Understanding market trends and effective planning strategies can yield improved financial results for start-ups and growth companies.
Starting your start-up. What type of entity you form impacts your taxes, which hits your bank account both immediately (quarterly taxes) and in the long term (at exit).
A C Corporation(c-corp) is taxed on income (currently at historically low rates), and if income is paid to shareholders (as dividends), shareholders are also taxed. A c-corp, therefore, may not be a great choice if you’re looking to generate personal cashflow from your business. Most VCs expect reinvestment of profits in growth (with returns coming at exit—via IPO, M&A, or secondary sale—rather than during the investment term). Upon a properly structured sale of a c-corp, there will not be two levels of tax (and if the business has losses, there may never be income tax).
Many VCs insist on investing in c-corps, both because of restrictions from limited partners (LPs) (which have their own tax concerns) and because of the availability of Qualified Small Business Stock (QSBS) for c-corps. To briefly note popular alternatives, LLCs and S corporations are not taxed at the entity level—instead, members are taxed on their shares of the company’s income. It is possible to convert to a c-corp from an LLC or S corporation without tax, but this is not always the case (and existing equity holders of converting S corporations cannot benefit from QSBS, whereas equity holders of converting LLCs can in certain instances). While the c-corp model is usually the choice for VC-backed companies, certain types of businesses might prefer a one-level-of-tax entity, like an LLC, that can deliver to a potential buyer the benefits of an asset sale with just one level of tax to sellers.
Four magic letters. QSBS is a key economic driver in VC investing.
Here’s why: if you hold QSBS-eligible stock for more than five years, the gain from its sale is subject to an exclusion from taxes of the greater of $10 million or 10x basis (generally what you paid for it). This is a federal exclusion, but many states follow suit. For example, a New York-based founder selling QSBS stock after five years for $30 million (who paid a de minimis purchase price for such stock) would only pay tax on $20 million of gain, which would reduce her federal and state tax bill by more than $3 million. An investor selling the same stock after the same hold period who paid $5 million for such stock would be eligible for a gain exclusion of up to $50 million (well over her $25 million of gain). This would effectively zero out her federal (and possibly state) tax bill, which might have been more than $8 million absent QSBS.
QSBS can only apply to stock of a c-corp, and must satisfy several requirements. Only certain businesses qualify for QSBS (professional services generally do not, but many VC-invested businesses do qualify). Note that there are many possible foot faults over the life of the business that could disqualify stock, including certain stock buybacks or investments by the company.
Two more magic letters. Intellectual property (IP) rights are critical to start-ups.
At the time of formation, founders and employees must assign all business-related IP to the company (and agree to continue doing so as long as they work for the company). Failure to take this simple step may significantly devalue the business (because it may not own its “special sauce”) while providing economic leverage to non-assigning founders/employees (who may own that “special sauce”). Companies frequently get this wrong, and what may seem like a small issue in terms of a missing signature can become very expensive and painful at the time of an M&A exit.
You can’t take it with you. Ideally your venture becomes very successful, which will result in non-ideal taxes at the time of your death. These taxes can be mitigated by proper planning early on by lifetime transfers to trusts.
An ideal time to make gifts of startup interests to a trust is before they increase in value, as later transfers can come with expensive tax bills (gifting well in advance of an exit is most advantageous). The ideal recipient for long-term estate planning is an irrevocable trust, which can be tailored to the wishes of the founder and may stay in existence for hundreds of years to support family members, friends, and philanthropic activities. A founder need only set up a trust once; the same estate planning vehicle often can be used for multiple business ventures. Certain trusts can also be used to multiply QSBS benefits.
Equity Incentives / Early Equity. In a c-corp, early employees may be incentivized via stock grants subject to vesting based on time or other criteria (restricted stock).
