Return on Venture Money is Not the Bottleneck

I think the bottleneck to increased startup formation is people, not exits or tax rates.

If exits were the problem, then LPs would stop putting money into venture funds as expected returns diminish. Fred Wilson (and many others) have said that lack of money is not the problem. I believe them. So exits can’t be the problem (For startup formation, that is. Exits are certainly a problem for the VC funds.)

From the point of view of the money, lowering capital gains taxes–much as I personally enjoy lower rates–is not going to increase the rate of startup formation. As previously noted, there is already plenty of money looking for a home with the current returns. Increasing the returns would only draw more money into an already overly funded pool.

From the entrepreneur’s point of view: while I hate to depart from economic orthodoxy and I do believe that incentives matter, I don’t think that the entrepreneur we want to encourage (the one creating a large company that employs a lot of people, not home-based businesses and restauranteurs) thinks much about the after-tax difference in the amount of money he’d make in a success. Ventures are generally binary: the company fails or the company succeeds. In a success the entrepreneur hopes to come out of it with quite a bit of money, and whether it’s $10 million or$12 million is not really the point. The change in after-tax return is completely swamped by whether there is a return at all.

1. If there are problems limiting startup formation (which I don’t believe – since there were a ton happnening from 2005 – 2008, with very little return), I think they are:

1) Target market conditions – i.e. the economy right now
2) Incentives & Regulatory problems – i.e. Sarbox / Taxes / Employment law – create a discouraging environment for long term company growth.

For VCs, the third issue is – their money isn’t needed and their value isn’t much relative to their price.

More specifically, I think there are two big problems with thinking the problem is people and your POV, if the goal is startup formation that helps solve the economic crisis that we’ll be recovering from for the next 10 years:

1) I think you are holding a very narrow “Silicon Valley” type view of startups.

You’re inventing this mythical entrepreneur figure that wants to create a big company that employs a lot of people, and putting him above the people creating home businesses and restaurants.

That’s like believing that Tim Geithner is the ONLY guy who can solve our financial crisis. More importantly, it’s too founder-centric. And it’s very rare.

Overall, you are buying into some vision that Silicon Valley style entrepreneurism is the utmost expression of startups, and will fuel a recovery.

We need a much wider variety of startups, esp. now.

2) Financial incentives matter at every level to everyone involved – even the uber-entrepreneur, but certainly they matter a lot to the people that he has to hire.

Taxes may not be the biggest problem now – the biggest problem now is clearly the market (i.e. people and businesses won’t be buying stuff).

But if you want to grow startups, you need to fix the stuff I listed in the previous comment, including taxes so that people are encouraged to earn more, getting rid of Sarbox, so that IPOs do happen, changing capital investment tax rules to incent production and employment, decoupling healthcare from employment, etc. etc.

Furthermore, Obama is going to try the Euro-social vision, and in that world VCs aren’t gonna matter much. Nor is any of what I’m saying would help actually gonna happen.

Overall, it’s a totally academic argument at this point. It’s not a good time to encourage people to start their own businesses and it looks to be getting worse.

2. One more addition: You may be right that lowering cap gains taxes won’t increase the rate of startup foundation, but I think that raising it SURELY won’t increase the rate of startup formation either.

Setting it to zero for startups, as Obama promised in the campaign (and his budget “promises” for 2014), could help attract some attention I’d think.

As it stands, the proposed increase is just one more straw on the camel’s back for the people that would be considering doing a startup.

3. I agree with you on the second post. I don’t know what changing the cap gains tax rate does to the rate of business formation. Logic says that lowering it would cause people to move from activities that produce ordinary income to activities that produce capital gains. My point is that this factor is small compared to others. For instance, California state level cap gains tax rate is 9.3% (I believe.) Nevada’s is 0%. That’s a big difference, but you don’t see Silicon Valley streaming east through the Donner Pass. (OTOH, many hedge funds set up in Connecticut for tax reasons, but if the managers didn’t live there already I bet they wouldn’t have.)

I, of course, would never hold a “Silicon Valley” view of startups, being a New Yorker, but the difference in job formation between venture backed startups and the mass of startups is an interesting one. I need to dig up the article that informed my view and will post later today.