A Discussion Hypothetical:
Example 1. In 1996, Larry Page and Sergey Brin began developing a technology that ultimately becomes the Google search engine. While their idea initially had little value, through significant hard work, they developed this technology into a household name. In 2005, after several years and many rounds of financing, the corporation they founded undergoes an IPO. After the IPO, the value of the Google shares owned by Mr. Page and Mr. Brin is several billion dollars.
Example 2. Sometime in the 1990’s, Michael Moritz and other principals at Sequoia Capital start a venture capital fund to invest both the principals' (GP) capital and unrelated third-party investors' (LP) capital in early stage companies to help them grow. The LPs, not having experience in managing a venture capital fund and seeking to piggy-back on the expertise of Mr. Mortiz and his associates, agree to pay a 2% annual management fee to Sequoia AND also to forfeit 20% of any positive return on the investments of the fund to Mr. Moritz and his fellow GPs. At the time of the investment, the capital in the fund owned by Sequoia's principals (GPs) and by its external LPs had little (but not insignificant) value associated with its investments. In 1999, Sequoia participated in the first round of venture financing for a company known as Google, which was starting to get a lot of buzz and needed the capital to grow its business. In 2005, after several years and many rounds of financing, the corporation in which Sequoia invested undergoes an IPO. After the IPO, the value of the Google shares owned by the venture capital fund, including Sequoia (and indirectly both Mr. Moritz and the LP investors), is many millions of dollars and many times the fund's investment in Google.
Under current Federal income tax rules, it is likely that Messrs. Page, Brin and Moritz will realize a long-term capital gain on the sale of their Google shares, taxable at a maximum Federal income tax rate of 15%. The parallel treatment is arguably appropriate. Each of these individuals received equity in an entity that had a low value at the time of receipt. Each person invested significant time and effort into making the investment in Google what it was. While I am sure that each individual received some salary for their work, most of their return for their sweat equity investment was realized in the form of the astronomical appreciation in Google stock.
This hypothetical illustrates the crux of the carried interest debate. No one in Congress or Treasury is questioning the capital gains treatment to be enjoyed by Mr. Page and Mr. Brin. The issue before Congress currently is whether Mr. Moritz should receive a different tax treatment than the Google founders.
KSTax
4 Comments
Reader Comments (4)
Hi- While I am against congress on this issue, I'm not sure that this metaphor is entirely accurate. I think that Congress would still give the 80% of LP equity from Sequoia the capital gains treatment but would only penalize Mr. Moritz.
Actually, changing the metaphor seems to make your argument even stronger, because its ironic here that Mr. Moritz is the one who will have done all the work, but his LPs will get the entrepeneur's tax treatment!
The distinction proffered by F.Li is important. Here's a slightly different take:
Example 1: Same as above.
Example 2: Sometime in the 1990’s, Michael Moritz and other principals at Sequoia Capital start a venture capital fund to invest both the principals' (GP) capital and unrelated third-party investors' (LP) capital in early stage companies to help them grow. The LPs, not having experience in managing a venture capital fund and seeking to piggy-back on the expertise of Mr. Mortiz and his associates, agree to pay a 2% annual management fee to Sequoia AND also to forfeit 20% of any positive return on the investments of the fund to Mr. Moritz and his fellow GPs. At the time of the investment, the capital in the fund owned by Sequoia's principals (GPs) and by its external LPs had little (but not insignificant) value associated with its investments. In 1999, Sequoia participated in the first round of venture financing for a company known as Google, which was starting to get a lot of buzz and needed the capital to grow its business. For the sake of simplicity, let's say the Sequoia fund invested $100, of which $1 was provided by the GP (Mortiz, et al) and the remaining $99 was provided by the LPs. Mr. Moritz goes onto the board of Google and becomes a key strategic advisor. In 2005, after several years and many rounds of financing, the corporation in which Sequoia invested undergoes an IPO. After the IPO, the value of the Google shares owned by the venture capital fund, including Sequoia (and indirectly both Mr. Moritz and the LP investors), is say $1,100 (an 11-fold increase in value). Of this $1,100, Sequoia's partners are allocated $209 ($11 for their 1% investment + 20% of the positive return on the LPs' $99 investment), and the remaining $891 is allocated to the LPs.
The Google-related "sweat equity"--i.e. the effort that Brin, Page, and Moritz put into managing Google--is a red herring. The relevant sweat equity is the effort that Moritz put into identifying Google as a target and his decision to invest (and, equally importantly, his decision when to divest). It is for THESE decisions that Moritz is so handsomely compensated--not by Google, but by the LPs, who forgo $198 (20%) of their returns in exchange for riding the coattails of Moritz's investment expertise. And it is the taxation of this 20% "carried interest" that is the subject of much discussion on capitol hill--and, I believe, the subject of this blog, no? It seems to me that the carried interest is a form of incentive fee that Mr. Moritz charges his LP investors; rather than a fee he charges Google for helping manage the company. If the latter were the case, other investors in Google would surely share the costs, and perhaps they do... but not in the form of carried interest, but rather in the form of his board member salary, consultation fees, etc.
In other words, Moritz is paid for his services. He's getting money for a service. That's compensation (less his share of the 1% investment, of course).
It looks open and shut. LP managers should be paying regular income rates and should be penalized for falsifying their previous returns.
But by that logic, Messrs. Page and Brin are also getting stock as compensation for their services and their gain on sale of Google stock should also be taxable as such. That is the point of example. Should Moritz get different tax treatment than Page and Brin?