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Abstract:
Private equity fund managers take a share of the profits of the partnership as the equity portion of their compensation. The tax rules for compensating service partners create a planning opportunity for managers who receive the industry-standard "two and twenty" (a two percent management fee and twenty percent profits interest). By taking a portion of their pay in the form of partnership profits, fund managers defer income derived from their labor efforts and convert it from ordinary income into long-term capital gain. This quirk in the tax law allows some of the richest workers in the country to pay tax on their labor income at a low rate. Changes in the investment world - the growth of private equity funds, the adoption of portable alpha strategies by institutional investors, and aggressive tax planning - suggest that reconsideration of the partnership profits puzzle is overdue. In this Article, I offer a menu of reform alternatives, including a novel cost-of-capital approach that would strike an appropriate balance between treating returns on human capital as ordinary income and rewarding entrepreneurial activity with a tax subsidy.

While there is ample room for disagreement about the scope and mechanics of the reform alternatives, this Article establishes that the status quo is an untenable position as a matter of tax policy. Among the various alternatives, perhaps the best starting point is a baseline rule that would treat carried interest distributions as ordinary income. Alternatively, Congress could adopt a more complex "cost of capital" approach that would convert a portion of carried interest into ordinary income on an annual basis, or it could allow fund managers to elect into either the ordinary income or "cost of capital" approach. Any of these alternatives to the status quo would tax carried interest distributions to fund managers in a manner that more closely matches how our tax system treats other forms of compensation, thereby improving economic efficiency and discouraging wasteful regulatory gamesmanship. These changes would also reconcile private equity compensation with our progressive tax rate system and widely-held principles of distributive justice.

tax, venture capital, hedge funds, private equity, executive compensation, capital gains, partnerships

Abstract:
In this Essay, Victor Fleischer describes the "gap" between what is taught in law schools and what is needed in corporate transactional practice. The Essay identifies three related reasons why schools have struggled to teach transactions effectively: (1) the lack of a conceptual framework, (2) the lack of qualified teachers, and (3) the lack of quality teaching materials. The Essay then describes how the Deals program at Columbia Law School addresses these problems and provides students with a pedagogically sound and effective introduction to corporate transactional practice.

Abstract:
This is a case study of the MasterCard IPO. The deal design undertakes two tasks related to the MasterCard brand: (1) managing regulatory costs (in particular, reducing its antitrust exposure) and (2) enhancing the company's image as a safe, secure brand that facilitates a middle-class consumer lifestyle. These tasks are unusual for an IPO, a transaction which is normally thought of as an exercise in managing transaction costs. Here, the legal structure of the deal not only affects brand image in the usual sense (how consumers view the Priceless brand). It also affects brand image in the sense that it affects how regulators, judges, and juries, standing in the shoes of consumers, view the firm. There is a potential positive feedback effect: increased transparency and independence from the member banks reduces antitrust exposure, which in turn protects the image of the firm as consumer-friendly, which in turn reduces the likelihood of hostile action by antitrust regulators. I focus on two unusual structural elements: a dual-class voting structure, and the creation of a charitable foundation.

The dual-class voting structure is unusual because the insiders (the member banks) retain more economics than votes, flipping the usual dual-class voting structure upside-down. The member banks retain effective control of the company, and they retain much of the economics of the firm. But they give away enough formal voting power to reduce their antitrust liability going forward.

The charitable foundation is an example of both regulatory cost engineering and branding. The foundation will hold a large block of MasterCard stock. Elements of the foundation's structure - its function as a corporate governance and anti-takeover device, and the limits on its ability to sell MasterCard stock or engage in charitable giving for several years - suggest that genuine altruism is an ancillary goal.

The foundation may also enhance the brand image of the company. But there is a disconnect between the MasterCard foundation's purported philanthropic goals and its low levels of anticipated charitable giving. In sum, the utility of the charitable foundation as a regulatory arbitrage tool is clear; its ability to improve the welfare of anyone other than the member banks is unproven.

IPOs, branding, marketing, antitrust, interchange, charitable, foundations

Abstract:
Branding is an unappreciated feature of contract design. Corporate finance scholars generally assume that consumers focus on product attributes like price, quality, durability, and resale value. But consumers choose brands, not just product attributes. This Article claims that the legal infrastructure of deals sometimes has a branding effect - that is, an effect on the brand image of the company. Deal structure affects the atmospherics of the brand.

