Sunday, November 02, 2008

Entrepreneurship and Taxes

Although there are some valid points buried within, it is hard to discern why ABC News deemed this editorial by Michael Malone worthy of publication. Although I agree with him, that entrepreneurship plays an enormous role in the success of our economy, and that laws and government regulations are nonetheless constructed in a manner that is favorable to large businesses, and in many ways unfavorable to small businesses and start-ups. I don't think that it can be reasonably disputed that this has become worse under G.W., who right now is trying to gut antitrust regulations on his way out the door.

But a lot of what he claims is just plain stupid. Platitudes like, "Sen. Barack Obama, being a Democrat, seems to have very little idea of how the economy actually works" and "Sen. John McCain, being a Republican, has a marginally better understanding of the economy and the role of business - but his attention, as usual with GOP elders, is focused upon established companies, which undergird our economy, but do little to create new jobs or new wealth" - as if McCain's expressions about the limits of his understanding of economics are reduced to vapor by his party affiliation, or as if Obama would have an economic epiphany if he switched parties. Facts? Evidence? Who needs those when you have stereotypes and caricatures.

Malone's observations about entrepreneurship are similarly trite,
Meanwhile, established and big companies understandably hate entrepreneurship and will do almost anything to slow the progress of entrepreneurs - like all of those onerous regulations described above. And it has worked: This year has seen almost no high tech company IPOs, traditionally that moment when entrepreneurs gained their freedom and rewarded their teams.
A low level of high tech IPO's can, it seems, only result from start-ups being stifled and crushed by the iron fist of established companies. It has nothing to do with, for example, their number, the economy, or their state of readiness for going public. Malone also forgets how rare it is for a company to go public, and glosses over the fact that, once public, they're well on their way to being one of the "established and big companies" that supposedly "hate entrepreneurship".
These days, the only recourse for a hot start-up company is to sell out to an established company - further consolidating power and wealth. And meanwhile, of course, those older companies find it much more pleasant to buy these new competitors than compete with them.
It's not the only recourse, but obviously when the economy is bad it can become a superior alternative to trying to ride out a recession - not every company is Google. But really, prior to the original dot-com bubble, how many software companies dreamed of an IPO rather than, for example, being purchased by Microsoft? How many V.C.'s, investing in these companies, expect every company in their portfolio to end up going public as opposed to accepting favorable buy-outs from established companies? And sometimes a buyout is the best option for a company that has no viable stand-alone business model. How many start-ups like YouTube can afford to operate at an extremely high cost indefinitely, while their owners struggle to come up with a way to monetize their content? For that matter, what's so bad about being purchased by a major player, whether pre-IPO or post-IPO?
Nothing in McCain's campaign suggests that he understands any of this, or will change the status quo. To look more hip and in-the-know about the tech world, the senator likes to point to the fact that eBay's Meg Whitman is his campaign's advisor on business.

She is, in fact, one of the finest business executives I know, but Meg is not an entrepreneur.
Wait - didn't Malone just tell us that an understanding of the economy can be inferred party affiliation alone? Okay, so even he knows that's bunk. But to attack McCain's association with Meg Whitman, as an attempt to "look more hip" because, although one of the best business executives in the nation who helped elevate eBay from a start-up to a titan, she didn't personally start eBay? Of all of the companies that have rapidly risen from start-up to multi-billion dollar enterprises, how many have done so without bringing in professional management? How many entrepreneurs are their who are considered to be word-class, great, or dare I say even good CEO's once their businesses went public? (I'm only half-joking here - Ford, Jobs (in the latter part of his career), Ellison... Do I need both hands to count them?) For the most part, professional managers don't start businesses, and entrepreneurs reach a point where they need to bring in professional management.
And this suggests that a McCain presidency is not going to come to the aid of America's entrepreneurs - and that the best we can hope for is that it will get out of the way, at least when it comes to taxes. That may work, but it will be a long, slow recovery.
So we've switched back from high tech to the more generic category of "entrepreneur", with a lot of entrepreneurs being decidedly low tech, most employing only themselves, and almost none earning so much as to not benefit from Obama's tax cut. But no, neither candidate is going to give the type of tax relief that would make a typical entrepreneur smile - relief from self-employment taxes, or (something that could benefit all wage earners) eliminating the double- and triple-taxation of income that results from payroll taxes.

Surely here Malone is focusing solely on capital gains taxes, something that would be a pressing issue for a minority of entrepreneurs - those seeking venture capital, with capital gains taxes figuring into the V.C.'s calculation of return on investment, and those giving out stock options and intending to go public. (I'm not overlooking other circumstances where capital gains taxes can arise; but most small businesses aren't actively looking for investors or buyers, and they typically don't fall from the sky.)
As for Obama, leaving aside all of his other proposals for massive social change, the single most frightening plank in his platform is his plan to increase the capital gains tax. If there is one single factor in the U.S. economy that defines the rate of new company creation, it is taxation on capital gains - in particular, the differential between the capital gains and regular tax rates. To understand the long Reagan/Bush/Clinton boom of 1980-2000, you need only look at Reagan's slashing of that differential.
Leaving aside for the moment the "sheer terror" of a 20% capital gains tax, did it occur to Malone that he should actually read Obama's tax proposal before attacking it?
The Obama plan will ... Eliminate capital gains taxes for small businesses, cut corporate taxes for firms that invest and create jobs in the United States, and provide tax credits to reduce the cost of healthcare and to reward investments in innovation.
Truly terrifying.
Assuming that his comments about "corporate greed," etc. indicate that he has no intention of getting rid of Sarbanes-Oxley or any other crippling corporate regulation, then Obama's plan to raise the capital gains tax will all but kill creation of new companies - especially new tech companies - in America.
Yeah, "raising" the capital gains tax to zero will do that.... But let's pretend that Malone has a point - let's pretend that we're entering a business environment where the capital gains tax rate will be 20% instead of fifteen percent:
No new Apples or Facebooks or Twitters, no explosive new industries spinning off endless amounts of money and jobs, no new competitive advantages in the global economy.
That first example is fascinating. Apple, Inc., of course, was founded in 1976. You know, when the maximum capital gains tax rate was 49%. And yet Jobs and Wozniak still started their company? Amazing. Well, they reportedly incorporated on April Fool's day, so maybe they just didn't "get" that they were supposed to wring their hands and fret about their eventual capital gains tax exposure instead of starting their company.

