Sunday, January 13, 2008

The Toxic German Venture Capital Tax Regime

If I were to be appointed a deputy minister for venture capital tax policy in the finance ministry of a western European nation, and if I were then mandated to construct a framework of rules designed to suppress and hinder the development in my country of a venture capital industry, I would promulgate a set of rules along the following lines:

Investment Holding Period: I would impose a mandatory minimum holding period of three years for all investments within a venture fund. Venture capital investment is, of course, short to medium term by definition. It is the job of a venture fund investment manager to exit an investment as soon as it is possible to capture a desired gain. This rule would, therefore, put the venture fund manager in conflict with his duty to his investors. This rule would be a stand-alone venture-fund-breaker. But it would be a stealth rule -- only knowledgeable venture industry insiders would appreciate its devastating effect.

No majority holdings: I would prohibit a venture fund from taking a majority interest in a portfolio company. There are times in the lives of many venture investments that an investment manager must take control of a portfolio company in order to save the company and/or protect the fund's investment. Likewise, a venture fund might find itself to be the only possible source of new capital for a struggling start up company under circumstances in which the depressed valuation of the company would lead inevitably to the venture fund's stake exceeding 50% if it were to inject additional capital. This rule would therefore force the venture fund to let the company go under or to lose all or part of its investment notwithstanding its willingness to provide additional capital.

No active participation in management: Venture fund investment managers would be prohibited from taking an active role in the management of their portfolio companies. It is part of the job of venture fund investment managers to bring not just capital but also experience, expertise and special skills to their portfolio companies. Those companies are normally early stage and are often managed by unproven, inexperienced, first-time entrepreneur-managers. This rule would therefore tie an investment manager's hands and force him or her to stand on the sidelines while a portfolio company management team struggled and failed.

No re-investment of gains. Investment managers would be prohibited from re-investing proceeds acquired, e.g., through the IPO or trade sale of a portfolio company. Instead, they would be required to distribute such proceeds to the venture fund's investors. Such a rule would, of course, normally be left to agreement between the managers of the venture fund and its investors. By imposing this rule we would seek to limit the growth of venture funds in our country by allowing them to grow only through infusions of outside capital.

The penalty for violation of any one of these rules would be a re-classification of the venture fund as a trade or business, with the resulting imposition of our standard trade tax. This would dramatically lower the IRR of the venture fund and impair its ability to raise capital. We would further provide that violation of any of the rules in connection with even one portfolio company would subject the entire fund, and all of its investments, to re-classification as a trade or business.

As deputy minister for venture capital tax policy I would confidently tell the Finance Minister that we had hereby crafted a framework that could not fail to limit the growth of the venture capital industry in our country. Our proposed regime would simultaneously restrict the ability of venture fund investment managers to rationally conduct their business and would inhibit the flow of capital from outside investors into venture funds based in our country.

German readers will recognize, of course, that this regime is in fact the regime adopted by the German Finance Ministry. It helps explain why at least one leading German venture fund has left the country and re-incorporated itself elsewhere and why 50% of the members of the German venture capital association are considering doing likewise.

On the face of it, it is absurd to think that the motivation given above, to deliberately suppress the development of a venture capital industry in Germany, is in fact the motivation of the German Finance Ministry. Yet, if that is not in fact the policy, then it is difficult to see what is the policy.

A possible alternative explanation is that the tax policy officials within the ministry are simply profoundly ignorant of the nature and character of venture capital investment. That, too, is implausible. These officials have had voluminous input from the venture industry, have seen the public studies showing Germany at or near the bottom of venture-capital-friendly jurisdictions within the European Union, and have witnessed the withering of the venture capital industry in their country over the last seven years. This regime, which is so toxic to the venture industry, is no accident.

Whatever the true German policy may be the result is painfully clear: (1) no sensible venture fund group would today form a fund in Germany, and (2) no institutional investor that had done its due diligence and fully understood the German rules would invest in a German venture fund.

So far as it appears at this time, the battle is over. These are the new rules, and there is no liklihood that they will change in the foreseeable future.

1 comment:

Bresslau said...

Dear Edward,

thanks for the insight in the German situation. I just read an article at the BMWi that states that some changes are being considered through das Gesetz zur Modernisierung der Rahmenbedingungen für Kapitalbeteiligungen.
The article can be found at,did=234980.html
What are your thoughts on that?
Best regards,