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Incentives and Carried Interest

without comments

The House recently passed a bill to tax carried interest at the higher income tax – rather than the lower capital gains – rates. This has generated considerable consternation and debate in the venture world and somehow led to Chris Dixon asking Jim Robinson to go fuck himself [1]. In brief, taxing carried interest – the “profit share” that money managers take from any positive returns they make – at income tax rates would increase the tax burden on VCs and possibly lead to changes in the way VC funds are structured. Some smart people think this is a good thing, as it seems a bit silly for money managers to receive a government subsidy at a time when there are so many money managers.

Let me add some thoughts into the mix [2]. First and foremost, I don’t really buy the argument that taxing money managers at a higher rate will directly lead to a decrease in capital flowing into funds. Pension funds, endowments and high net worth individuals still have lots of money, and they’re willing to pay someone to manage it. I may be wrong here, because I don’t pretend to understand all the subtleties of the system, but this is not the argument that speaks to me.

But I do believe that people respond strongly and (fairly) efficiently to financial incentives. Over the past two decades, some of our nation’s smartest people have gone into banking and private equity because you can make great money there. If science and engineering had the same compensation structure and magnitude as high finance, we’d have a lot more scientists and engineers.

Fred Wilson uses this argument as he writes in favor of taxing carried interest at a higher rate. If it were less lucrative to be a money manager – the result of this tax increase – fewer of our best and brightest would become money managers. On the surface, that seems like a good thing. And it may be. But one of the things that makes the American startup scene great is the number of smart VCs out there. Sure, VCs come in many flavors – some are brilliant folks dedicated to supporting entrepreneurs, and others are idiots. But the last thing we need is to turn VCs into mutual fund managers – the bottom of the financial hierarchy with minimal alignment with their investors or incentive to perform. Mutual fund managers don’t take carried interest, just a management fee. Because of this and other factors, mutual fund management is one of the least lucrative executive positions in finance and is staffed accordingly.

I don’t want to see venture capitalists without significant carried interest – timid, risk-averse and totally misaligned with the interests of entrepreneurs and LPs. This will inevitably lead to lower returns – and an eventual decrease in money flowing into venture capital, and by association, startups.

Money managers are given the task of allocating the free world’s capital. Their decisions of where to put that capital to work have an overwhelming effect on our nation’s growth, development and standard of living. There’s a strong argument to be made that they’ve been doing a terrible job of late – rather than investing the past decade’s excess wealth in infrastructure, science and technology, they decided to build houses in suburbia that now lie vacant, rotting in the Sun Belt summer. There’s a growing body of research showing that this choice will have a significant impact in our nation’s economic growth and competitiveness for decades to come.

I want the smartest people in the world deciding which companies have a chance to succeed or fail. There’s a problem in money management, but I’m not sure increasing taxes on the managers’ incentive to succeed is the right answer.

[1] Matt Mireles’s post on this exchange is totally worth reading.

[2] I don’t really have a dog in this fight. Tipping Point doesn’t manage a fund of outside capital, and thus we don’t make any money from carried interest. I don’t personally invest in venture-fundable companies, so I’m not secretly hoping that VCs get weaker so I have access to better deals. I really just want to see a thriving startup ecosystem that leverages technology to drive fundamental change.

Written by Brad Hargreaves

June 13th, 2010 at 10:13 am