another great posting from Yokum on where you should incorporate

What state should I incorporate in?
I think there are three primary choices for the state of incorporation for most technology startup companies: (i) Delaware, (ii) the state where the company has its headquarters (i.e. California), and (iii) the Cayman Islands.

Almost all of the companies that I represent that intend to receive venture financing are incorporated in Delaware. I represent a few pre-VC financed California companies were already incorporated by the time that I met them. I also represent a few Cayman companies that have headquarters outside the U.S.

Reasons to incorporate in Delaware
Regardless of where the operations of a business entity are located, Delaware is frequently chosen as the state of incorporation for the following reasons:

Investors insist on Delaware
Almost all investors, regardless of where they are located, are familiar with Delaware corporate law. They may also be familiar with the corporate law of state where they are located. Because of the various advantages that Delaware law provides, most venture capital investors insist on investing in a Delaware entity.

If a company is incorporated in another state, such as California, and needs to reincorporate in Delaware in connection with a venture financing, the company will incur additional legal expenses in connection with the reincorporation. If a company ultimately undertakes an initial public offering of its stock, the underwriters will usually require that the entity be incorporated in Delaware. In order to complete a reincorporation, a California company typically creates a subsidiary in Delaware and merges into it, with the Delaware company surviving.

Compliance with securities laws may be problematic if there are lots of shareholders. All contracts of the company must be reviewed in order to ensure that the reincorporation doesn’t accidentally terminate an agreement.

One example of a material difference in corporate law between states is the stockholder vote necessary to sell a company. California corporate law provides that a merger requires the approval of a majority of the outstanding shares of each class of the corporation. This means preferred stock as a class and common stock as a separate class. In contrast, Delaware corporate law provides that a merger requires the approval of a majority of the outstanding stock entitled to vote. The fact that holders of common need to approve a merger of a California corporation is one reason why venture funds prefer Delaware. Venture funds don’t want common holders to have the ability to block a merger.

Delaware has a predictable, fair and well-developed body of corporate law
Delaware has a specialized court (the Court of Chancery) that has original jurisdiction over corporate law matters. Because of its unique expertise on corporate and business law matters, the Court of Chancery has produced a large body of decisions that has clarified and interpreted the Delaware corporate statutes. In addition, the Court of Chancery (and the Delaware Supreme Court which hears appeals from the Court of Chancery) is focused on the timely resolution of corporate law disputes. An appeal from the Court of Chancery may often be heard and ruled upon by the Delaware Supreme Court in a matter of days.

Directors of Delaware corporations are afforded a high degree of protection
While the directors of Delaware corporations have a fiduciary duty to act in the best interest of the stockholders, Delaware courts will, as a general matter and absent fraud or self-dealing, defer to the good faith business judgments made by the directors. In addition, Delaware corporate law allows for a corporation to indemnify its directors for losses that they may incur from being sued. Attorneys are generally more comfortable advising directors on their fiduciary duties under Delaware law as opposed to the law of any other state.

Complying with procedural formalities is efficient in Delaware
Observing proper corporate formalities under Delaware law is efficient, which is critical to preserving the limited liability feature of corporations. Delaware was one of the first states to allow voting by electronic proxy and attendance at stockholder meetings through the Internet. Additional areas of flexibility include the ability of less than all stockholders to act by written consent and the allowance of electronic signatures. Filings, such as an amendment to a company’s certificate of incorporation in connection with a venture financing, can be made electronically and are generally accepted upon submission within a day.

In addition, Delaware law is more flexible with respect to the number of directors. When a California corporation has two shareholders, it must have two directors, and when it has three or more shareholders, it must have three directors. Delaware corporations are only required to have one director.

Reasons not to incorporate in Delaware
There are some reasons why a company may not want to incorporate in Delaware, including the following:

Delaware franchise taxes
An entity that operates in a state other than Delaware will need to comply with tax and regulatory requirements in both Delaware and the state in which it operates (including qualifying to do business as a “foreign” corporation in that state and paying the relevant fees).

In particular, Delaware has an annual franchise tax that it levies on its corporations, although this amount is generally negligible for a start-up company with few assets and stockholders. If a company is not going to raise venture financing and will not otherwise be forced to reincorporate to Delaware, then incorporating in the state where it conducts business will save the company from paying Delaware franchise taxes. However, the cost and hassle of reincorporating to Delaware in the future may be greater than any tax savings in the early stages of the company.