Because restricted stock in early-stage companies is worth little when granted, employees typically prefer to be taxed based on grant value (for a much lower tax bill than if they were taxed upon vesting). An 83(b) election accomplishes this, but it must be done within 30 days of grant. In this scenario, if an employee leaves employment and forfeits stock, she cannot recoup the taxes paid, so an 83(b) election does present risk; however, it is often worth it—particularly if the value at grant is nominal. The benefit of the election is that if the stock is held for more than a year at time of exit, it will be taxed at the long-term capital gains (LTCG) rate, rather than the much higher ordinary income (OI) rate; if the stock is QSBS eligible and has been held for five years, it’s probably time to throw a party.
Once a c-corp has gotten past early stages, stock options are the more typical choice to incentivize employees. Options must have an exercise price no less than the FMV of the underlying stock, unless they are structured to comply with or meet another exemption under 409A. Depending on option type, option exercise may or may not be taxable.
Phantom stock is another, less common, instrument, that takes the form of a bonus paid to an employee upon sale of the company (or at other times). Such arrangements are generally more flexible than options, but there are some technicalities that need to be addressed. Phantom stock and options are taxed at OI rates at exit, except in the case of options that have been exercised (i) at least a year prior to exit and (ii) at least two years after the date of grant, which are then taxed as LTCG (but may also incur tax at the time of exercise, which cannot be recouped if the exit is less fabulous than expected). In either case, these instruments are not QSBS-eligible, but stock received upon exercise of an option can be eligible (with the holding period beginning at the time of exercise).
It’s important to grant options quickly after promising them in reliance on a valuation of the underlying stock (typically called a “409A valuation”), as the 409A valuation can become stale or unreliable. If you receive a term sheet—for a financing or M&A—your previous 409A valuation ceases to be valid for purposes of reliance and could result in adverse tax consequences. The same can be true even if you receive a verbal offer. Improperly granted (or not granted) options frequently become thorny issues in M&A transactions.
Don’t feel too SAFE. Early-stage financing often takes the form of convertible notes or simple agreements for future equity (SAFEs), as the cost and timeline of a priced financing round may not make sense in a company’s early days. It is important to carefully model out the dilution that will result from conversion of these instruments, particularly because of valuation caps and discounts that can have a substantial impact and are often not well understood by founders raising money for the first time. Counsel can ensure you are maximizing your cap table for both the present day and future equity rounds and evaluate the tax treatment of convertible debt and SAFEs, which may be treated as stock for tax purposes on exit.
Many investors in SAFE financings request side letters with pro rata rights for the equity financing into which the SAFE converts (the “Equity Round”) and on a go-forward basis. While this is generally fine for material investors, it is important to clarify that any pro rata rights on a go-forward basis will be subject to the same amendment and waiver thresholds as those agreed to by the lead investors in the Equity Round. Otherwise, the company will have to seek waivers from multiple constituents in each subsequent financing round, and may suffer additional dilution if it is unable to receive those waivers.
Structuring an M&A exit. Most start-ups’ liquidity events take the form of M&A exits, where tax consequences will vary greatly depending on the structure of the transaction.
For a c-corp, a stock sale, including certain mergers, is likely more tax favorable than a sale of assets. A stock sale is taxed at LTCG (assuming a hold period of more than a year), with QSBS exclusions potentially applying. An asset sale is subject to two levels of tax, with the c-corp paying tax on the gain from the sale (offset by the c-corp’s usable net operating losses), and shareholders paying tax when the sale proceeds are distributed (QSBS exclusions could reduce or eliminate the second level of tax where applicable). Buyers usually prefer to buy assets, but unless a c-corp has sufficient usable net operating losses, it will be tax prohibitive for it to sell assets. This analysis is very different for the sale of an LLC or s-corp, which can sell assets, for example, with one level of tax (but no potential QSBS benefit).
