The Rational Exuberance of Structuring Venture Capital 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.

Keywords: tax, venture capital, behavioral economics, startups

JEL Classifications: K34

Working Paper Series