Silicon Valley became famous as a great incubator of partnerships that helped develop companies like Apple, Cisco, eBay, Google, Intel and Sun Microsystems. But if President Barack Obama has his way, Silicon Valley will be hammered.
Obama outlined a budget that would more than double federal taxes on general partners — the entrepreneurs who incur the risk of assembling and managing partnerships for startups, distressed companies, real estate projects and other ventures. A significant part of their compensation is what is termed "carried interest" — generally a 20 percent share of what's left over after a portfolio company has been sold, after limited partners have been repaid their capital contributions with a preferred return, and after partnership expenses have been paid.
Currently carried interest is taxed at a 15 percent capital gain tax rate, but President Obama wants to tax it at a 39 percent ordinary income tax rate.
"States will undoubtedly follow the lead of the federal government and treat carried interest as ordinary income, too," says Jim Anderson of SVB Financial Group, San Francisco, which serves about 550 venture capital partnerships in the U.S., India, China, Israel and the U.K. With higher federal taxes plus state taxes, general partners would face a total hit around 50 percent. The tax hikes don't apply to limited partners who provide the money, but they're not the ones who decide whether a business venture is started or where it would operate.
An advantage of a partnership structure, which has been used for decades, is that it tightly aligns the interest of the general partner with the interest of the limited partners who provide almost all the capital. The only way a general partner can make money from the carried interest is to run the business so that limited partners make money.
In this respect, a partnership offers a compelling advantage over a corporate structure, quite apart from the lower costs of a partnership. In recent years, we have seen the interest of corporate executives at odds with those of shareholders, as these executives arranged "poison pills," "golden parachutes" and outrageous bonuses even when they ran their companies into the ground.
Startup companies do not have access to public stock markets, bond markets or commercial paper markets, and often they cannot get commercial bank loans. Expertise and financial support — over $10 trillion — from venture capital firms as well as private equity firms is crucial. As University of Chicago economist Steven Kaplan put it: "Evidence for the positive productive effects of private equity is unequivocal."
SVB's Anderson believes that Obama's proposed tax hikes would be injurious for Silicon Valley, driving venture capital enterprise away to lower-tax jurisdictions and possibly out of the country. Big venture capital firms like Accel, Sequoia Capital and Summit Partners are exploring opportunities in Asia, China, Europe and the Mideast. Silicon Valley has depended on startups to maintain a fertile entrepreneurial environment as older companies lose their competitive edge.
Silicon Valley would be especially hard hit by Obama's soak-the-rich taxes. According to a recent survey, two Silicon Valley ZIP codes have the highest average gross incomes in the state. These people make the state's biggest mortgage payments, and Obama plans to squeeze them by reducing the deductibility of their mortgages. All this plus higher California taxes could spur an exodus that might eventually turn Silicon Valley into a ghost town.