The Missing Preferred Return
46 Pages Posted: 24 Feb 2005
Date Written: February 22, 2005
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.
Keywords: Venture capital, tax, private equity, buyout
JEL Classification: K12, K34
Suggested Citation: Suggested Citation