Death of the venture capital tax for start-up founders – Part 2

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In the first article in this series, we saw that you – as the founder of a start-up – have already gone through the usual sources of funding and have now turned to venture capitalists. The first drawback you have is that you need it; they don’t need you. The point is, you are burning money and you have not yet reached the “bend” of the “J-curve”. Your dream is about to die. But, they’ve got a thousand founders online behind you.

The second downside you have is that their legal and tax advisors are probably in a different league from your legal and tax advisors. At the February 2015 meeting of the Silicon Valley Section of Financial Executives International, a panel of seasoned CFOs recognized that a company’s legal and tax advisors are likely to change as a company “rises through the ranks.” During the start-up phase, you will have a caliber of advisers. As you move into cycle A financing and then cycle B financing, your operations and financial systems become more complex. As you move through this range of being highlighted, the breadth and depth of financial issues becomes even more complex. And, if you’re one of the few startups that is entering the IPO process, you’ll have yet another caliber of advisors. But, your deal is signed from the start-up phase with the caliber of advisers you had at that time.

The tax consequences are intertwined and complex. And, there are two issues involved. The first question is whether you, your legal advisor, and your tax advisor are aware of the tax consequences. If venture capitalists have a duty to disclose these consequences, it will likely be buried on page 42 of a master document. Its versatile appearance will give you the impression that it is normal. The point is, you are negotiating, everything is on the table and the master documents can be changed. So, it really behooves your legal and tax advisors to be aware of the existence of these tax consequences.

The second question is whether you, your legal advisor, and your tax advisor are aware of the strategies you could employ to minimize the negative effects of these tax consequences. VC investors will be under no obligation to disclose these strategies to you. In fact, it can be argued that your use of these strategies goes against the financial interests of venture capitalists. As such, VC investors have no motivation to tell you about these strategies.

We will come back to these strategies but first we will talk about the hole that is being dug on your behalf.

Recall the discussion above about a company having a different caliber of advisors for different levels of operations and finances that it achieves. You should expect the person in your CFO role to be replaced. A given individual may have the skills and experience to straddle two levels. But, nevertheless, you should expect some substitutions. The same could apply to your legal advisor. Perhaps a good analogy is that of pitchers in a baseball game. You see a pitcher’s pitch less often during an entire game. More likely you will see a starter, a lifter and a closer. Everyone has their respective role.

Now we turn to you. At the end of the last article, we mentioned that venture capitalists would tell you how important you are. But, here is the reality. Just because you know how to “build a better mousetrap” doesn’t mean you know how to run a business that “builds a better mousetrap”. Technical skills and managerial skills are two different things. If your startup is a tech startup, you are probably some kind of engineer. And, engineers have a particular strand of DNA that manifests itself in a condition known as “Sheldon syndrome” (as on the Big Bang Theory TV show). You think you know and can do it all, but you really can’t. And running a business for an IPO is not one of the things you can do. VC investors know this and they will want to set up professional management.

It doesn’t mean that you no longer have a role in your own business. You do. It’s just not what you think your role should be. When venture capitalists turn to professional management, it may well serve them to let the “prodigy” retain the title of CEO. Let the “prodigy” be the rock star. But, the person who runs the business on a day-to-day basis is the seasoned executive, whom we will call an “operations manager”. Venture capitalists will relieve you of the mundane tasks of running the business. You can focus on the questions of strategy. They are doing you a favor. If this sounds familiar to you, please raise your hand.

At this point, venture capitalists have convinced you that you are absolutely essential to the business. But now the business is in danger. What happens if you leave or are hit by a bus? So we need to tie your financial success to 1) persistence and 2) looking both ways when crossing the street. One of these methods is “back-end” compensation. No salary but a big payoff if the business is successful. Isn’t that so? Ramen noodles for five years, followed by $ 25 million. If you are “on the bus” and if you are a “team player” with no doubt about your loyalty and commitment, you will. Your remuneration will not include any salary. Your compensation will take the form of shares and options.

What is starting to happen is that venture capitalists take another big step in your tax death. The first step was to convert your business to a C company. The second step was to convert yourself to back-end compensation. The rationale for each of these two steps seems plausible. But, these two stages are not unrelated.

Your equity will take the form of restricted stock purchase agreement (RSPA) shares. At the start of the deal, you get X shares at a sell price of (say) $ 1. But, in tax jargon, stocks are subject to a “significant risk of forfeiture”. As such, you do not yet own them for tax purposes. In the first year, the company can buy back the shares for the initial sale price of $ 1. At the end of the first year, 20% of the shares are released from the repurchase of the company. At the end of the second year, an additional 20% of the shares are released. Etc. This is called an acquisition schedule. Now your specific RSPA may be a little different from this one, but you get the idea.

Hold on for impact.

As each 20% block of shares – or, whatever your particular case – is released from a possible repurchase by the company, they vest and become taxable to you. When RSPA shares are vested, you are taxed on the dollar amount of those vested shares as valued on the date they vest. If the share price has risen to $ 2 per share on a given vesting date, you are taxed on the $ 2 per share as opposed to the grant price of $ 1. And, to put salt on the wound, they will be taxed at your “ordinary income” tax rate as opposed to the “capital gain” rate. The capital gains tax rate will only apply when you sell stocks and the amount of taxed gains will be the amount greater than the value on the vesting date.

Let’s say you received 5 million shares at $ 1 per share. To the company. . . to investors in VC. . . the allocation of shares is a “paper” debit. It’s not like cash compensation. The cash compensation affects “the track”, but not the allocation of shares. . . it’s paper. So here you are a year into the RSPA deal and 20% of your shares are vested. Let’s say the company still values ​​stocks at $ 1. There is no disbursement by the company. The business gets a paper-based deduction to offset the profits in cash, if any. And you have $ 1 million in income to report. Please tell me that you reported the acquisition of your RSPA shares on your tax return. In the absence of cash compensation, where in the world do you get the money to pay your income tax bill? If you live in California, for example, your combined federal / state tax burden on the $ 1 million acquisition will be around $ 500,000.

If you just had an “oh, snap” moment, penalties and interest will apply for the previous year’s failures to include the acquisition of RSPA shares in the tax return. If you go to the IRS before the IRS comes to you, you could avoid criminal prosecution. You will absolutely need representation. But, you probably won’t want to use the legal and tax advisors who got you into this mess. Think about it a bit.

The other form of compensation consists of unqualified stock options. Although complex on their own, they are not usually the source of “oh, snap”. Yes, they are taxed at the regular income rate. But, most people have a handle on their tax consequences.

If a founder does nothing, it is likely that more than half of his wealth from the business will go to taxes. But, one decision – without anything else – can turn much of that wealth from “ordinary income” into “capital gain” and reduce your tax burden by about a third. However, this ruling – when paired with certain IRS-recognized tax strategies – could reduce the founder’s tax liability by a total of 50% to 85%.

In our next installment in this series, we’ll cover the strategies you can use to help minimize the negative tax consequences of RSPA shares and NQSOs.


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