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Job Creation and the Rich: The Facebook Story

President Obama is on the prowl for new targets for (1) raising more tax revenue and/or (2) demonizing “the rich” for campaign purposes. Among Obama’s proposals, besides raising taxes on high-income individuals generally, is to more than double the tax rate paid by many private equity and venture capital investors from 15% to 35%, by reclassifying sales of their businesses (or shares in their businesses) as ordinary income rather than capital gains (more detail here and, drawn from prior versions of the proposal here and here). A common trope being retailed in some form or another by Obama and his allies is that taxing the wealthy and private equity and venture capital has no impact on job creation. As is common to liberal arguments, rather than argue that they are proposing a worthwhile tradeoff, liberals deny even the possibility that their policies involve any tradeoffs whatsoever. As well they might: the voters are hardly going to accept anything right now that impedes the growth of private sector businesses and jobs.

Now, there are a lot of economic angles to this argument, which have been ventilated in more detail elsewhere. But a concrete example may be useful in illustrating how wealthy individuals, private equity and venture capital contribute to the growth of businesses and jobs: the story of Facebook.

Facebook, as you may recall, was largely the brainchild of 20-year-old Harvard student Mark Zuckerberg, and – to simplify a story that has involved a lot of acrimony and litigation – was founded by Zuckerberg and his roommate Dustin Moskovitz in February 2004 to provide a way for Harvard students to interact online. The company was not created in response to any consumer demand to spend money on such a product (seven years later, it still doesn’t cost you anything to have a Facebook account, and the company’s revenue comes mainly from advertising and similar streams). It was created because the founders thought it was a good product and that creating it would generate its own demand (the antithesis of demand-is-everything Keynesian economic theory). They were right – they got 1,200 subscribers within 24 hours, and the user base of Facebook has grown like wildfire for years since, to over 800 million today.

But while they were not exactly paupers – each invested about $1,000 at the start, and later $10,000 – there were limits to how far Zuckerberg and Moskovitz could spread their business idea without investment. Enter the money. First came Eduardo Saverin, also a Harvard student, the son of a wealthy Brazilian businessman; Saverin had reportedly made some $300,000 investing in oil futures, and put a stake in Facebook to become one-third owner and the company’s first CFO. That got the venture off the ground, born from the start in commodity trading profits. (Saverin was later bought out to resolve litigation)

Just four months after the company’s founding, in June 2004, it got a major investment: $500,000 from Peter Thiel. Thiel had been running his own multibillion-dollar hedge fund since 1996, and had made $1.5 billion in 2002 from taking PayPal (which he founded) public and selling it to eBay. Once again, an investor flush with cash from hedge fund profits and the sale of a new business provided the rocket fuel that allowed Facebook to take off from dorm-room startup to major online network. (Thiel reportedly received a 7% stake in the company, now worth well over a billion dollars).

As a startup, Facebook needed constant inflows of cash. The company moved its headquarters to Palo Alto around the time Thiel invested, and spent $200,000 in mid-2005 to buy facebook.com (its prior domain name was thefacebook.com). It cost money from the very beginning to defend against lawsuits. And the company seems to have lost millions in its first two years of operations.

Yet the product itself grew and grew, expanding overseas by the fall of 2005, and the constant inflow of capital kept it able to sustain that growth. Venture capital firm Accel Partners put $12.7 million into Facebook in April 2005, followed by Greylock Venture Capital, which invested $27.5 million that same year. By 2007, Microsoft invested $240 million in exchange for just a 1.6% stake in the company, implying that the whole enterprise was now worth $15 billion. Today, Facebook has over 2,000 employees, and expects to grow that to 9,400 employees by 2017.

Anecdote is not the singular of data, and like most stories of individual companies you can overdraw the policy implications from Facebook’s growth. Yes, Facebook is an extreme example. Yes, Facebook grew in the shadow of the Bush tax cuts of 2001 and 2003, but it also grew up in high-tax states like Massachusetts and California, and of course I couldn’t tell you the particular tax rates paid by the various wealthy investors in the company. But Facebook’s story, and thousands of others like it (if less dramatic) illustrate three timeless truths:

(1) Growing businesses need capital;

(2) Capital for risky startup ventures – especially ones with as steep an upward growth trend as Facebook – tends to come primarily from wealthy individual investors and from the venture capital and private equity vehicles they fund (the business career of Mitt Romney is full of examples of this); and

(3) The more of that capital you have, and the better the after-tax returns it can earn, the more seed corn there is to grow still more of those businesses.

You would think that President Obama – who at least in 2008 drew a lot of support from Zuckerberg and his Silicon Valley ilk – would appreciate this concept. But Obama remains the same man who in the primary debate in 2008 in Philadelphia told Charlie Gibson that he wanted to raise the capital gains tax “for purposes of fairness” regardless of whether it brought in more revenue. Even as the economy has stagnated and dragged down his own political fortunes with it, Obama seems unwilling to even consider the importance of private capital in any recovery. Investors in new businesses, consider yourselves unfriended.

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