I explore this link between deal structure and brand image by first examining the Google IPO from last summer. From a traditional corporate finance perspective, the goal of a properly structured IPO is to manage the information asymmetry between issuer and investors and to lower the cost of capital. From this perspective, the success of the Google deal is questionable. Few would call the deal elegant or efficient. But this is not really what the Google IPO structure was about, or at least it is not the full story. When Google structured its IPO as an auction, it reinforced its image as an innovative, egalitarian, playful, trustworthy company. Talking about Google's IPO makes you want to use Google's products. By that measure, the deal was a success.

I also examine the branding effects of three other deals: the Ben & Jerry's public offering in 1984, which sold stock only to Vermonters; Steve Jobs's contract with Apple, which entitles him to cash salary of exactly one dollar; and Stanley Works' failed attempt to reincorporate in Bermuda to minimize its tax liability.

Finally, I conceptualize the role of branding as it relates to deal structure. Deal structure may be a useful advertising medium for companies targeting early adopters of cult-like products. Certain legal events in the lifecycle of the company - what I call branding moments - provide opportunities for firms to signal company values to these early adopters.

Google, IPO, auctions, marketing, brands, corporate governance, executive compensation

Abstract:
This Essay examines the problem of tax noncompliance through the prism of the options backdating scandal. The noncompliance of backdating was obvious, at least to tax lawyers. Backdating wasn't a sophisticated tax scheme. Rather, the noncompliance was collateral damage from weak internal controls and, in some cases, the rent-seeking of executives.

Noncompliance in the face of clear rules is an overlooked problem in the corporate tax shelter literature, which tends to focus on disclosure, deterrence, or statutory interpretation. We should also study what creates the demand for tax shelters. The evidence from backdating suggests that a fast-and-loose attitude can develop when innovative companies outgrow their internal controls. When viewed in institutional context, a subset of corporate tax shelters, although adorned with more formal attire than backdating, may also be best understood as a compliance issue rather than a problem of textualism or inadequate penalties.

The implication for law reform is that process matters. Culture matters. We may have more success in closing the tax gap if we support procedural changes in the way companies approach tax compliance rather than altering the substantive rules in ways that may have unintended consequences for non-fraudulent transactions.

options backdating, executive compensation, corporate tax, tax shelters, tax avoidance, corporate culture, Sarbanes-Oxley

Abstract:
This teaching case describes the hedging program of Southwest Airlines and asks students to consider whether the purchase of additional (now more costly) fuel hedging contracts makes sense. The case prepares students to consider arguments for and against hedging. The case also explores the legal implications of hedging and its relationship to shareholder vs. stakeholder theory, and it asks students to consider in what circumstances hedging against unsystematic risk is a proper exercise of fiduciary duty.

hedging, Southwest, airlines, fiduciary duty, shareholder value

Abstract:
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's 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.

Tax, venture capital, behavioral economics, startups

Abstract:
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's 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.

tax, venture capital, behavioral economics, startups

Abstract:
This Case Study discusses the branding impact of the Google IPO. In a longer, Article-length version of this paper which appears in volume 104 of the Michigan Law Review, I argue that branding is an unappreciated element of contract design. Corporate finance scholars generally assume that consumers focus on product attributes like price, quality, durability, and resale value. But consumers choose brands, not just attributes. The legal infrastructure of deals sometimes affects the brand image of the company.

This Case Study explores the link between deal structure and brand image in one specific but noteworthy deal, the Google IPO. It is an extreme example of the branding impact of deal structure, but one that helpfully demonstrates the branding implications that exist, to a lesser degree, in other deals. The primary goal of structuring an IPO is to lower the cost of capital by managing the information asymmetry between the issuer and investors. From this perspective, the success of the Google deal is questionable. Few would call the deal elegant or efficient. But the auction structure allowed Google to do more than raise money. Google also reinforced its image as an innovative, egalitarian, playful, trustworthy company.

Google, IPO, auctions, marketing, brands, corporate governance, executive compensation

Abstract:
This Essay analyzes the "Blackstone Bill," which would treat Blackstone and other publicly-traded private equity firms as corporations for tax purposes. Earlier this year, the Blackstone IPO fueled a heated, somewhat confusing debate about taxing private equity. This Essay seeks to clarify what the legislation will accomplish, and what it won't.

