There is a brilliant investor/venture capitalist who lives in Berkeley California named Moshe Alafi. He was a big supporter of my first company, TOPS, and of my third company, Cybergold. After I sold TOPS to Sun Microsystems in 1987, the venture fund that had invested in TOPS offered to make me a partner. I remember discussing this option with Moshe Alafi. He said: “Why would you ever want to invest somebody else's money? You do all the work and they get most of the profit.”
I didn't listen to Moshe. I joined that venture capital fund, and actually I did quite well.
However, Moshe's question has become even more poignant today because Congress may still be looking to increase taxes substantially on venture capital investment profits. I remain very committed to being a venture capitalist, but the question Alafi originally raised – why? – has become even harder to answer. You can work years helping to cultivate a startup, and ultimately earn very little if the startup is unsuccessful. Now, if taxes are raised, venture capitalists will earn materially less even if the startup is successful. It's no surprise, then, that some of my venture friends are leaving the business.
Formal venture capital takes what's called limited partner's money and invests it on their behalf. Most profits — if there are any — are returned to those investors along with their original capital. About 20 percent of the profits are retained by the venture capital fund and distributed among its partners. Traditionally, these profits, called “carried interest,” have been treated by the government as long-term capital gains, which today are taxed at 15 percent. The idea is to encourage the investment of capital to create new businesses, jobs and a stronger economy. The change proposed by the government is to treat profits on carried interest for venture capitalists as regular income, soon to be taxed at 39%. Clearly, this is a disincentive to practice venture capital.
The investors in the Claremont Creek venture funds are institutions, principally university endowments, pension funds and environmental organizations. They use their profits so that needy students can be subsidized to attend our finest universities, pensioners can retire with dignity and so that the environment can be kept clean.
All this will be jeopardized by the tax decision, but this is hardly the only problem we are facing that is affecting innovation. Major U.S. corporations began trimming longer-term R&D decades ago. Venture-backed startups took up the slack for decades and essentially became outsourced corporate R&D arms. As venture capitalists leave the business, however, fewer startups will be funded. This exacerbates another existing problem: Venture capitalists have already been investing aggressively in countries such as India and China at the expense of America. Capital and talent are the most mobile assets in the world and go where they are most welcome.
There is also the lingering problem of Sarbannes-Oxley, which makes it unreasonably expensive for small public companies, which many startups would like to become, to do business. And changes should be made in America's increasingly underpowered efforts to attract and retain highly educated, talented and hard-working foreign entrepreneurs, who have long been the mainstay of many California startups.
Today, too many are returning to their roots in India, China and elsewhere and creating startups there.
I am hoping the U.S. legislators and regulators realize that their laws and rules are undermining America's innovation engine. The proposed increase in taxes on venture capital profits is only the latest example.
If the mentality for a more restrictive tax environment prevails, the perspective my investor friend Moshe Alafi gave me in 1987 may resonate more loudly. Additionally, our country may well lose and never regain its prominent role, if Congress doesn't wake up.