Non-U.S. businesses
Some companies may be initially incorporated in the U.S., but may determine that establishing an off-shore parent entity is beneficial for investment or tax reasons. For example, some non-U.S. venture funds are prohibited from investing in U.S. companies.

Companies incorporated in tax-favorable jurisdictions like the Cayman Islands, the British Virgin Islands and Bermuda are not subject to taxation in their jurisdiction of incorporation, although depending on the nature of their operations, they may be taxed on their earnings in higher tax jurisdictions. Thus, a Cayman company may avoid paying U.S. corporate taxes on a portion of its worldwide income.

However, there are serious tax issues associated with establishing an off-shore parent company when there is an existing U.S. entity or if intellectual property originates in the U.S. Thus, if there is some reason that a company may need to establish an off-shore parent company in the future, then legal and tax advisors should be consulted prior to incorporation.

The Cayman Islands has become the preferred jurisdiction for many Chinese companies. Only companies established in the Cayman Islands, Bermuda, China and Hong Kong are pre-approved for listing on the Hong Kong Stock Exchange. In addition, Cayman corporate law has enough flexibility to permit U.S. style preferred stock financing arrangements and most venture capital investors that regularly invest in companies with headquarters in China are familiar with Cayman law and the documents used in these financings.

a terriifc post on what type of entity should entrepreneurs form

Written by our friend from Wilson Sonsini, Yokum Taku. Great information for every person thinking of starting a new company.

http://www.startupcompanylawyer.com/2009/03/12/what-type-of-entity-should-i-form/

What type of entity should I form?
March 12, 2009

C corps, LLCs, and S corps differ significantly in the areas of taxation, ownership, fundraising, governance and structure, and employee compensation. Almost all technology startup companies that I work with are C corps. Any company that raises venture financing will need to be a C corp in order to issue preferred stock.

If founders want the benefit of flow through tax treatment with respect to losses prior to an outside financing, an S corp election may make sense as long as there are no entity or non-U.S. citizen/resident stockholders. However, S corp losses can only be used to offset personal income up to the founders’ basis in the S corp stock, which may decrease the utility of the S corp election. In any event, the S corp election can be easily revoked at the time of a financing. The legal documentation for an S corp is basically identical to an C corp.

I generally avoid LLCs as most technology startup companies need to grant options to employees and consultants, and there is no easy “off the rack” method to do this. In addition, the conversion of an LLC to a C corp results in additional legal and accounting expense. However, LLCs may make sense for businesses like consulting companies.

The primary differences between C corps, LLCs and S corps are outlined below.

Taxation
C Corps. A C corp is a separate taxable entity independent from its stockholders. Thus, the earnings of a C corporation are generally taxed twice: once at the corporate level on the corporation’s taxable income and a second time at the stockholder level on dividends or distributions. In addition, C corps often must pay higher state franchise taxes than LLCs or S corps.

Although the double-taxation feature of C corps may be undesirable, its impact may be diminished where a company does not pay dividends or generates taxable income at a lower marginal tax rate than the rate applicable to the individual stockholders. If a C corp generates net operating losses rather than net income, these are carried forward to offset future corporate taxable income. However, such operating losses may not be used to offset taxable income of the individual shareholders.

LLCs. LLCs are flow through entities for tax purposes, meaning that taxable income earned by the entity is passed through to individual members. Thus, earnings are taxed only once, at the member level. An LLC may elect to be taxed as a C corp, an S corp, or a partnership. It may specially allocate items of income or loss among its various members. It may use taxable losses generated at the entity level to offset taxable income of the individual LLC members. However, such flexibility is countered by increased compliance costs due to the application of complex partnership tax rules that also apply to LLCs.

S Corps. Similar to LLCs, S corps receive flow through tax treatment. However, an S corp must allocate its taxable income to the individual stockholders according to their ownership stakes in the company. Taxable losses at the entity level may be used to offset personal taxable income of the individual stockholders, but only to the extent of the tax basis of their interests in the entity.

