Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock

Abstract:     
The capital structures of venture capital-backed U.S. companies share a remarkable commonality: overwhelmingly, venture capitalists make their investments through convertible preferred stock. Not surprisingly, a large part of the academic literature on venture capital has sought to explain this peculiar pattern. Financial economists have developed models showing, for example, that convertible securities allocate control depending on the portfolio company's success, operate as a signal to overcome various kinds of information asymmetry, and align the incentives of entrepreneurs and venture capital investors. In this Article we extend this literature by examining the influence of a more mundane factor, tax law, on venture capital structure. A firm that issues convertible preferred stock to venture capitalists is able to offer more favorable tax treatment for incentive compensation paid to the entrepreneur and other portfolio company employees: Instead of being taxed currently at ordinary income rates, the entrepreneur and employees can defer tax until the incentive compensation is sold (or even longer), at which point a preferential tax rate is available.

No tax rule explicitly connects the employee's tax treatment with the issuance of convertible preferred stock to venture capitalists. Rather, this link is part of tax "practice" - the plumbing of tax law, familiar to practitioners but, predictably, opaque to those, including financial economists, outside the day-to-day tax practice. Despite its obscurity, this tax factor is likely to be of first order importance. Intense incentive compensation for portfolio company founders and employees is a fundamental feature of venture capital contracting. Favorable tax treatment for this compensation is a byproduct and, we believe, a core purpose of the use of convertible preferred stock.

We also highlight an important but low visibility tax subsidy for the venture capital market, and the early stage, usually high technology, firms that are financed there. Although this subsidy arose inadvertently, it has an interesting structure. Funds are not provided directly to companies selected by the government (a familiar technique outside the United States), or to all companies. Instead, venture capital investors are enlisted as the subsidy's gatekeeper. As a practical matter, only companies that can attract venture capital investment receive this subsidy. Our analysis thus adds a different twist on the familiar debate about providing subsidies through the tax system, instead of through direct expenditures or favorable regulatory treatment.

Working Paper Series