Many venture capitalists expect that they’ll be paying higher taxes when they cash out of investments in the near future, regardless of whether the nation tumbles over the “fiscal cliff” or lawmakers strike an agreement.
The tax rate on capital gains is one of many factors venture capitalists consider before making an investment. It’s also used by their financial backers, called limited partners, to assess whether the industry will yield desired returns.
The extent to which a higher tax rate would impact investments remains unclear. Still, the economic uncertainty created by the fiscal cliff and hostile negotiations, combined with the likelihood of a higher tax rate, may cause venture capitalists to pause before cutting large checks.
The top tax rate for capital gains will automatically jump to 20 percent from 15 percent if the Bush-era tax cuts expire on Dec. 31. A deal among lawmakers could minimize the increase or even keep the rate flat, though many investors think the latter unlikely.
“What you will see if capital gains rates go up high is venture capitalists will become more conservative,” said Mark Heesen, president of the National Venture Capital Association.
That’s because a higher capital gains rate stands to have a material impact on the amount of money investors recoup after they funnel early stage or growth capital into young companies as they expand.
“The capital will continue to flow to start-ups because that is where the growth will be, but we need to make sure that whatever policies the government puts in place accelerates ... capital flowing to start-ups,” said Steve Case, chairman and chief executive of Revolution, a District-based investment firm.
“There’s three parts to the algorithm. Ultimately you can’t cut your way out of [the fiscal situation] or raise taxes your way out of it,” Case said. “You need to grow your way out of it. That focus on growth is important.”
For Case, that focus should include rules that allow investors to pay lower taxes on capital gains — or no taxes at all — if they hold onto investments for an extended period of time. That would encourage investors to pour their money into new companies with long-term potential that may take more time to materialize.
“When the details are written, I hope there would be a recognition that not all investments are created equal,” Case said. “The people who are willing to invest in these younger, riskier companies, as long as they hold them for a long period of time, should be treated differently.”
The National Venture Capital Association released a survey last week of 600 chief executives and venture capitalists that shows 49 percent of CEOs and 42 percent of investors expect the U.S. economy to improve next year. That’s down from 53 and 47 percent, respectively, last year.
The same report found both chief executives and venture capitalists predict cybersecurity legislation and immigration reform have a better chance of passing in the new year than tax reform or a federal budget overhaul.
“I don’t see the pessimism coming in as a result of the capital gains rate going up as much as I see it from the uncertainty of the market as a result of the fiscal cliff,” Heesen said.
The last economic downturn saw the size and frequency of venture capital deals fall to their lowest levels in a decade as the stock market lost its appetite for initial public offerings and large firms were hesitant to make acquisitions.
“If we have fewer companies being successfully acquired or going public, our returns are not as healthy. If our returns are not as healthy, then our investors are not going to continue to invest in venture capital,” Heesen said.