Ownership (Stockholders)
C Corps. C corps may have an unlimited number of stockholders (subject to SEC reporting requirements if the number exceeds 500). The owners do not need to have a relationship with one another nor have a role in running the day-to-day affairs of the company. Additionally, they may transfer their ownership freely and readily (by selling their stock) without affecting the continuing existence of the business or the title to its assets. Thus, the perpetual existence of the entity is unaffected by the death or withdrawal of any one shareholder.

LLCs. Similar to a corporation, an LLC may have an unlimited number of members. However, ownership transferability for an LLC is not as flexible as that for a C corp. Generally, a member needs the approval of other members before selling an interest in the LLC. Also, a death, withdrawal, expulsion, or other departure of a member may constitute a termination of the LLC and a deemed liquidation for federal tax purposes.

S Corps. Unlike C corps. and LLCs, S corps are limited to 100 domestic stockholders. Stockholders must be individuals, with limited exceptions for certain trusts, estates, and exempt organizations. Stockholders must also be U.S. citizens or residents. Ownership transferability is flexible and similar to that of C corps. Finally, the perpetual existence of the S corp is unaffected by the death or withdrawal of any stockholder.

Fundraising
C Corps. Most venture and institutional investors favor C corps because they may have separate classes of stock, allowing for the creation of various levels of preferences, protections, and share valuations. A C corp is also the easiest type of entity to take public in an initial public offering.

LLCs. Although LLCs may be attractive to businesses financed by a small number of corporate investors and/or individuals, they are often not suitable for companies planning to attract venture capital or pursue multiple rounds of funding. LLCs require complicated operating agreements that may render the operation of the LLC undesirably difficult with a high number of members. They may be unattractive to tax-exempt venture fund investors because their investment in a flow through entity may produce unrelated business taxable income. Finally, investors simply may be less familiar with LLCs and therefore less willing to invest in them.

S Corps. S corps are not a popular entity choice because, in addition to presenting the same challenges to tax-exempt venture fund partners as those presented by LLCs, S corps are limited to one class of stock (meaning no preferred stock financings) and 100 stockholders. Such inflexible features are typically unattractive to venture investors.

Governance/Structure
C Corps. C corps have well-defined structural accountability, with governance responsibilities held separate and apart from the owners. Management is accountable to the board of directors and therefore has the ability to transact business without stockholder participation in each decision. However, corporations are required to pay attention to formalities that legislatures and courts have determined to be significant (e.g., meetings of boards of directors and maintenance of corporate bylaws, corporate minute books, stock ledger books, separate bank accounts, etc.).

LLCs. LLCs operate more informally then C corps and are either managed directly by the owners or managed by one or more owners (or an outside party) designated to fulfill such responsibility. Unlike corporations, they are not bound by corporate formalities such as holding regular ownership and management meetings. However, in contrast to corporations, they do not operate under a well-defined regime of uniformity and legal precedent.

S Corps. S corps operate in a manner similar to C corps. and must therefore adhere to statutory formalities for decision making.

Employee Compensation
C Corps. Businesses that plan to use equity incentives (e.g. stock options) to attract and retain talent often prefer to operate as C corps. C corps can offer incentive stock option plans that allow employees to defer tax on the equity compensation until they sell the underlying stock. Additionally, C corps. may offer certain fringe benefits to employees that are tax-deductible to the company and also tax-free to the employee.

LLCs. While an LLC may reward employees by offering them membership interests in the LLC, the equity compensation process is awkward and may be unattractive to employees. Furthermore, LLCs are not able to offer certain forms of equity compensation available to C corps., such as incentive stock options.

S Corps. Although S corps can grant stock options, they should not be granted to non-U.S. residents. S corps are less flexible than C corps with regard to fringe benefits and must either report the benefits as taxable compensation to the employees or forfeit the fringe benefit deduction available to the company.

Starting up with a friend: What could possibly go wrong?

a bit of a long article but the concept is important and the points made are very true. i'd add a few things to the list but its a good start for folks who are in this position.

http://danieltenner.com/posts/0005-starting-up-with-a-friend.html

Posted on March 11, 2009
by Daniel Tenner

It seems like a fool-proof plan: start up with a close friend. You’ll get along (obviously), and you’ll get to share the exciting, fantastic, scary experience of starting up with someone you care about. It’s not a bad idea, but there are a few caveats that you should be aware of before you proceed.