An exit transaction may include both cash and equity of the buyer. In these deals, ensuring that sellers are not taxed upon receipt of illiquid buyer equity is key (with a secondary but also important consideration being whether QSBS benefits can continue post-transaction). This tax analysis considers not only the structure of the exiting entity but also the structure of the purchaser. When a c-corp sells to another c-corp, whether the transaction can be structured for tax deferral depends upon many factors, most importantly the portion of the purchase price paid in stock. The percentage of the deal value paid in stock will depend on the fair market value of the stock rather than an ascribed value to which buyers and sellers agree. Tax deferral generally is easier to accomplish where the buyer is an LLC rather than a c-corp, but if the sellers have QSBS, that status cannot be maintained if acquired by an LLC, while sale to a c-corp may allow the status to be maintained (with certain potential limitations).
The tax treatment of an M&A exit has a significant impact on the dollars that shareholders take home; founders should seek advice of counsel prior to granting exclusivity to a buyer to ensure that the deal on the table is workable from a tax perspective.
Show me the money. In addition to tax structure, features of M&A exits that impact investors’ returns include purchase price adjustments and indemnification.
M&A exits are often “debt-free, cash-free,” meaning the purchase price is increased on a dollar-for-dollar basis based on cash on hand of the company (often excluding certain categories of restricted cash) and declared on a dollar-for-dollar basis based on debt and debt-like items. In addition, deals are often done based on “normalized” working capital, meaning the parties agree on an appropriate level of working capital and the purchase price is adjusted by the amount by which working capital differs from this mutually agreed target.
In addition, after the closing of a transaction, it is possible for the buyer to claw back proceeds from selling stockholders pursuant to indemnification provisions. Limitations on indemnification are heavily negotiated, including for how long indemnification will be available and what percentage of deal proceeds will be generally available for indemnification. If a company has leverage to negotiate these points before granting exclusivity to a potential buyer, the outcome will typically be better than waiting until leverage has shifted to a buyer during exclusivity.
Three more magic letters. Representation and warranty insurance (RWI) is a product that buyers can procure that shifts the burden of most indemnification away from sellers to a third-party insurer.
Private equity buyers are very familiar with the product, and many strategic buyers have started working with it over the past few years. There is a cost to RWI, which can be borne by buyers or sellers, or split; procurement of a policy can be time-consuming for a buyer, so it is important that sellers raise the preference for RWI early in an M&A process.
Carrots and sticks. Frequently an M&A buyer will provide incentives for key employees to stay engaged following a transaction by using a carrot-and-stick approach.
The “carrot” takes the form of new compensation, often in the form of restricted stock or option grants (or, if your buyer is an LLC, profits interests, which may result in LTCG rather than OI on exit), as well as potentially right-sized compensation packages for the continuing team. Certain service providers may be subject to an excise tax of 20% for certain “excess” payments made in connection with a sale. To avoid this excise tax, a shareholder vote must be obtained that is predicated on sharing with shareholders details of compensation packages (both historical and forward-looking). This is often uncomfortable for key employees but necessary to avoid a heavy tax burden.
The “stick” used by buyers to ensure that key employees stick around post-transaction takes a few forms. Many buyers will require that key employees “revest” a portion of their deal consideration, essentially agreeing to receive such consideration on a deferred basis subject to continued employment. In deals with private stock consideration (including “rollover”), such consideration may be subject to buyback at a reduced value if an employee leaves employment. In these scenarios, it is important to negotiate “good leaver” protections.
Another “stick” is non-competes that buyers require employee equity holders to sign in connection with an exit transaction. Unlike employment-related non-competes, those entered into in connection with a transaction have enhanced enforceability on the theory that they are part of the value being purchased by a buyer.
Exit timing and planning. M&A exits take longer than financings, and many companies wait too long to start their sale processes with too little cash runway, thereby limiting their leverage in a highly negotiated transaction (unlike financing transactions, M&A transactions are not guided by NVCA forms and use longer, more bespoke documents with diligence and disclosure processes that can frustrate a leadership team). Leverage shifts to buyers once exclusivity has been granted, so the more that can be negotiated in a term sheet (including legal issues such as structure and indemnification limits or RWI), the better it is for a selling company and its leadership team.
