What Proposition 30 Means for California’s Entrepreneurs

Kevork Djansezian/Getty Images News

Nothing terrifies investors or entrepreneurs as much as the concept of expropriation. When governments decide to expropriate legally obtained assets, entrepreneurs who worked tirelessly to build businesses and investors who risked scarce capital end up with little to nothing for their troubles. In fact, developing countries often get saddled with country risk premiums, making it harder for them to attract capital because the mere threat their governments will someday seize profitable companies or industries keeps investors away.

So it’s all the more puzzling that California, home of Silicon Valley and the densest concentration of entrepreneurs in the nation (possibly the world) would pass Proposition 30 in last month’s election. Regardless of your personal views on the issues of taxing and spending, there is one thing that cannot be overlooked. Prop 30 includes a gigantic retroactive tax increase on legitimate capital gains and ordinary income that dates back to Jan. 1, 2012.

The top marginal rate jumps by 29.13 percent to a staggering 13.3 percent of income. Oddly, California doesn’t distinguish between ordinary income and capital gains in the way the federal government does. The result is that we have nearly doubled the 15 percent federal capital gains tax rate, and this applies to income earned in the past, for which taxes have already been paid.

How This Happened

As is the case with many propositions, the voters may have been fooled by the governor and his allies who aggressively pitched it as a way to “save education in our state.” In fact, the money from Prop 30 simply replaces money the governor redirected from education to other priorities in his 2013 budget. So a more honest and fair characterization of Proposition 30 is a general purpose tax hike in the state which already has the highest income tax rates in the nation.

It isn’t clear that most voters had a very good understanding of the tax increase’s magnitude or retroactive nature. Campaign workers were reportedly paid $3.00 per signature to qualify it for the ballot, and the two largest public sector unions (California Teachers Association and Service and Service Employees International Union) spent $22 million campaigning for its passage.

But even with all that campaign money, it took a very creative Official Title and Summary in the California Voter Guide prepared by the Attorney General to push the measure over the finish line. Take a look and you’ll see that there is no explicit mention of retroactivity or the new top rate of 13.3 percent in the summary!

Prop 30 Hits Entrepreneurs the Hardest

California’s entrepreneurs are hit particularly hard by Prop 30. Why? Because entrepreneurs often invest their life savings and go for years with a low or zero salary. Most start-up ventures end up failing in the end. But in those rare cases when something of great value is created and a meaningful liquidity event takes place (usually in the form of an acquisition or IPO), nearly all the money earned from the undertaking hits at one time. Instead of the income being spread evenly over the life of the company (the average time to exit for venture-backed start-ups is 7 or 8 years), a single once-in-a-lifetime event occurs such that eight years of income shows up in the single year, making entrepreneurs highly vulnerable to the top marginal tax rate.

Exhibit A of this phenomenon is Facebook, which might have been the impetus for Prop 30 in the first place. Thousands of workers toiled long hours and worked for low pay (at least in the beginning) to build one of Silicon Valley’s generational companies. When their deferred reward hit eight years later in the form of a $90 billion IPO, it proved an attractive tax target for California’s politicians. The only problem was that the IPO occurred before the tax hike, hence the need for the retroactivity in Prop 30.

What Prop 30 Will Mean for California’s Entrepreneurs

A precedent has been set with Prop 30. What would stop voters or legislators from passing a 100 percent top marginal rate extending back to 2010? You might scoff at the notion, but the state has now determined it can legally reach into individuals’ savings accounts and take money out on a whim.

This creates a feeling of fear, resentment and uncertainty — the worst possible environment for investment to take place. It discourages both angel and venture investing because it reduces the return on potential capital gains. Already, we’re seeing rumblings from investors, such as this tweet from prolific angel investor Scott Banister.

I don’t think entrepreneurship overall will decrease — most start-up founders do it for the love of the entrepreneurial journey, or because they have a passion for a particular vision that they want to bring to fruition. But Prop 30 may just dampen enthusiasm for starting new businesses in California specifically.

Contrary to popular opinion, entrepreneurs aren’t crazy cowboys. In reality, we think carefully through risk-reward tradeoffs (John Dickerson does an admirable job covering the thoughtful risk calculations we made at my last start-up, Redbeacon, in this Slate article). Given the inherent risks entrepreneurs take just to start a new company, will they want to now take on additional tax and regulatory risk? The truth is, great tech start-ups can now be built almost anywhere.

It seems California’s population exodus may have begun already with a net migration of 3.4 million people out of California since 1990. Many of the people “voting with their feet” are the wealthy and productive classes we need to stay and rebuild the Golden State to its former glory.

Entrepreneurs are job creators, risk takers and innovators who generate new wealth. We know that small businesses generate nearly two out of three new jobs in the U.S., and we also know California is suffering greatly with the second-highest unemployment rate in the nation. So why would it kill the goose that lays the golden eggs? As bank robber Willy Sutton replied, when asked why he robs banks, “because that’s where the money is.”

Ethan Anderson is a Silicon Valley entrepreneur. He is a former Google Product Manager and the founder and CEO of Redbeacon, the 2009 TechCrunch50 winner, which was acquired by the Home Depot earlier this year.


Must-Reads from other Websites

Panos Mourdoukoutas

Why Apple Should Buy China’s Xiaomi

Paul Graham

What I Didn’t Say

Benjamin Bratton

We Need to Talk About TED

Mat Honan

I, Glasshole: My Year With Google Glass

Chris Ware

All Together Now

Corey S. Powell and Laurie Gwen Shapiro

The Sculpture on the Moon

About Voices

Along with original content and posts from across the Dow Jones network, this section of AllThingsD includes Must-Reads From Other Websites — pieces we’ve read, discussions we’ve followed, stuff we like. Six posts from external sites are included here each weekday, but we only run the headlines. We link to the original sites for the rest. These posts are explicitly labeled, so it’s clear that the content comes from other websites, and for clarity’s sake, all outside posts run against a pink background.

We also solicit original full-length posts and accept some unsolicited submissions.

Read more »