When I started my first company with one of my closest friends, I expected things would go very well between us. We understood each other in ways that would take years to build up (and did take 10 years). We knew each other, and we knew we could rely on each other. We were prepared to have many surprises along the way — starting a business is always going to be a scary adventure.

What we weren’t prepared for was that the main problem would come from us and the dynamic between us.

What happened, in brief
I’m not going to go into all the details of what exactly went wrong, for a number of reasons (among them, it would be a one-sided account and inherently unfair on my friend and first cofounder). The long and short of it is, we had different expectations about the business. I left my safe, comfortable corporate job to work on it, so I needed it to succeed, or else I would find myself back in the corporate world. By contrast, my friend had already started several companies and was comfortably well off, so he didn’t have the same expectations and requirements.

It turned out we have a different definition of “the business isn’t working out”. For me, it was working out if it was making enough money to cover my expenses. For my friend, it wasn’t working out unless it was making enough money to also add to his existing wealth and thus justify the time and effort which he poured into it. Both those views were correct, but because we knew that we understood each other, we didn’t realise that our views were different until that difference had grown into a huge misunderstanding.

This core divergence of views could have been resolved easily if we’d known about it and discussed it ahead of time, but we didn’t know about it, so it festered and turned into dozens of other misunderstandings, so that by the time it finally became clear what our main divergence was, much of the damage was already done and it was entangled in a huge mass of emotional misunderstandings.

This almost cost us our friendship. We got through this thanks to the help and mediation of another very good friend, who helped us to communicate to each other how we felt, so that we could move forward together rather than against each other.

I’m glad to say the mediation worked, and we’re still friends (perhaps even stronger than before). Nevertheless, I learned some important lessons from this.

1. Make your agreements explicit
The first lesson is to keep agreements explicit. It’s not enough to think that your friend understands what you think: make sure he does by discussing it openly with him. As my mediating friend phrased it, “unspoken promises” have a tendency to turn into broken promises (which are always hard to swallow). Avoid unspoken promises.

Here’s an example of a really bad thing to keep implicit: “We’ll only call it quits if the business is bankrupt and can’t raise any more money.” The promise here is that we’ll keep going until the very end. This may seem obvious to one party in the business, but it may not be so to the other. One partner could, for instance, feel that the time to call it quits is when the business has 3 months of cash flow left. Another may feel that it’s worth going deep into credit card debt territory before giving up.

Don’t make this mistake: keep those agreements explicit.

2. Detail your agreements
Once you make some agreements explicit, it should become clear that you need further discussion to figure out exactly what your explicit agreement is. Don’t be afraid to do this. It’s not “too early to discuss this”.

Here’s an explicit agreement that’s not detailed enough: “We want the business to make a lot of money”. Really? How much are you happy with? 10’000 pounds a month? A million? What is the definition of success? It’s almost certain that you and your business partner have different views as to what “a lot of money” is. Being on the same page about what you expect out of your business will ensure that you don’t pull in different directions when things are going well. Think of how mortifying it would be to find out that your partner wants to pull the plug when you think that the business is successful.

3. Don’t be afraid of discussing the bad stuff
There are a number of subjects which seem almost embarrassing to discuss when things are going well. For example, “What if one of us decides to pull out?” Your first reaction to this topic might be “What? We’re barely getting started, and already we’re talking about what happens if one of us pulls out?”

The reality is that people’s life circumstances change through time. They get married, or decide to leave the country, or get engrossed in a different pursuit, etc. Many things can get in between a founder and his start-up. Similarly, many things can go very wrong with a start-up. When those things do go wrong, or when one of the founders decides to pull out, is not the time to discuss these things. You need to discuss them with a clear head when no one is thinking of pulling out and the business looks healthy and hopeful.

When you discuss your start-up’s future, do not be afraid to talk about the disaster scenarios. Also, when you negotiate what will happen if a partner quits, don’t be so sure that it won’t be you.

4. Write things down
There are two reasons to write things down: first, people’s memories of conversations are faulty. Writing things down also ensures that there is no disagreement, later, about what was decided. You don’t need a long document for this — even just one or two pages describing your agreement is enough to avoid later misunderstandings.

