So, you’re the founder of some start-up. While the MoneyTree™ Report - produced by PwC and the National Venture Capital Association with data from Thomson Reuters - suggests that the vast majority of venture capital money goes into some form of technology, your company – your baby – might be in any industry.
You’ve gone through the usual funding sources. You’ve cashed out a good chunk of your own savings. You’ve obtained loans – or equity investments – from family and friends. Maybe you’ve even tapped the angel investor corps. But, you’re still burning cash and you only have so much “runway” left. You need more cash to make it past the elbow in the “J” curve or the “hockey stick.” And, with nowhere else to turn, you turn to the venture capital investors.
You want to sell them as little of your company as possible for as many dollars as you can get. But, they know the position that you’re in. They want you to give up as much of your company as possible for as few dollars as you will take.
You have two things going against you at this point. First, your dream is on the line. For them, your dream is one of a thousand dreams . . . it’s about the money and it’s about the control. Don’t kid yourself by thinking that it is anything different. Second, your legal and tax advisors are dwarfed by their legal and tax advisors. You’re likely going through this for your first time. They are going through this for the tenth time this year. You are at a clear disadvantage. Certainly, there is the obvious battle on the surface about who has what percentage. But, to use a naval analogy, there is sub-surface warfare in play . . . and it’s about taxes. If you are even aware that it is occurring, you will likely not understand the consequences or the foregone choices you didn’t know you had until you are presented with your income tax bill years in the future. If I’ve scared you, good.
So, here’s the deal . . . if you want the money, you sign.
Chances are that you organized your company as a limited-liability company. In tax parlance, an LLC is a type of “pass-through” entity. This means that the company itself is not income taxed on its profits and losses. Instead, the reporting of those profits and losses is passed through to the owners and is reflected on the owners’ income tax return. It is important to note “reporting of those profits” is different from the “cash distribution of those profits.” The company might need to retain cash profits to add “runway.” So, you have taxable income without the cash to pay the taxes. That’s called “phantom income” and the VC folks don’t like it. As a result, VC folks tell you that you need to convert your LLC to a corporation. And, given the two tax flavors of corporation – C and S – it will be a C. This is step one.
The decision to convert your company from an LLC to a C corporation puts your firm on a particular path. In other series in our column, we have discussed tax considerations in the sale of a business at length. In brief, the vast majority of business acquisitions – 95% or so – are so-called “asset sales” as opposed to “stock sales.” This is primarily driven by the buyer’s tax preferences. Asset sales translate to double-taxation for C corporations. (For greater discussion on why, please refer to the prior series we mention.) On the other hand, a stock sale of a C corporation sidesteps that double-taxation. But, there are only so many buyers whose circumstances allow them to do a stock deal and not be adversely affected with respect to taxes. Other than a few exceptions, a conscious decision to convert to a C corporation likely means that you are targeting publicly traded companies as buyers of your firm.
That publicly traded company will likely buy your company with its own shares in exchange for your shares (perhaps with some cash). In most cases, this will qualify as a tax-free stock-swap. It is important to note that if your buyer is not organized in a U.S. jurisdiction, even if publicly traded, your buy-out will be fully taxed as if it were an all-cash sale.
The next thing that the VC folks are going to tell you is how important you are. You are the visionary. We need you. And, to protect everybody’s interests, we need to ensure that you are going to be around. It seems reasonable. And, as you fully intend to be around, you don’t see what could possibly be wrong with such a request. So, you agree with their premise. This sets the stage for the proverbial bus . . . a tax bus . . . to hit the founder. Or, using a different saying, it’s the bullet you don’t hear that gets you. The VC folks will require you to convert your equity into RSPA shares. That is, shares subject to a Restricted Share Purchase Agreement. This is step two.
In our next segment in this series, we will continue our journey with our founder and see how the seemingly reasonable request to “keep the founder around” will lead the founder to tax death.
