A Modest Proposal on Job Creation
Jobs, jobs, jobs—that’s the mantra of the day.
Last week, President Obama presided over a “jobs summit” in the nation’s capital amid sinking poll numbers and persistently high unemployment.
The president asked for ideas on how to spur job creation. So, I’m humbly offering mine: Free venture capital (VC), tax private equity (PE).
VCs nurture companies in the startup stages and beyond. PE firms focus on improving the performance of mature companies. PE uses leverage to buy companies; VCs favor cash and equity to get them to the next round of financing.
And, most importantly, venture capital creates jobs—a lot of them. And although they’re not quite the vultures they were in the 1980s, private equity firms are, on balance, job killers—or at least poor job creators.
So, my plan for long-term, sustained job growth in the US is to fix the pipeline of initial public offerings, which has been broken since the dot.com bust. Let’s encourage more startups to go public by offering them some heavy incentives.
And let’s pay for it by ending the lower tax rates on “carried interest” for private equity partners—and hedge funds, too, while we’re at it.
But first, job creation. Everyone knows that small business creates most new jobs in the US, but venture capital is key. Manju Puri and Rebecca Zarutskie of Duke University found that venture-backed firms accounted for 8% of US employment by the year 2000.
More than 99% of start-ups aren’t backed by VCs, but VC-backed firms post nearly three times the job growth of non-VC-backed companies, according to Puri and Zarutskie.
And few startups without VC backing make it to the IPO starting gate.
Earlier this year, Mark Heesen, president of the National Venture Capital Association, told me that you get the most job growth after companies go public, when they’re flush with cash and ready to conquer the world. Think Google.
Problem is, the IPO pipeline is badly broken. “That’s fair to say,” says Josh Lerner, a professor at the Harvard Business School and a leading expert on venture capital and private equity. His latest book, Boulevard of Broken Dreams, focuses on the failures of government initiatives to help VC and entrepreneurship.
“The VC sector has been stalled since 2000,” he says.
Indeed it has. This year has seen only nine—that’s right, nine—venture-backed IPOs, only two more than last year’s record lows, and there are only 22 others in registration.
So, to encourage more firms to go public, let’s suspend capital gains taxes for the first five years after an IPO, and let’s also suspend Sarbanes-Oxley reporting requirements for the same period, until these firms are more established.
This would apply only to genuine startups—no repurposed spin-offs or established companies that went private. And it would not apply to startups that get acquired by bigger companies. Where’s the job growth in that?
“It makes a lot of sense,” says Prof. Lerner. “The disparity between capital gains and ordinary income tax rates has a big impact on start-up activity.”
How many jobs would this produce and how much will it cost? Who knows? And it probably won’t create a single job by next year’s midterm elections. But it’s one step towards recreating the conditions of the 1990s, when the US economy added more than two million private-sector jobs a year.
And since I don’t believe in cutting taxes without raising revenues or cutting expenses somewhere else, I think we should raise taxes on financial firms that don’t create jobs, but tend to eliminate them—like private equity.
PE has come a long way since the bad old days of the 1980s, whose pinnacle was Kohlberg Kravis Roberts’ $30-billion takeover of RJR Nabisco in 1989. PE-controlled firms represent 2% of private US employment. Private equity has become a key alternative-investment class among US institutional investors. The upper ranks of PE firms are populated by ex-Cabinet members, giving private equity real clout.
But there’s no way to put lipstick on this pig: PE-backed firms cut jobs, on balance—or lag other companies in creating them.
In a definitive study for the World Economic Forum, Prof. Lerner and colleagues studied thousands of US LBO transactions between 1980 and 2000 and found job growth lags (or job cuts exceed) those in “control” companies by from 1% to 4% annually in the first three years after an LBO. Net net, the PE firms lag by at least 3.6 percentage points over the first two years.
“They looked at 5,000 companies compared to exact peers and found a 3.6% net [lag] in the first two years,” says Josh Kosman, a reporter for the New York Post who just wrote The Buyout of America, a critique of the private equity industry.
“The third year typically shows the most job loss,” he adds.
“Over time, private equity firms build jobs and make companies stronger,” says Robert W. Stewart, vice president public affairs of the Private Equity Council, a trade association and lobbying group. He says studies show “substantial” job growth in PE-backed companies. You can visit PEC’s Web site and judge for yourself.
Meanwhile, private equity firms, along with other investment partnerships (hedge funds, real estate, and venture capital) get preferential tax treatment. When businesses are sold, PE firms get 20% of the profits, and the investors get the rest.
That income is taxed as a capital gain. But PE firms don’t put much money in these deals, although they do invest their time and expertise.
“They have nothing at risk. [They’re getting a] 20% commission when they sell a firm,” says Kosman.
And as Justin Fox of time.com points out, corporate executives who perform similar functions pay ordinary income taxes when they exercise stock options.
“We believe that a) carried interest [should be] treated as a long-term capital gain and b) now is not the time to be increasing taxes,” says Stewart.
I agree on the second point—but I seriously doubt raising this particular tax is going to hurt the economy. I would, however, exempt VC firms for the reasons cited above.
If there’s one thing we’ve learned, it’s that money doesn’t come from the sky. If you’re going to lose tax revenue by encouraging job creation (which should ultimately multiply revenue by many times), it’s got to come from somewhere.
Sorry, private equity, the free ride is over.
Howard R. Gold is executive editor of MoneyShow.com. The views expressed here are his own.