The second reason is that people may think they have reached an agreement when in reality they never agreed about the details. Once you put something in writing, you give it a certain air of finality that teases out those last remaining disagreement. Basically, putting an agreement in writing is like putting a new piece of functionality in code. Until it exists in that form, it’s just vapour.

Halfway through my misunderstanding with my friend, we thought we’d figured out a way forward. I wasn’t sure that we were both thinking the same thing, so I made the effort to put it in writing, in the form of a business plan. When my friend read it, and understood more clearly what I meant, he recanted, and the agreement fell through. It’s a good thing that it fell through, because it would likely have resulted in even more problems later on if we’d gone through with it based on our flawed understanding of each other.

5. Don’t make it work at all costs
Yes, I know this is your friend that you’re starting up with, and this is your great opportunity to start your own business. However, if, in those discussions, you find that there’s an intractable disagreement, don’t fall into the trap of thinking that the most important thing is to smooth things over and start the business.

Starting up with someone is almost like marrying them (temporarily), in a way. You’ll be talking to them almost everyday, and possibly even more than with your significant other. You’ll be working on a “baby” (your business) for many months. It’s a big commitment, basically, and much like any other kind of significant commitment, you shouldn’t go into it if you think there are major problems, because those problems will only get worse.

6. Don’t assume things will get better with time
It’s easy to rationalise away big problems by assuming that things will get better with time. In some cases, they will, but in a majority of cases, they won’t. What this means, for example, is that you shouldn’t assume that your inexplicably small share of the business will magically grow to 50% later on. This is even less likely to happen if the business is working well (if the business isn’t working out, chances are it doesn’t matter anyway).

Sample questions
This article wouldn’t be complete without a list of questions that you might go through and discuss with your cofounder. Use them as a guideline or as a checklist, as you please.
What do we both mean by “the business is successful”?
What do we both mean by “the business is not successful”?
What happens if one of us needs to voluntarily pull out, for any reason?
What happens if one of us cannot work on the business anymore, for involuntary reasons?
What are the conditions under which we’d call the business a failure and pull the plug?
What is plan B for each of us if we do pull the plug? Are we both prepared for that plan B?
What do we expect of each other, both in terms of responsibilities and in terms of attitude and effort?
What is and is not an expense? What is the maximum amount someone can spend on an expense without checking with the other? (from Sebastian Marshall)
When and how will profits be distributed? How much will be reinvested? What will the reserves be? (from Sebastian Marshall)
What happens if one partner needs cash and the other wants to reinvest it into growth/expansion? (from Sebastian Marshall)
How will you handle it when (not if) the hours each partner is working are unbalanced? (from Sebastian Marshall)
This is not a final list by any means, but it should at least provide some starting points to make the implicit explicit. If you have other suggestions, please do add them in the comments below.

Conclusion
I don’t regret starting that business with my friend, but I do regret not clarifying those kinds of questions upfront. It would have saved me a lot of worry. If your business is struggling, you don’t need the additional pain of seeing your friendship unraveling under the stress of accumulated misunderstandings.

So, do yourself a favour, and set out to:
Make your agreements explicit so that you don’t break implicit promises
Detail your agreements so that your promises are clear
Don’t be afraid of discussing negative scenarios, so that you don’t add the stress of misunderstanding to already bad situations
Write things down so you’ll remember
Don’t make things work at all costs, so that you don’t spend the next years living with a deal that’s not acceptable to you
Don’t assume things will get better with time, so you’re not surprised when they don’t

Will The Four Horsemen Ride Again?

Venture Capital is getting dissed right and left these days...

From WSJ Venture Capital Dispatch
http://blogs.wsj.com/venturecapital/2009/03/03/will-the-four-horsemen-ride-again/

March 3, 2009, 06:57 PM EST
Will The Four Horsemen Ride Again? --> -->

By Scott Denne
The slow pace of initial public offerings has forced venture capitalists to find a solution to their late-stage liquidity woes, funding private exchanges such as InsideVenture Inc. (see our story here) and Web portals that let wealthy individuals in on the action. The drought, which started in early 2008, even spurred the National Venture Capital Association to launch a committee to investigate the issue, with the group’s chairman, Dixon Doll, urging the committee to “move beyond clichés, such as Sarbanes-Oxley bashing.”

