Why Do Venture Capital Funds Burn Research and Development Deductions?

Abstract:     
Venture capital funds form a separate corporation for each venture that they support, within their portfolio of diverse ventures. The separate incorporation reduces the tax value that could be achieved from deducting research and development costs. The resulting taxes are draconian, sometimes confiscatory. If R&D deductions were used optimally, taxable investors could achieve a tax regime that does not reduce their pretax return, and taxable investors would drive tax-exempt investors out of the funds. If capital must come from tax-exempt investors, the funds should still be trying to use the R&D deductions against taxable income of the successful ventures. Tax exempt investors, in event, do not justify the draconian taxes, the VC funds bring upon themselves by their structure.

The justifications offered for separate incorporation do not survive scrutiny. It is not necessary to incorporate before an initial public offering or before the fund's full R&D deductions have been used. Inertia and the EBIDTA measurement of success are not plausible explanations given the size of the tax values that are lost. Tax planning to achieve employee capital gain increases total tax paid to the government, once the venture level effects are considered. Stock options are inefficient means of compensation because the time-value-of-money cost to the employer is so high and because options induce managers to impose too much risk on the venture. Partnership options in an unincorporated entity, moreover, could imitate stock if that were an advantage.

A possible explanation is that VC funds are attempting to manage earnings statements issued to the stock markets. R&D deductions would be accounting losses. R&D expenses, however, do not seem to suppress stock prices significantly and may in fact lead to overvaluation by the markets. If the funds are giving up valuable deductions to manipulate stock prices, they are probably not succeeding in the manipulation. Even the best of the surviving explanations, accordingly, leaves the question as to why the VC funds incorporate each venture separately as an anomaly.

The willingness of sophisticated funds to burn their R&D deductions undercuts the arguments that R&D needs subsidy, better than ordinary income tax. The continuing puzzle as to why the deduction-destroying structure is used makes it plausible that the fittest structure does not always inevitably survive.

Keywords: tax, venture capital, R&D

JEL Classifications: O32, E22, G24

Working Paper Series