Venture capital, technology and taxes

Venture capital, technology and taxes

0160-791X181/010107-05$02.00/0 Copyright o 1981 Pergamon Ptca Ltd Techdogy Iv So&y, Vol. 3. pp. 107-l ll(1981) Printed in the USA. All tights reserve...

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0160-791X181/010107-05$02.00/0 Copyright o 1981 Pergamon Ptca Ltd

Techdogy Iv So&y, Vol. 3. pp. 107-l ll(1981) Printed in the USA. All tights reserved.

Venture Capital, Technology and Taxes Reid W. Dennis

Throughout history men and women with adventurous spirits have been willing to accept the exposure to inordinate risks in return for the promise of extraordinary rewards. The discovery of America in 1492 was essentially “a venture capital” project, although Christopher Columbus may have lacked some of the attributes of today’s skilled professional managers and Queen Isabella of Spain probably did not consider herself a venture capitalist when she used the royal jewels to finance the voyage. In the United States, the venture capital “industry” began to emerge during World War II and its development accelerated in the immediate postwar period as the electronic age burst forth upon the nation. The earliest participants in venture capital investments were primarily wealthy individuals who operated either individually or through pooled family funds, with the Rockefeller, Phipps and Whitney families setting the example. The institutionalization of the industry began in 1946 with the organization of the American Research and Development Corporation of Boston, financed in part by the John Hancock Mutual Life Insurance Company and the Rosenwald family. However, it was not until 12 years later with the passage of the Small Business Investment Act of 1958 that the banks and insurance companies began to participate in the industry in a meaningful way. From 1960 through 1962 approximately 585 Small Business Investment Company (SBIC) licenses were approved and more than $200 million in private capital was raised to finance their opera-

tion . The SBICs were off to a fast start, but disappointment set in almost immediately. Investor expectations were unreasonable, and managements lacked experience as well as an appreciation of the discipline required in the venture investment process. There was too much emphasis on short-term results, particularly by the publicly held SBICs, and the industry was burdened by cumbersome and excessive government regulation. Unfavorable economic conditions and a weak stock Reid W. Dennis is Managing Partner of Institutional Venture Partners, Menlo Park, Calafoornia,and a Director and Past President of the National Venture Capita/ Association. From 19J2 unti/ 1973 he was active in the inv&tment opera&m of Firemen !sFund Insurance Company, San Fran&o, andthe American Express Company. He resignedas President of the Amerkan Express Investment Mariagement Company in I 974 in order to form Institutional Venture Associates; InstitutionaL Venture Partners was formedin 1980. Active in the venture capital investment jieidfor 30 years, Mr. Dennli is director of a number of corporations.



Reid W. Dennis

market also contributed to poor financial performance and investors rapidly grew disenchanted. Indeed, the infant industry almost died in the process of being born. Partly in response to the difficulties facing the SBICs, in the mid- 1960s and early 1970s a number of new private venture capital firms were formed. These new firms - which did not require governmental approval and, therefore, avoided the attendant regulations - were almost all formed as limited partnerships, although a few of the largest firms were structured as corporations. Their professional managers were often technically trained, possessed master’s degrees in business administration, and had usually gained considerable investment experience working for other financial organizations. Their investors included insurance companies , pension funds, major corporations, foundations, endowments, wealthy individuals and families. It is these independent, private venture capital firms that today represent the core of the venture capital industry, and it is these firms that over the past decade have been the most active in the financing of emerging, innovative, high-technology enterprises. The relative importance of the private firms in the industry is shown in Table 1. Although the data for the early years are sketchy, it is believed that the total capital committed to the industry remained relatively static during the period from 1969 through 1977 and ranged from approximately $2.5 billion to $3 billion. Thus, the $4.5 billion as of December 31, 1980, represents a gain of 50% or more in the total capital committed during the past three years. However, during this same period, the capital committed to the independent private firms has increased at least 150%. Resurgence of the Private Sector There are several reasons for the dramatic resurgence of the independent private sector of the industry. Certainly the outstanding investment record of some of the major firms has become more visible, at least in part, as some of their more successful portfolio companies have completed their initial public offerings. Over the past seven or eight years, a number of leading venture capital partnerships have achieved an internal rate of return on their investor’s funds of 24-40%, and a few have even exceeded that range. Such results compare very favorably to the rates of return that have generally been achieved in marketable securities and, of course, far outstrip the results obtained by investing in high-grade medium and longterm bonds. A venture capital investment typically involves a commitment for four to eight years with little or no liquidity along the way and with the probability that additional funds will be required from time to time before success can be assured. Because of the very long-term nature of the investment, the venture investor often will be actively involved in providing advice and counsel to the management of the enterprise, either informally or through participation on the company’s board of directors. To quote one West Coast venture capitalist: “Venture capital investors are different from other types of investors in that they get to blow on the dice!” The venture capital investor’s principal objective can be simply stated: to

Venture Cap&i, Techdogy




TABLE 1. Tool Capital Committed to the Organized Venture Capital Industry (Jhimate at December 31, 1980) Independent Private Venture Capital Firms Small BusinessInvestment Companies Corporate Subsidiaries (Financial and Non-Financial)



$4.5 billion


billion billion



Source: Venture Capital Journal

achieve - over an extended period of time - a significantly above-average rate of return on invested assets through both realized and unrealized long-term capital gains. As a result, the most meaningful incentive for investors, investment managers and entrepreneurs alike has been the existence of substantial &$%ential between the maximum tax rate on realized long-term capital gains and the maximum rate on ordinary income. Table 2 shows that this differential has varied widely over the past 18 years. The differential between the two key tax rates declined substantially from 3.6 times in 1963 to 1.4 times in 1977. This decline had a demoralizing effect on the attitude of investors toward investments promising long-term capital gains. The effect was further amplified as investors realized that much of the gain was the result of inflation. Thus, not only did investors have to cope with inflation, but, in addition, they had to pay a heavy tax on inflation. Under these conditions, investors shifted their emphasis toward the generation of current income. Indeed, the entire nation shifted its emphasis toward consumption rather than production .

