unrealized tax loss? I doubt it.
Go back to the person who bought art at the art fair. The Instagram hero artist gets stuck in some sex scandal and falls out of favor. The art that was previously worth $5000 goes to $0. Do you get to recognize the loss? No chance.
Yellen and by proxy, Senator Warren have no concept of risk.
Digging further in the tax proposal my friend Rob uncovered this gem. It’s a letter to members of the Angel Capital Association.
We need your help. As you are likely aware, the President’s proposed “Build Back Better Act” is currently being hotly debated by the House of Representatives and a proposal is likely to go to the Senate this week. One element of the tax legislation being proposed is of grave concern to many of us because it would severely curtail the capital gains tax exemption for Qualified Small Business Stock (“QSBS”) that currently exists in Section 1202 of the tax code.
For a qualified small business, investment in their stock currently benefits from 100% exclusion of capital gains tax on gains of up to the greater of $10M or 10x your cost basis if the stock is held for at least five years. This incentive is extremely valuable to entrepreneurs/founders, key employees, and investors, and serves to stimulate support of early-stage ventures and small businesses that by many measures generate all net new jobs in this country. The new legislation would reduce the exemption to 50% from 100% and apply the alternative minimum tax that also is currently excluded for tax filers with average gross income over $400,000. One particularly punitive aspect to the change is that this would apply to all transactions after September 13, 2021, even though the investments could have been made many years ago under the assumption that gains would be excluded.
The Angel Capital Association (ACA), with guidance from our government relations counsel, GrayRobinson, and in conjunction with numerous other organizations like the National Venture Capital Association, The Center for American Entrepreneurship, Carta Inc., Engine and others, is finalizing a joint letter to Nancy Pelosi, Speaker of the House, and Kevin McCarthy, Minority Leader of the House requesting removal of this proposed change. ACA also wants to enlist its 14,000+ individual members in supporting removal of the proposal by encouraging them to contact legislators in both the House and the Senate.
ACA is providing the attached letter which we encourage you to send in the next 72 hours to your elected leaders in both the House and Senate. We anticipate that the proposed legislation will be sent to the Senate from the House this week, which means that essentially all Democrats likely will have to support this change under the reconciliation process. Our hope is that Republican and some Democrat Senators will support this effort to help preserve the incentives to start, build and invest in these highly risky ventures. Recognizing that many early-stage companies will fail, all incentives that help mitigate those losses by supporting those ventures that do survive and thrive is vital to our ecosystem.
We hope that you will help us in this effort by contacting your representative(s) at your earliest convenience. We greatly appreciate your support.
Sincerely,
Pat Gouhin, ACA CEO
It might seem odd that there is a carve-out in the tax code to exempt accredited investors on their first $10MM of investing profits.
Instead of deciding “what’s fair”, let us consider the carve-out in terms of costs, opportunity costs, risk, and societal benefits.
First off, if we want to tax everything under the sun, maybe it is time to eliminate all the rules around accredited investor status. Let anyone invest in anything they want using the money they earned. Of course, see Yellen’s perspective and you understand that she doesn’t believe people are rational and trusted to invest their own money for their own benefit unless they belong in a special class the government decides the parameters around.
What are the costs of having the QSBS 1202 policy?
Certainly, the government misses out on tax dollars. Without accounting for write-offs, charges against income, and other parts of the tax code that are used to whittle down tax liability, the gross amount is $3.8MM on a $10MM gain. 38% top tax rate. Of course in reality it will be a lot less than that but for argument’s sake, let’s be as the accountants say, “conservative”.
What happens to incentives for people that might invest in startups? With higher taxes, less investment goes to startups. That’s an opportunity cost, and in an economic (not accounting) analysis would be added into the cost.
Society sees less innovation and lower standards of living because fewer companies are funded. That is an opportunity cost.
Less job creation and opportunities for people. Less potential wealth built. That is an opportunity cost.
Those opportunity costs can also be viewed as benefits to people and society. When people are gainfully employed, they pay taxes. They live happier lives. They aren’t a liability to the government and the government has to pay less in transfer payments otherwise known as the safety net or welfare.
When people have jobs, they buy products and services that will enrich and improve their own life, and that gets a virtuous, dynamic, free-market economic wheel spinning with network effects that similarly effect more and more people.
Remember, investing in a startup is extremely risky. If you took a random sample of 100 angel or venture-backed startups, it’s likely 50%-70% of them fail. That means some investors took a chance on them and lost money. Changing the tax code around startup investing means even fewer people will be incentivized to put their money in startups.
When you are raising a venture fund, one incentive limited partners have is the tax treatment on potential gains. It balances the risks.
Because of the risk, most people won’t invest in a startup. But, because the societal benefits are so large from the innovation startups bring along with the wealth and positivity that happens when one is successful, we have a carve-out in the tax code.
Most of my compatriots in venture capital are Democrats. Hopefully, they will be a voice of reason to Democratic legislators who are pushing this tax bill. However, they are dealing with people who don’t listen to reason anymore. Political people have long ago become nothing more than religious zealots.
They don’t care about society or people. They care about government.
It’s hard to reason with a fanatic.
Well played as usual.
JLM
www.themusingsofthebigredcar.com
A big part of the problem is that the people making the decisions have very little experience in the private sector. Yellin has never had a job outside the bubble, nor her husband. People who have grown up in academia and government have a very limited view of the value created by work -- like stocking shelves in a market or being a plumber or welder. Starting a business or at least giving it a good try is dangerous and noble. You could lose everything and then have to start over. Anyone working at the fed ever lost everything?