I have been in the venture capital business for over four decades and for the last 22 years as managing partner of Icon Ventures, a Silicon Valley firm committed to best practices in venture capital. We are a small integrated team that has backed several startups that have grown to become multi-billion-dollar market leaders such as FireEye, Palo Alto Networks, Bill.com and Maven Clinic. As an experienced VC practitioner, I can speak with first-hand knowledge of the importance of capital gains tax treatment for carried interest at the partnership level.
Early in my career, I joined US Venture Partners (USVP) when the venture capital industry was in its early stages of development. USVP had just raised a $50 million fund which was considered large at the time. We benefited from the tailwinds created by the Economic Recovery Tax Act of 1981, which reduced capital gains taxes from 28% to 20%. Yet, despite the fund’s size, management fees were insufficient to cover all expenses, and USVP’s founders endured very modest salaries for several years. Their economic motivation to build a venture firm was primarily based on their carried interest stake.
Fortunately, the risk they took turned out well. Our first deal was a $250,000 seed investment in Sun Microsystems. It was then that I learned how deeply venture investors work with founders at every step in their journey. When Sun achieved great success and went public in 1986, all stakeholders were rewarded—founders, employees, and investors alike. We made our first large distribution to our limited partners and shared the benefits through our carried interest. Our economic interests were all aligned and treated as capital gains.
Tax policy alignment at risk
Alignment of interests is a core value of venture capital and needs to be reflected in tax policy as well to maximize value for all. Capital gains treatment has always been the north star of our industry and for decades was unquestioned by both accountants and tax lawyers…that is until 2007, when Representative Sander Levin introduced the “Carried Interest Fairness Act,” which argued that it should be treated as ordinary income. This marked a turning point, when sound tax policy was first labeled a ‘tax loophole’.
I thought at the time, how can this be possible? The definition of a tax loophole is when people take advantage of a poorly written tax bill in ways that are inconsistent with the intent of the law. How can the driving force behind what we do be labeled in this way? I could only surmise that once the dollar amounts get large enough, it attracts attention, and sadly, over time, it casts venture investors in a negative light since people often don’t look past the sound bites.
Potential for unintended consequences
Some argue that as the venture industry has grown, it can afford to treat gains as ordinary income but the data makes clear the potential of unintended consequences. Indeed, as an asset class, venture capital has significantly grown, but it pales by comparison to private equity, real estate and other alternative asset classes. Furthermore, when you break the numbers down to the fund size level, the data is even more illuminating. While US venture firms invested over $220 billion last year, a significant portion came from roughly a dozen larger, more prominent firms. Beyond these major players, surprisingly, last year the median size of a new venture fund was only $21.3 million. If carried interest is taxed at ordinary income rates, this would create significant disincentives for capital formation, particularly in underserved markets across the United States. Blunting venture capital’s ability to democratize access to all markets not only flies in the face of “fairness” but undermines the untapped potential of the venture industry.
The importance of preserving a healthy venture capital industry – especially now!
Venture capital has clearly proven to be a form of investment that “punches above its weight class.” Even small VC firms can significantly impact economic prosperity and job creation. At Icon Ventures, with just four general partners, we’ve co-invested in startups that created over 48,000 jobs!
Yet, proud as we are of our track record, it is more important to look ahead. As we immerse ourselves in the Age of AI, the breadth of the coming change has never been greater. AI will transform most if not all industries from healthcare to cybersecurity and create entirely new ones yet to be imagined. The venture community is actively embracing AI, but given the societal concerns AI raises, it’s vital we commit to this new era of investing as a “force for good.” If ever alignment with policymakers mattered, this is that time.
The Tax Cuts and Jobs Act of 2017 sensibly established a three-year holding period for carried interest to receive capital gains treatment, aligning with venture capital’s long-term nature. Let’s not change something that doesn’t need fixing. Whether a fund is big or small, if their charter is to invest for long-term value creation, we can ill afford less incentive for success. The stakes are too high at such a critical time.
My two cents.
________________
Joe Horowitz, Founder and Managing Partner of Icon Ventures.
Icon Ventures is a leading Silicon Valley venture capital firm with offices in Palo Alto and San Francisco. Joe launched Icon in 2003, which has grown from $100 million in assets to $1.4 billion today. His venture capital experience includes a 10-year tenure at U.S. Venture Partners. Joe was also Chairman and CEO of Geocast Network Systems, a broadband infrastructure company backed by Mayfield, Kleiner Perkins and IVP. At Icon, Joe has had 16 successful exits to date, including early-stage investments in FireEye, Palo Alto Networks and Proofpoint that all achieved multibillion-dollar market valuations. He received his MBA from the Wharton Graduate School of Business and attended Columbia University as an undergraduate, where he studied engineering & applied sciences and then earned a degree in economics. Joe currently serves on the National Venture Capital Association Alumni Council after having served on the NVCA Board from 2017 to 2021.