Would-be entrepreneurs in senior and middle management positions in established companies were also discouraged from venturing forth into new enterprises. The changing rates on capita gains and the 50% limitation on personal service income evolved to the point that the maximum tax rate on these two very different forms of remuneration were essentially the same. In 1977 and 1978 there was little incentive to give up a well-paying position and risk a successful career in order to join a young struggling company - no matter how promising its future might be! A iMajor Reversal The Tax Reform Act of 1978, which emerged from the debate generated by the “Steiger Amendment, ” marked a major reversal in the long-term trend of tax policy. As a result, the differential in rates shown in Table 2 actuaIIy increased significantly from 1.4 times to 2.5 times, and several biIls currently before the 97th Congress hold the promise that the cM%erentiaImay be widened still further to approximately 3.0 times. The change in rates enacted in 1978, more than any other single factor, has had a dramatic impact on the venture capitaI industry. Table 3 shows that, during the past three years, the private sector of the industry has had new capitaI committed to it at an unprecedented rate. This table shows that the total new private capital committed during the past three years ($1,789

Reid W. Dennis


TABLE 2. Maximum Incremental Federal Tax Bate for Individuals

Taxable Year




% Long-Term Capital Gains

% Personal Service Income

O/bOrdinarya or Unearned Incomeb

Differential (C) + (A)

25 25 35 49 28

N.A.’ N.A.’ 50 50 50

91 70 70 70 70

3.6 x 2.8 x 2.0 x

1963 1965 1970 1977 1979

1.4 x

2.5 x

‘1969 andprioryears b19i’0 andsubsequent years ‘Not applicable

TABLE 3. Estimated Fundings and Disbursements (Millions of Dollars) New


Private Capital Committed to Venture Capital Firms

1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980

$171 97 95 62 56 57 10 50 39 570 319 900

Source: Venture

Capital Journal

Disbursements to Portfolio Companies $

450 350 410 425 450 350 250 300 400 550 1,000 1,000

Initial Public Offerings of Companies with Net Worth of $5 Million or Less Number


698 198 248 409 69 9 4 29 13 21 46 135

$1,367 375 551 896 160 16 16 145 43 89 183 820

million) was almost four times the total committed during the previous eight years ($466 million). This veritable flood of new capital has resulted in a record rate of disbursements into portfolio companies. At no time in its history has the organized venture capital industry ever been more active than it has been during the past 12 months. If past experience is a reliable guide, this recent high level of investment activity will result in the creation of many of the nation’s most rapidly growing enterprises during the decade of the 1980s and beyond. Table 3 also shows that the climate for initial public offerings of securities of small companies has improved during the past three years. This is also vital to the

Venture Capital, Technology

and Taxes


venture capital process, for ultimate liquidity is an important objective of both investors and entrepreneurs. To the extent that the public market is available, small companies have the opportunity to raise the additional capital they require and still remain independent. When the public market is not available, a merger with a larger and financially stronger firm may be the only course of action open to the small company in order to satisfy the requirements, both for liquidity for its shareholders and additional capital for its growth. The good health of the public securities market can be very fragile and is particularly affected by the moods and emotions of investors. Euphoria sometimes depression often accompanies an follows a change in national administration; unexpected crisis; the forces of greed and fear are constantly pitted against one another. It is futile to try to protect public investors against themselves, but both corporate managers and securities underwriters need to act responsibly in order to treat public investors fairly. The wild price gyrations of some recent public securities offerings raise large caution flags. Certain of these new issues are going to have a difficult - if not impossible - task in living up to investor expectations indicated by their extremely high prices. There is little or no room for error or unforeseen delays, and one may wonder if some companies are not “going public” before they are ready to assume the heavy responsibility that accompanies such a course of action. Clearly, the recent changes in capital gains tax rates have improved the risk/reward ratio for both investors and entrepreneurs. The proposed changes now being considered, if enacted, will further lower the barriers to capital transactions and will result in the still more efficient reallocation of capital to its most productive use. Additional progress has also been ‘made in the liberalization of S.E.C. Rule 144 pertaining to the sale of securities acquired in private transactions, and the Department of Labor has revised its proposed Plan Asset Regulation, permitting pension funds to once again invest more freely in venture capital firms. Disincentives Std.. Remain The venture capital process is beginning to work extremely well, but enormous disincentives to investment and personal risk-taking still remain. The 70% tax rate on investment income, the double taxation of dividends, the partial exclusion of the deductibility of capital losses and investment interest expense, and the punitive tax treatment of stock options are all candidates for revisions and all would have a beneficial effect on the nation’s economy. The tax rates on long-term capital gains should be reduced and the “differential” referred to in Table 2 increased still further. In both Germany and Japan capital gains tax rates are essentially zero, and the personal savings rate is three to five times that enjoyed by this country. In an era when the United States lags the leading industrial nations of the world in the rate of capital formation and productivity increase, in an era when it desperately needs to put more people to work, it would appear to be very poor national policy to retain a capital gains tax rate that is significantly higher than that of its principal competitors in world markets. As a nation, there is still so very much to be done!