Moving beyond clichés is one thing, says Paul Deninger, a vice chairman of middle-market investment bank Jefferies & Co. But, he asks, will venture capitalists own up to the part they have played in the withering of IPOs? As investment banking has become more consolidated over the last decade, Deninger said venture firms have largely stopped listening to the advice from smaller banks like his and tied their interests to those of the brand-name investment banks to their own detriment.

“Venture capital needs to take stock of itself and realize the error of its ways,” Deninger said. “The strategy of a Goldman Sachs is to serve [large companies like International Business Machines], not the VC ecosystem. When things were great, who was leading the charge?”

In the 1990s, four smaller investment banks, dubbed “the four horsemen” - Alex.Brown Inc., Hambrecht & Quist Group, Robertson Stephens & Co., and Montgomery Securities - underwrote a large number of the venture-backed IPOs, which averaged about 130 a year before the dot-com bubble, compared with about 40 a year since, he said. Those full-service boutiques employed a large group of research analysts that offered potential investors insight into the latest technologies being developed, and held conferences where technology companies could present to these investors.

The problem with the large banks, he believes, is they tend to serve only the largest institutions, which must put a more substantial portion of money into an IPO offering to make it worth their while. Smaller banks, meanwhile, cater to the “next tier” of institutional investors for whom $1 million is a meaningful position. By catering to smaller investors, but more of them, banks like Jefferies can get smaller offerings out the door and create demand for the stock after the initial offering, Deninger said.

The silver lining to the current economic climate, Deninger said, is that smaller banks are getting more attention from venture capitalists and institutional investors. “The firms that have gotten in the way of [the IPO] market are the firms that have gotten us into this mess.”

Hitting For Average Vs. Swinging For Fences

another good article from the WSJ - ya gotta love the honesty of our friends at AlphaTech.

March 2, 2009, 11:32 PM EST
Hitting For Average Vs. Swinging For Fences --> -->

By Scott Austin
Baseball enthusiasts often disagree about who’s the more valuable hitter: the slugger who often strikes out but occasionally connects with the big home run or the light-hitting speedster who racks up singles and doubles.

An onstage chat about investment returns at Monday’s Demo 09 conference sparked an analogous disagreement among venture capitalists.

Deep into the talk, which was titled “Venture Capital in the Post Recession” and streamed live on Demo.com, David Hornik, a partner at August Capital, explained that it’s the “wild success stories” that have always driven the venture capital business. Those investors that manage to make the home-run investments “will always drive great returns for their investors,” said Hornik, whose early-stage firm manages more than $1.3 billion in capital.

Christine Herron, a principal at seed-stage investor First Round Capital, which typically invests just a few hundred thousand dollars per investment, politely bit back. “That’s taking a very big-fund mentality,” she said. “For seed stage investors or angel funds that manage $100 million, you can keep hitting a double, double, double, and still have a great fund.” Herron said that a fund she worked at in the early 1990s, Geocapital Partners, was able to yield a respectable 4x to 5x return by stringing together several smaller hits. “We didn’t have the expectations of putting down a check worth $20 million to $30 million.”

Another seed-stage investor, Bryce T. Roberts of O’Reilly AlphaTech Ventures, believes the venture industry needs to scale back expectations. “I think that’s one of the things that’s come out of this downturn is recasting what success looked like,” he said. “When I first got into venture capital in 2001, it was all about trying to build the billion-dollar business….I’m all about swinging for the fences, but that’s the spotlight being cast on the venture industry.

“How many multibillion dollar business have been created in the last seven to 10 years? How sustainable is that as a model versus taking smaller amounts of capital and preserving optionality, and taking a slower path to growth rather taking a ton of dilution and multiple rounds of financings? That’s going to be a really attractive and viable model for entrepreneurs going forward.”

Earlier in the discussion, Roberts said the size of seed rounds are growing because in this environment it may take longer, up to 24 months, before venture capital investors swoop in. “We used to be able to invest $100,000 to kick a ball out for 9 to 12 months, now we’re looking at $1 million to $2 million for a seed round.”

Gov't Bailout for VC's?

Not something I'd imagine we'll be seeing...

http://online.wsj.com/article/SB123595208950605121.html

OPINION: INFORMATION AGE
MARCH 2, 2009
Too Risky for Venture Capitalists
Why proposals for a government bailout were roundly rejected.
By L. GORDON CROVITZ

With industries from autos to banking begging for taxpayer handouts, what would you call an industry that says thanks, but no thanks? Crazy, but like a fox. Even for venture capitalists, some ideas are just too risky.

