The State of America’s Tax Institutions

SLU Billikens vs UCLA for the NCAA Final in Miami, Florida. SLU's Bruce Hudson and John Roeslein attempt a shot on goal. SLU won this game 2-1 in overtime. (4 January 1974) [Photographer unknown, scan of original photo from SLU Sports Information Office

The Missing Preferred Return

Managers of buyout funds typically offer their investors an 8% preferred return on their investment before they take a share of any additional profits. Venture capitalists, on the other hand, rarely offer a preferred return. Instead, VCs take their cut from the first dollar of nominal profits. This disparity between venture funds and buyout funds is especially striking because the contracts that determine fund organization and compensation are otherwise very similar. The missing preferred return might suggest that agency costs pose a larger problem in venture capital than previously thought. Is the missing preferred return evidence, perhaps, that VCs are camouflaging rent extraction from investors? This Article argues that the missing preferred return is evidence that venture capital compensation practices do not properly align incentives. Making VC pay subject to a preferred return would help investors screen out bad VCs and would motivate VCs more effectively when they find, court, and negotiate with entrepreneurs. This positive effect that the preferred return may have on “deal flow” incentives may be less important for VCs with strong reputations. Even for elite VCs, however, the status quo appears to be inefficient, albeit in a different way. If a fund declines in value in its early years, as is usually the case, the option-like feature of VC pay distorts incentives. Compensating VCs with a percentage of the fund, rather than just a percentage of the profits, would eliminate this distortion of incentives. Thus, the current industry practice is puzzling. None of the usual suspects like bargaining power, boardroom culture, camouflaging rent extraction or cognitive bias offers an entirely satisfactory explanation. Only by peering into a dark corner of the tax law can we fully understand the status quo. The tax law encourages venture capital funds to adopt a compensation design that misaligns incentives but still maximizes after-tax income for all parties. Specifically, by not recognizing the receipt of a profits interest in a partnership as compensation, and by treating management fees as ordinary income but treating distributions from the carried interest as capital gain, the tax law encourages funds to maximize the amount of compensation paid in the form of a profits interest. One way to do this is to eliminate the preferred return, thereby increasing the present value of the carried interest, which in turn allows investors to pay lower tax-inefficient management fees

The Rational Exuberance of Structuring Venture Capital Startups

This Article takes the bursting of the dot com bubble as an opportunity to reevaluate the tax structure of venture capital startups. By organizing startups as corporations rather than as partnerships, investors and entrepreneurs seem to leave money on the table by failing to fully use tax losses -- especially since the vast majority of startups fail. Conventional wisdom attributes the lack of attention paid to losses to a gambler\u27s mentality or optimism bias. I argue here that the use of the corporate form is, in fact, rational, or at least that there is a method to the madness. I make four main points. First, the tax losses are not as valuable as they might seem; tax rules prohibit many investors from capturing the full benefit of the losses. Second, the VC professionals who structure the deals do not personally share in the losses, so they have little reason to care about the tax effects of the losses. Third, gains are taxed more favorably if the startup is organized as a corporation from the outset, and again, this favorable treatment of gains is especially attractive to the VC professionals -- further evidence that agency costs may be playing a role here. Fourth, corporations are less complex than partnerships: organizing as a corporation minimizes legal costs and simplifies employee compensation and exit strategy

Brand New Deal: The Branding Effect of Corporate Deal Structures

Consider the unusual legal structures of the following four deals: When Google went public in 2004, it used an Internet auction to sell its stock to shareholders. When Ben & Jerry\u27s went public in 1984, it sold its stock only to Vermont residents. Steve Jobs\u27s contract with Apple entitles him to an annual cash salary of exactly one dollar. Stanley Works, a Connecticut toolmaker, considered reincorporating in Bermuda to reduce its tax liability. Under public pressure, it changed its mind and remains legally incorporated in Connecticut. What do these deals have in common? In each case, the legal infrastructure of the deal had a branding effect: the design of the deal altered the brand image of the company. The structure of each of the first three deals is difficult to understand using the traditional tools of corporate finance alone. The deals appear to be inefficient, at least if one thinks about efficiency in the usual way. But if one also considers the impact of the deal on brand image, the Google, Ben & Jerry\u27s, and Apple deals are success stories. The Stanley Works deal was a failure. But it did not fail because of some flaw in its financial design, such as a miscalculation of the tax savings or difficulty in communicating the tax benefits to its shareholders. The deal failed because its managers failed to predict the negative impact that its legal infrastructure would have on its brand image

Brand New Deal: The Branding Effect of Corporate Deal Structures

Consider the unusual legal structures of the following four deals: When Google went public in 2004, it used an Internet auction to sell its stock to shareholders. When Ben & Jerry\u27s went public in 1984, it sold its stock only to Vermont residents. Steve Jobs\u27s contract with Apple entitles him to an annual cash salary of exactly one dollar. Stanley Works, a Connecticut toolmaker, considered reincorporating in Bermuda to reduce its tax liability. Under public pressure, it changed its mind and remains legally incorporated in Connecticut. What do these deals have in common? In each case, the legal infrastructure of the deal had a branding effect: the design of the deal altered the brand image of the company. The structure of each of the first three deals is difficult to understand using the traditional tools of corporate finance alone. The deals appear to be inefficient, at least if one thinks about efficiency in the usual way. But if one also considers the impact of the deal on brand image, the Google, Ben & Jerry\u27s, and Apple deals are success stories. The Stanley Works deal was a failure. But it did not fail because of some flaw in its financial design, such as a miscalculation of the tax savings or difficulty in communicating the tax benefits to its shareholders. The deal failed because its managers failed to predict the negative impact that its legal infrastructure would have on its brand image

The Supercharged IPO

A new innovation on the IPO landscape has emerged in the last two decades, allowing owner-founders to extract billions of dollars from newly public companies. These IPOs-labeled supercharged IPOs-have been the subject of widespread debate and controversy: lawyers, financial experts, journalists, and members of Congress have all weighed in on the topic. Some have argued that supercharged IPOs are brilliant, just brilliant, while others have labeled them underhanded and bizarre. In this Article, we explore the supercharged IPO and explain how and why this new deal structure differs from the more traditional IPO. We then outline various theories of financial innovation and note that the extant literature provides useful explanations for why supercharged IPOs emerged and spread so quickly across industries and geographic areas. Theory provides support for both legitimate and opportunistic uses of the supercharged IPO