Then Reagan came along and saved the world by cutting capital gains taxes to... fifteen percent? You're joking, right?
The late 1970s and early 1980s brought decreases to the top rates for both ordinary income and capital gains. The top tax rate on ordinary income dropped 20 percentage points to 50 percent in 1982. The capital gains exclusion increased from 50 percent to 60 percent in 1979. As a result of the exclusion and rate cut, capital gains tax rates fell from a maximum of 39.875 percent including an add-on minimum tax, which was widely applicable in 1978, to 20 percent in 1982.

The tax rate differential was eliminated by the Tax Reform Act of 1986 (TRA86) at the same time that top ordinary income tax rates were slashed to 28 percent. When tax rates on ordinary income increased in 1991, the top capital gains tax rate was held fixed at 28 percent. It was subsequently cut to 20 percent in 1997 and to 15 percent in 2003. In comparison, the top tax rate on ordinary income is now 35 percent.
Well there you have it - and don't go believing your lying eyes - we had no boom in tech start-ups, tech IPO's, or flood of so much money into tech businesses that we created a dot-com bubble, because the capital gains tax rate was at or above 20% until 2003. And we've had a boom in tech start-ups, IPO's, etc., since that time because... no, wait, Malone insists we haven't, and that it's a real problem. How is that possible? Maybe he's looking for his answers in the wrong place?

Now about those new Facebooks and Twitters? Those are Malone's best examples of businesses that might not have been started under a 20% capital gains tax, that should go public, or where it would be somehow a tragic loss if they were purchased by an established company? It sounds like Malone is trapped in a time warp - it's 1999, and all a tech company needs to justify a multi-billion dollar valuation and an IPO is a large user base. A business model? A path to profit? An ability to so much as break even? That's so old-school.

Facebook reminds me of the housing bubble. Back when things looked good, people were talking about its being worth $15 billion, and it was spurning proposals for acquisition by companies like Yahoo!, reportedly in the $billion range. Various companies wanted to buy in; Microsoft purchased a 1.6% share of Facebook for $246 million, suggesting a market value in excess of $15 billion. And it tried, and tried, and tried to turn its huge volume of user eyeballs into profit, and the result of those efforts?
As most of Facebook’s growth is outside the US, you’d expect that most of their revenue comes from advertisers targeting international audiences, as well. But that’s not the case. As TechCrunch pointed out months ago, many, many countries generate little to no advertising revenue per user.

* * *

Despite raising probably over half a billion in cash over the last two years, cash reserves are quickly depleting the future may be even more grim for Facebook as the economy slows. Advertising dollars may be one of the first things to be cut. However, as TC points out, Facebook CFO Gideon Yu is in Dubai, looking for more funding for the company.
Facebook grew quickly upon fantastic speculation about its possible future value, spent investor money like a drunken sailor, and is looking at a future where it may not be able to raise enough cash to sustain its operations. So are you thinking, "Why isn't this company going public", or are you thinking, "It needs to be bought out by somebody who has deep pockets and a way to either turn it into a money-maker or to use it to augment their existing money-making operations"?

Twitter is a clever concept, and it has a devoted user base, but it has no obvious path to profitability. Meanwhile, dare I say "established" companies like Facebook have added Twitter-like features to their user interface, to keep those eyeballs on their own sites. And they're having trouble with reliability - with their bandwidth exceeding their capacity - forcing the implementation of policies that may alienate some of their users.

Malone may have a point, that investors paying capital gains taxes at 20% won't invest in companies like, webvan,,,,,,,, Twitter and Facebook, because the marginally lower potential return on investment makes it less desirable to invest in a company that may never develop a viable business model. He may also see companies like Twitter and Facebook as those most likely to turn into corporate giants after an IPO, rather than crashing and burning when they can't even hit a break-even point and run out of money. But let's not pretend that history supports him.

Basicaly, Malone misdirects uninformed attacks at both candidates, gets basic facts wrong, has no clue about the history of the capital gains tax, and seems to know just about nothing about, well, anything. And you know what? If you read the parts of Malone's piece I didn't discuss, you may conclude that I'm being too easy on him.

1 comment:

  1. Facebook has acquired some companies. If it's evil for established companies to eat up new ventures, is it evil for new ventures to do exactly the same thing?

    What is it about an IPO that is so transformative? If it's okay for Facebook to gobble up small companies, why isn't it fair game for Google (a reasonably new venture) to do the same thing? Or Microsoft?

    Is it better that a company like YouTube collapse under its own weight, than that it be bought by Google? Google already had similar technology, of course, and was really buying YouTube's brand and market share.


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