There are two ways of looking at the Blackstone Bill. The first way is as a substantive change in the tax law. Specifically, the bill may be viewed as a rifleshot approach to changing the tax treatment of carried interest. The second way is to think of the bill as a mechanical correction of the publicly-traded partnership rules. Specifically, the bill may be viewed as a technocratic response to the regulatory gamesmanship of Blackstone's deal structure, which allows it to avoid the corporate tax that other, similarly-situated financial intermediaries pay.

In terms of a change in the substantive tax treatment of carried interest, the merits of the Blackstone Bill are questionable. The efficiency and distributive consequences are unclear; the revenue potential is indeterminate. The bill fails to achieve what we ultimately want: taxing the returns from managing financial assets consistently regardless of the form in which the business is conducted.

But the Blackstone Bill is nonetheless defensible as a response to aggressive regulatory gamesmanship. To put it more provocatively, the bill is justifiable because the Blackstone IPO structure is offensive to the rule of law values on which our tax system relies.

tax, private equity, ptp, corporate tax, publicly-traded partnership, IPO

Abstract:
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.

Venture capital, tax, private equity, buyout

Abstract:
How is it that Enron, allegedly the seventh-largest company in the U.S., didn't pay any income tax for four out of the last five years? In this short commentary piece, I argue that the tax Code got it right and the accountants got it wrong. Using the MIPS transaction (a debt/equity hybrid) and an off-balance sheet partnership as examples, I argue that in Enron's case, the tax Code did a better job of measuring income than the accountants. The reason Enron didn't pay any income tax is because it didn't have any real income. On a more cautionary note, however, the article suggests that the tax bar must move quickly towards effective self-regulation if it wants to avoid the current problems facing the accounting industry.

Abstract:
This case study is a teaching exercise that was first used in the "Deals Workshop" seminar at Columbia Law School in April 2003. The case involves a potential investment by Columbia Venture Partners, a venture capital fund, in MedTech Inc., an emerging developer of medical devices for the cardiovascular market. The case offers an opportunity to examine the relative importance of various terms in typical venture capital contracts, such as valuation, liquidation preference, conversion rights, board representation, tag-along and drag-along rights, and vesting. The case also illustrates the use of negotiation tactics, including the use of "market" or industry standards, efficient risk allocation, and how to bring other objective criteria into the discussion.

The case includes a teacher's manual followed by a background memo and term sheet intended for distribution to the students.

Abstract:
Sovereign wealth funds enjoy an exemption from tax under section 892 of the tax code. This anachronistic provision offers an unconditional tax exemption when a foreign sovereign earns income from non-commercial activities in the United States. The provision, which was first enacted in 1917, reflects an expansive view of the international law doctrine of sovereign immunity that the United States (and other countries) discarded fifty years ago in other contexts. The Treasury regulations accompanying section 892 define non-commercial activity broadly, encompassing both traditional portfolio investing and more aggressive, strategic equity investments. Because section 892 was not written with sovereign wealth funds in mind, the policy rationale for this generous tax treatment has not been closely examined before.

This Article provides a framework for analyzing the taxation of sovereign wealth. I start from a baseline norm of "sovereign tax neutrality," which would treat the investment income of foreign sovereigns no better and no worse than private investors' income. Nor would it favor any specific nation over another. Whether we should depart from this norm depends on several factors, including the external costs and benefits created by sovereign wealth investment, whether tax or other regulatory instruments are superior methods of attracting investment or addressing harms, and which domestic political institutions are best suited to implement foreign policy. I then consider whether we should impose an excise tax that would discourage sovereign wealth fund investments in the equity of U.S. companies. If desired, the tax could be designed to complement nontax economic and foreign policy goals by discouraging investments by funds that fail to comply with best practices for transparency and accountability.

The case for repealing the existing tax subsidy is strong. We should tax sovereign wealth funds as if they were private foreign corporations; there is no compelling reason to subsidize sovereign wealth. My analysis also shows that imposing a special excise tax may not be the optimal regulatory instrument for managing the special risks posed by sovereign wealth funds, although a carefully-designed tax would be more effective than the status quo.

