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Financing and Venture Capital
Many successful start-up and growing companies face the proposition of raising capital for company expansion. This financing can come in many stages from the less formal “friends and family” fundraising to the structured world of venture capital funding. In every one of these stages of capital raising, companies and owners have numerous issues to navigate, including structuring questions, company valuation, tax considerations, and complex state and federal securities law regimes. As entrepreneurs, our attorneys understand both the excitement and anxiety that are a part of growing businesses.
While these financing issues can present an intimidating undertaking for entrepreneurs, it is extremely important that they be handled appropriately by experience counsel. Neglecting to address the relevant legal issues at the outset can result in significant hurdles for later stages of financing and development. Comprehensive planning of financing rounds pays real dividends in the long run and can have extremely adverse implications for companies and entrepreneurs if not handled skillfully in the early stages. We counsel both companies in various phases of financial development and capital raising, as well as investors looking to protect their investment and maximize the chances of success.
Many entrepreneurs do not realize that share issuance, even at the beginning stages of the company, is a taxable event. Usually, although not always, shares are deemed of little value in the beginning stages of a company, so there is no tax owed. However, depending on how and when shares are issued, severely adverse tax consequences can result. Even in the early stages of a company, it is generally advisable for founders to execute an intellectual property (IP) assignment to the company in exchange for shares. In addition to the fact that the company should own the IP associated with a business idea rather than the individuals, an IP assignment can lessen tax liability since it exchanging a property right for shares rather than shares for services.
For both founders and new hires as a company grows, investors generally want to see shares vest over time, which provides an incentive for management to stay with the company over time and avoid “dead equity,” which is equity that has already been issued and vested without continued services being rendered. Generally shares are issued to entrepreneurs either through restricted stock (including restricted stock units RSU) or options.
There are complicated rules governing issuance of stock options, which should be formalized through a company stock option plan, including how many stock options can be granted annually depending on whether a stock option is qualified a stock option (a/k/a statutory or incentive stock options exclusively for employees that carry preferential tax treatment) or non-qualified stock option (for non-employees with non-preferential tax treatment). There are different tax rules that govern the exercise of qualified versus non-qualified options. Generally, issuance and vesting of option agreements is a non-taxable event as long as the strike price of the stock option is equal to the fair market value of the underlying security. If the strike price is less than fair market value such that the holder of the option receives an immediate economic benefit, then the grant is taxable.
Depending on the type of stock option, exercise of an option and sale of the underlying security can have significant tax consequences. When a qualified stock option is exercised, even if the underlying security has appreciated and is worth more than the exercise price (presumably it would be), the exercise is not taxable for ordinary income tax purposes, although may be subject to the alternative minimum tax. The exercise is not subject to employment tax withholding. For non-qualified stock options, however, the value of the exercise (underlying security fair market value minus strike price) is taxable as ordinary income and subject to employment tax withholding. For non-qualified stock options, the spread on the value of the underlying stock and the strike price is deductible by the company, since that difference is a theoretical loss to the company for not issuing the shares at fair market value, whereas the spread is not deductible in the case of qualified stock options.
For qualified stock options, only $100,000 of the security underlying the option can be exercised in any calendar year in for shareholders who own more than 10% of the shares, options strike prices must be at least 110% of fair market value at grant and may not be exercisable for at least 5 years. For non-qualified stock options, these limitations do not exist. For qualified stock options to qualify for long-term capital gain, the underlying stock must be held for at least one year and the option grant must have occurred at least two years ago.
Restricted Stock, 83(b) Elections, and 409A Valuations
When restricted stock vests, however, that is a taxable event in the year of vesting, even if the shares cannot be sold. Particularly if the venture is successful and the shares appreciated significantly over the course of the vesting schedule, this can leave entrepreneurs with a punishing tax liability. The way to deal with this conundrum is through an 83(b) election, which must be made shortly after share issuance. With an 83(b) election, the recipient of the restricted stock must pay tax on the fair market value of the stock at the time of the issuance. This also results in a tax liability for the recipient, but it is generally much lower than the tax that would be due when the stock vests if the venture is successful. However, 83(b) payments are risky in that there are no refunds from the IRS if the stock ends up being worth less than the valuation upon which tax is paid.
The tax liability for an 83(b) election is based on the valuation at the time of issuance. For publicly traded stock, assessing valuation is easy. For private stock without liquid market, valuation is much more difficult. An equity fundraising round generally establishes a valuation and at least theoretical fair market value. Without a benchmark, however, parties can either make their own assessment about valuation, which is very vulnerable to challenge by tax authorities in the event of an audit, or engage professionals to value the company and render a 409A opinion, which is less subject to challenge than a company’s self-interested assessment.
The 1933 Securities Act provides that all securities must either be registered (which involves a lengthy and expensive process with the SEC) or be issued pursuant to an exemption. The vast majority of companies, including start-ups, issue securities pursuant to a private placement exemption that is based on Section 4(2) of the 1933 Act, as well as subsequent case law and regulations. The most common private placement exemption is Section 506 of Regulation D pursuant to the 1933 Act. Section 506 allows issuers to issue securities to an unlimited number of accredited investors and up to 35 non-accredited investors (we strongly advise companies only to issue securities to accredited investors in private offerings). There are various restrictions to be mindful of when issuing securities, including what representations to make to investors and rules involving advertising and solicitation in connection with an offering. Generally, private placements restrict an issuer’s ability to generally solicit, although Section 506(c) permits solicitation and advertising if all of the investors are accredited and the issuer takes reasonable steps to verify their accredited status. It is extremely important to conduct these activities under the guidance of experienced counsel.