Hundreds of the country's venture capitalists this past month blogged against or otherwise rejected proposals that the U.S. government fund early-stage investing. They dismissed a recent column by Tom Friedman in the New York Times that urged bailout funds for venture capitalists. "You want to spend $20 billion of taxpayer money creating jobs?" Mr. Friedman wrote. "Fine. Call up the top 20 venture capital firms in America" and invest the money with them.

Venture capitalists certainly agree that innovators and start-up companies, not bailed-out GMs or Chryslers, will create the new jobs. They rightly brag that almost 20% of U.S. gross domestic product is generated by companies built by venture capital, such as Intel, Apple and Google. Still, they almost universally panned the notion of taxpayer support. Their real-time rejection is an excellent example of how social media -- here, the venture community dissecting a proposal online -- can now quickly take down bad ideas.

"The top venture firms don't want, don't need and are never going to take government money. The same is true of the top entrepreneurs," Fred Wilson of New York's Union Square Ventures wrote on his blog. "The worst firms, on the other hand, will gladly accept government money," which would go to investors who can't raise funds privately and to entrepreneurs whose ideas shouldn't be funded. "It's a problem of adverse selection."

Venture firms have had a hard time profitably investing $30 billion each year for the past several years. Even in the paralyzed markets of the last quarter of 2008, more than $5 billion was invested in more than 800 deals. Returns, however, have been low. Some areas, such as clean tech, look especially troubled now that oil no longer costs $145 a barrel. Another $20 billion would be impossible to digest efficiently. Instead of subsidizing the biggest venture firms, Geoff Entress of Rolling Bay Ventures in Seattle posted that tax breaks are needed for seed-stage angel investors, who "are quickly becoming an endangered species."

The idea of direct government funding is also anathema because it would undermine market discipline. Pension funds, endowments and other institutional investors keep a close eye on how their invested money is doing. Venture firms can raise new funds only if their previous performance was good.

Several venture capitalists pointed out the irony that government-funded venture capital could mean trading a credit bubble for another technology bubble. Artificially inflating the venture coffers through a government fund could risk repeating the debacle of 1999-2000, when too much money chased too few good ideas, resulting in the sharp deflation of the Internet bubble. Taxpayer funds would reduce hard-won investment discipline as cheap money backed riskier, less-promising ventures. Valuations assigned to companies would artificially rise, poorly selected start-ups would fail, and taxpayers would be on the hook.

Taxpayer money would bring other unwanted side effects. As Bill Gurley of Benchmark Capital in Silicon Valley put it on his blog, "If American citizens were truly appalled with John Thain's bathroom and the GM executive's private plane, then they should find plenty to abhor in the well-compensated VC community." Congress would no doubt hold hearings on the "obscene profits" earned by the founders of the next Google.

If policy makers want to help entrepreneurs and their investors, there's no mystery about what's needed. Immigration needs to be reopened. Venture capital is still available, but the U.S. is now a laggard in the other half of the equation, which is making sure the entrepreneur's sweat, energy and risk-taking can ultimately pay off. Sarbanes-Oxley helped kill the market for public offerings, which had been a lucrative step for successful start-ups. Income taxes are going up, not down.

And the U.S. capital gains tax rate of 15% contrasts with the 0% rate in Hong Kong, Singapore and even Germany, where there's an understanding that these investments are made with income that's already been taxed once.

This no-bailout-please episode is a wider reminder about the downside of Washington picking winners and losers. Government spending almost always distorts markets. John Maynard Keynes included among his prescriptions a do-no-harm fiscal stimulus of simply paying people to dig and then fill in ditches. Venture capitalists have now reminded us that throwing taxpayer money at an industry is more likely to be a kiss of death than to transform frogs into princes.

Innovations supported by venture capital in technology, health care, education and other promising but risky industries are at the heart of our economy, too important to be dictated by nonmarket forces. Other industries now lobbying for their own bailouts should weigh more carefully the risks that come with taxpayer involvement. The lesson of accepting government involvement often is something ventured, nothing gained.

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