Abstract:
This mercifully short article discusses the growing importance of web logs (called "blogs") and describes "A Taxing Blog," the tax policy blog recently created by Victor Fleischer and Jeffrey Kahn. Recent blog topics include corporate inversions, the Vice President's tax return, the Bush administration's dividend exclusion proposal, and other things that tax nerds might find interesting.

Abstract:
This case study, intended as a teaching exercise, highlights the problems of contracting in a world of great uncertainty. Streetwatch is a startup company seeking financing, and the CEO has received two offers for investment, each with its own advantages and disadvantages. The case highlights the problem of asymmetric information as well as some possible responses, including monitoring, the structure of executive compensation, and staged financing and the "option to abandon."

The case also includes a negotiation and drafting "skills" exercise.

Abstract:
This brief Symposium Essay comments on Professor Kate Litvak's Article, The Price of Stability: Default Penalties in Venture Capital Partnership Agreements. Litvak organizes her Article around the concept that it is helpful to characterize contract default penalties as put options. Using a sample of 37 venture fund agreements, Litvak sets the harshness of the default penalty as her dependent variable. She then runs regressions against several independent variables: fund size, fund number, fund vintage year, amount of carry, and so on. Litvak finds a relationship between fund governance and the harshness of default penalties. More precisely, she finds a relationship between her proxies for the need for contractual protections against agency costs and the size of one possible contractual protection: default penalties for failing to answer a capital call. As agency costs (and the need for contractual protections) decrease, contractual penalties increase. The threat of capital withdrawal, she concludes, is a useful contractual tool to reduce agency costs between investors and low-quality venture capitalists.

I argue in this Essay that while it is conceptually accurate to characterize contract default penalties as put options, it is not especially helpful to do so. Practical considerations force Litvak to exclude an important element from her model; the cost to an investor's reputation when it fails to heed a capital call. To draw any useful conclusions, Litvak should account not only for the nominal penalty written in the contract, but also the real world penalty of never being allowed to invest in venture capital again. The reputation cost varies depending on the clientele of the fund. Pension funds, university endowments, and other repeat players care deeply about their reputations, while some individuals and corporate investors might be indifferent. And so the variation in contract default penalties might, in fact, be more strongly predicted by a clientele effect that she does not, and for practical purposes, cannot measure. In my mind, then, Litvak fails to make a persuasive case that governance considerations really have the effect she suggests. Moreover, Litvak's theory does not seem to comport with recent real world experience: the lemming-like answering of VC capital calls following the NASDAQ crash of March 2000.

clientele, venture capital, agency costs, reputation, options

Abstract:
Should we require companies to report the same amount of income to the IRS as they report to their shareholders? The idea behind "book/tax conformity" is that managers' desire to increase reported earnings would act as a check on their desire to minimize taxable income, and vice versa. Some scholars have proposed a comprehensive approach, adopting financial income as the basis for corporate taxation. Legislators, meanwhile, have offered a targeted approach that singles out equity compensation, which has historically been a significant source of the "gap" between book income and taxable income.

This Article argues that book/tax conformity carries unexplored costs that reduce its attractiveness, at least in the context of equity compensation (and quite possibly in other areas as well). Conforming the employer's tax treatment of stock and options with the accounting rules creates a paradox for employee-level taxation. Either employee taxation is also conformed to book, which raises liquidity, fairness, and other concerns, or we must diverge from section 83(h), which limits the employer's deduction to the amount included by the employee as income. Severing this link between the employer's deduction and the employee's inclusion would eliminate an important check on tax gamesmanship that is analogous to the check that book/tax conformity proponents seek to create. Conforming tax deductions for options with book, in other words, may simply trade one form of gamesmanship for another.

More broadly, book/tax conformity must be evaluated in light of (1) the cost of other gamesmanship that may result from conformity, (2) the availability of other means of combating manipulation, (3) potential distortions in compensation design, and (4) effects on the decision to be a private or public company. We conclude that equity compensation should be excluded from comprehensive book/tax conformity regimes, and one-off proposals to conform employer taxation of stock and options with book are probably misguided. On the other hand, we suggest that if targeted conformity of equity compensation is desired, revising the accounting rules for options to match those of stock appreciation rights, which would yield conformity at the tax end of the spectrum, possibly could improve upon the status quo.

book/tax conformity, equity compensation