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Exits for Startups

In today’s deal environment, founders of startups seeking an exit are likely to encounter offers of equity or a mix of cash and equity.  While Google, Apple, Facebook and Microsoft are flush with cash, private unicorns are also active acquirers today.  These private companies have reached sky-high valuations easily exceeding many public companies.

While an IPO remains a possible exit scenario for shareholders these unicorns, IPOs are delayed for a variety of reasons.  There might not be any need for cash or liquidity or the shareholders may be holding out for an even higher valuation.  Before an IPO, these private companies are acquisitive but typically seek to conserve their cash hoard.  One way to conserve cash is to use equity to finance their acquisitions.

Tax Considerations

No one likes to pay tax, but it’s even worse when you receive equity instead of cash.  The equity may fall in value, leaving you with a tax bill greater than the value of your equity.

When investors exit a startup, they won’t have a tax liability if they sell at a loss.  But founders rarely have this option – they almost always have no tax basis in their founder stock.  To avoid a tax liability, founders want the deal to qualify as tax-free, as will investors who face a potential gain.

Qualifying as Tax-Free

Fortunately, there are a variety of ways for an acquisition using equity to qualify as tax-free.  Perhaps the most common, because it is so flexible, is a merger.  In a merger, shareholders can receive up to 60% of the consideration in cash and still potentially qualify for tax-free treatment on the equity.

But a merger may not be possible if the target is foreign.  Even if a merger is feasible, it will be taxable if the buyer pays too much cash to qualify for the 60% limitation.  Here, there are potential solutions, such as forming a new holding company for both the target and acquirer.  But this solution can be just as challenging and out of reach as a merger.

Capital Gains Exclusion for Qualified Small Business Stock

When all avenues to tax-free treatment are blocked, founders have another potential wild card: the capital gains exclusion for qualified small business stock.  This is a complex exclusion for capital gains from the sale of stock of certain types of businesses, including many startups.  To qualify for the exclusion, a shareholder in a startup must have owned its stock in the startup for at least five years.

If a shareholder jumps through all the hoops and qualifies for the qualified small business stock exclusion, there is no federal tax liability on the sale of the stock.  This removes much of the pressure from qualifying for a tax-free transaction.  But even here, there are still benefits from tax-free treatment.

For one thing, even if the transaction is tax-free at the federal level, you may still owe state tax.  Some states, including California, do not provide the federal tax benefit for qualified small business stock.  That means you will still pay California state tax on the sale of your stock.

Also, if the sale qualifies as tax-free, you may qualify for the same qualified small business stock benefit for the new stock you receive from the acquirer.  That means you may qualify to exclude capital gain on a sale of your new acquirer stock in the future.  But if the sale is taxable, you will use the capital gain exclusion for qualified small business stock and it won’t be available when you sell your new acquirer stock.

Weighing Your Options

When receiving equity on a sale of their company, founders can get powerful tax benefits for tax-free treatment.  But the golden elixir of avoiding tax on an acquisition can be challenging.  To avoid potential pitfalls, founders need to evaluate the different alternatives and come up with the best plan.