Since the days of Queen Isabella, who some say was the first venture capitalist in history, venture capital has driven exploration, innovation and market opportunity. It has led to numerous important inventions and technologies in use today. Imagine for a moment that without venture capital, the search engine –- not to mention the computer — might not have been invented.

Venture capital is the fuel that drives innovation in many sectors vital to the health and growth of the US economy. As a cleantech venture capitalist, I am in a unique position to understand the circumstances threatening American innovation and with it, the U.S. economy.

Since the 1970’s, the role of venture capital has been to nourish entire new industries, including biotech, software development and online retail. In 2008, VC-backed companies employed 11% of the private sector work force – over 12 million people.

Cleantech needs as much venture capital support as it can get. It is an emerging industry aimed at solving the biggest problems such as climate change and our dependence on foreign oil. However, many of its products and services are still not commercially viable. The only way an industry with no immediate revenue stream can build the technology of tomorrow is through investment. Direct government support can only go so far, and it is the venture capital and angel community that will pick up the slack.

Recently, VC investment in cleantech companies has skyrocketed reaching $5.6 billion last year. If the VC industry implodes, cleantech falls with it.

The U.S. government, under the leadership of the Obama administration is undermining the green economy by a). misappropriating government stimulus money aimed at job creation and b). levying unfair taxation on the venture capital community – the very source within the private sector that generates job growth.

Stimulating job growth can only be achieved when the government is willing to support those sectors of the economy that hold the promise of growth like renewable energy and cleantech. It is a known fact that the biggest players in the economy fall behind the small, more nimble players when it comes to innovation and job creation.

Take the automobile industry, whose propensity to ship jobs out of the country has laid waste to cities like Detroit. The industry’s stubborn refusal to innovate, which has even been documented in film, brought it to the brink of collapse recently.

Yet, when push came to shove, the government stepped in to save these dinosaurs with enormous wads of taxpayer cash. Additionally, policies like Cash for Clunkers were designed to augment their bottom lines. The federal government even took control of 60 percent of General Motors.

Why pour federal dollars into propping up companies that refuse to innovate? Is this not a misallocation of resources at a time when so many new, pioneering companies are desperate for support? In 1998, both Google and eBay were tiny companies with fewer than 30 people working for them. Had it not been for venture capital (and the federal government’s support of these VCs), those startups would have faded away into obsolescence.

The Missed Opportunity In the Stimulus

Looking at the stimulus package today, one can see that it was a missed opportunity of gigantic proportions. $80 billion in stimulus funds were dedicated to cleantech – in effect making the government the country’s largest venture capital firm. Yet, instead of using this massive investment to encourage a new crop of innovators, the majority of the funds were funneled to big corporations.

To keep our economy strong, we must invest in America’s long-term competitiveness. Government support must be directed at small startups and research universities – and not at the big fish. This approach has worked for the country in the past, and it can work again today.

We must return to the days when American innovation flourished thanks to government-sponsored research conducted by universities and national laboratories. The federal government typically invested between $250,000 to $2 million on seed projects encouraging venture capital firms to step in and invest in the best and most promising of the government sponsored ventures.

This goes all the way back to the post-WWII period, when Vannevar Bush convinced Harry Truman to continue government support for science and technology research during peacetime. As a result, we got the Internet, Yahoo , Google, Fairchild Semiconductor and a long list of successful companies.

Taxing Innovation – A Case of Mistaken Identity

Not only is the government failing to support tomorrow’s innovators, it is also taking misguided steps to deter others from doing so as well. The recent “Carried Interest” bill that passed the House of Representative’s vote last Friday is emblematic of this approach by the federal government. The bill’s most grievous problem is that it lumps venture capital funds together with hedge funds and private equity funds.

With all due respect to the anti-Wall Street atmosphere in the country right now, hedge funds and venture capital have nothing to do with one another – aside from the fact that both speculate. But while hedge funds speculate on virtual instruments like derivatives, venture capital funds speculate on real companies with the promise of jobs resulting in measurable benefits to our economy. Moreover, hedge funds use leverage while venture capital firms use their own capital. The economy is suffering because of the high degree of leverage characteristic of the financial services sector.

Unlike private equity funds that buy companies, break them apart and sell off the assets, venture capital investment creates goods and services and puts jobs back into the U.S. economy. I still recall one of President Obama’s promises prior to winning the election in 2008 – job creation. Venture capital has done as much (if not more) to drive innovation and job creation in this country as the federal government.

The government wants to tax venture capital as part of a proposed hedge fund tax reform. The Baucus?Levin legislation now circulating in the House and Senate and it’s new carried interest tax hike represents a 157 percent tax increase over the next three years on growth capital investment. The new legislation proposes to treat 50 percent of “carried Interest” as ordinary Income and 50 percent as long-term capital gains in 2011 and 2012. By 2013, the tax treatment for carried interest would be 75 percent ordinary Income and 25 percent capital gains which would raise the effective tax rate to more than 38 percent.

Due to the financial crisis of 2009 and 2010 however, venture capital has shifted to safer bets and, as a result, far less seed capital is available for early-stage innovators, scientists and entrepreneurs. Over the coming year, there is a good chance that the $30 billion venture capital industry could permanently shrink to around $15 billion. A move to level new taxes on them at this time, when the industry is already on the edge, is a move to stifle innovation. The new proposed tax on VC’s is punitive and ill?conceived. This will discourage risk taking required to start, grow, and save American companies.

Clipping the Angels’ Wings

The government also wants to level new taxes on “angel investors” – individuals who invest in startups and entrepreneurs. At the same time, new legislation will impose additional regulation on these individuals, ostensibly to “protect” them from bad investment choices like those that brought down the housing market. The reality is that the legislation makes it much more difficult for firms like mine to solicit investments from high net-worth individuals.  It deprives a class of smart and self-made millionaires from tax benefits their higher net-worth neighbors will enjoy.

Angel investors are people with a high level of understanding and sophistication, and are responsible for most of the initial investments in startup companies today. Leveling new regulations and taxes on them is likely to shrink this source of investment in our economy.

It’s still not too late to change the course. Our country can no longer afford to prop up the big boys, while leaving the little guys to fend for themselves. With economists like Paul Krugman proposing additional stimulus spending, we must be quick to learn the lessons of the first stimulus plan. And there is still time to design tax codes and regulations that encourage, rather than discourage, innovation.

American innovation is our greatest resource, and nurturing it is the only way we can maintain our lead over fast-developing countries like China, India and Brazil. Mr. President, the country’s innovators are counting on you to make this right, before it’s too late.

Photo by dcJohn