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, much 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 efficiently allocate control between the investor and entrepreneur,signal the entrepreneur's talent and motivation, and align the incentives of entrepreneurs and venture capitalists.
In this Article, we examine the influence of a more mundane factor on venture capital structure: tax law. Portfolio companies issue convertible preferred stock to achieve more favorable tax treatment for the entrepreneur and other portfolio company employees. The goal is to shield incentive compensation from current tax at ordinary income rates, so managers can enjoy tax deferral (until the incentive compensation is sold, or longer) and a preferential tax rate. 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 that is familiar to practitioners but, predictably, is opaque to those, including financial economists, outside the day-to-day tax practice. Despite its obscurity, this tax factor is likely of first-order importance. Intense incentive compensation for portfolio company founders and employees is a fundamental feature of venture capital contracting.
Banking and Finance Law | Law | Tax Law
The Charles Evans Gerber Transactional Studies Center
Richard Paul Richman Center for Business, Law, and Public Policy
Ronald J. Gilson & David M. Schizer,
Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock,
Harv. L. Rev.
Available at: https://scholarship.law.columbia.edu/faculty_scholarship/902