Without carried interest perhaps hundreds of thousands of small businesses would never get started. Some people, including President Trump, say that we should tax carried interest as current income because some hedge fund or private equity managers get special tax treatment with carried interest taxed as capital gains. The hedge fund managers are not the only people who benefit from carried interest transactions. Some of you may know what carried interest is, but I think most people do not understand the term. I thought that I should define it in words people like me and you know, and then I will describe an example. By the way, if you want to see real examples of carried interest transactions in action watch “Shark Tank.”
A carried interest is when an investor agrees to help provide money for a business to start it or additional capital to run it under special terms. Generally speaking the small businessman or woman needs capital, and an investor will say, “I will lend you the money at a reduced interest rate, but in exchange for a lower cost of money to you, I want some of the stock in the company and monthly interest income. Then in the future, I want to be able to sell my stock, hopefully at a profit.” This future sale is referred to as an exit. Keep in mind there is no guarantee that the investor will get his money back.
Let’s look at some very significant numbers; according to DMdatabase.com, there are 18,204,677 incorporated businesses in the United States. Out of the total numbers, the number of businesses that employ 50 people or less is 17,627,718. So, 97% of all the businesses in America are small businesses. What is even more important is the number of companies that employ 10 or fewer people. That number is about 15.5 million, or just over 85% of all businesses.
Starting any new business is risky. According to the SBA, 40% to 45% of small businesses fail in the first five years. You may have a great idea for a new business. You have done your homework and studied the market. You have found a location, and all you need is the startup and some operating money.
How about we put some meat on the bones and let’s build a solid example of a carried interest transaction. Tony has had a steady job for 15 years. He makes a good living, and he has a small amount in savings. He loves to cook, and over the years, he developed Tony’s special sauce. People tell him he should open up a pizza shop and use his homemade sauce.
Tony likes the idea of having his own business, so he starts to construct a business plan. As he develops the plan, he begins to realize how much money he will need to start. At a minimum, cooking equipment, including a good oven, serving stations, tables and chairs, and a lot more will be required. Tony starts to price the things he will need, and when he totals the amount, it is many times more than what he has in the bank. It is disheartening because he doesn’t have the money. Tony thinks perhaps his bank will lend him the money to start Tony’s Pizza?
He takes his business plan and goes to see his banker. After a good number of visits, where his business plan is reviewed, and his credit score and the equity in his house are determined, the bank says it will loan him half of what he needs. Oh, and because of the risk, they want a very high-interest rate. Tony tells his wife Gloria what the bank has said, and he tells her I can’t build half a restaurant.
The next morning Gloria says, “Why don’t you talk to my brother John. Maybe he will have some ideas to help you find the money.” Tony meets with John and John says he wants to see the business plan. John calls Tony back after a few days and tells him that he wants to meet with him and a friend to talk about his pizza shop.
A few days later they meet, and the friend tells Tony, ”I have reviewed your plan and John has given me some of your outstanding sauce. I have a deal for you. I will lend you the money you need. I will loan it to you for an interest rate half of what the bank wants. For the lower interest rate, I want 15% of the company stock.” He then says, “In 7 years I will want the right to sell my shares. I will help you in the running of the business by keeping the books and producing reports we both can share. On a regular basis, we will meet and talk about the challenges and opportunities for the shop.”
Tony says, “I want to think about it for a few days and run the numbers, and I’ll get back to you by the end of the week.”
Our example is a simple version of how a carried interest transaction works. Let’s look at the benefit to the parties. The business owner, Tony, has the money he needs to start his business. He now will have a partner to work with him to increase his chances of success. The investor will share some of the risk of being an owner, but he also has a clear path to get his money back.
Carried interest has been used in millions of small businesses, creating the opportunity to hire people and build wealth.
It seems the government wants to tax the participation in the business and stock ownership (i.e. carried interest) as income. The risk to the lender is that he may never see a return on his investment, and to apply a tax up front, on the assumption that the business will be successful, will dry up capital for small businesses. Fewer businesses will be started and economic expansion will slow down. To make America grow, we need small businesses to start-up and expand. Small business is the business of America. Therefore a tax on carried interest should not even be considered.