The technology industry has come a long way from the dot-com era of the mid-1990s to early 2000s. Since Silicon Valley’s rise to fame, research parks, technology centers, universities and incubators across the country have emulated its success — becoming breeding grounds for highly sophisticated start-ups and game-changing innovations across industries.
The potential for exponential returns makes technology starts-ups an attractive option for investors. But while these entities share some similarities with traditional small businesses, they also come with a unique set of circumstances. Long lead time to see profits (if they ever come), a life cycle flush with active fundraising, and special considerations for entity structure and the ultimate exit are just a few of the challenges to overcome.
In the interview below, Cohen & Company Tax Partner Dennis Grady discusses the issues investors should evaluate before taking the tech plunge.
What are some of the significant differences between a traditional small business and a technology start-up?
From idea to launch to sale, they are two very different worlds. Before a tech start-up even secures funding to get off the ground, owners must have their eye on an exit event somewhere in the future. That changes much of the strategy and planning from the outset, starting with how the entity is structured. Then there is the funding. While a traditional small business often begins with either a loan, a grant or seed money from family or close friends, a technology start-up seeks funding from either angel investors or venture capital (VC) firms. Angels and VCs tend to take a much more active role in their investments. The funding source corresponds to the biggest difference — technology start-ups are expected to grow revenue at an accelerated rate, often at the expense of profitability. This growth is needed to support the company valuation and meet angel/VC expectations for a high return on their investment. To fuel this growth rate tech companies may go through multiple rounds of financing.
What type of entity structure should an investor look for in a tech start-up?
Many start-ups begin as flow-through entities to pass on early losses to investors, but tech entrepreneurs have to consider how later rounds of financing will impact and support future growth and scaling, meaning how the entity will fit for investors with an equity stake down the road. Once companies see signs of growth, maybe three to five years in, many choose to convert to a C Corporation, which is the entity of choice particularly for VC firms. In fact, some institutional investors make it a prerequisite for investing.
VCs have many reasons to prefer the C Corporation structure over a pass-through such as an LLC. A venture fund may have tax-exempt investors whose tax-exempt status can be jeopardized by certain allocations of partnership income. There is also a level of simplicity with a C Corporation; documents tend to be less complex than LLC agreements, particularly when raising capital or if a new investment structure is introduced. And VCs, who generally have their eye on exiting the investment in three to five years, like the fact that they can keep the transaction simple with the acquisition of stock from a C Corporation to later be sold for a capital gain or loss.
As a start-up becomes successful enough to consider a liquidity event, what tax opportunities are available for investors expecting a gain?
The Section 1202 gain exclusion provides for a partial exclusion of gain from the sale or exchange of certain small business stock. The exclusion, made permanent in the PATH Act of 2015, was originally enacted in the Revenue Reconciliation Act of 1993 and had been modified several times over the years. Most recently the law removed the previous AMT implications that had the effect of reducing the actual benefit to investors. Under current law, the gain exclusion can range from 50% to 100%, depending on when the stock was acquired. There is also an additional limitation on the excludable gain, either
$10 million or 10 times the investor’s tax basis in the stock, whichever is greater.
Investors also have the option to defer gain from the sale of qualified small business stock via Section 1045, which allows non-corporate taxpayers to roll over the gain into a new investment of qualified small business stock. This deferral window lapses 60 days after the original investment is sold.
What are some of the requirements for a sale of stock to qualify for the 1202 gain exclusion?
First, the stock must be Qualified Small Business Stock, meaning any stock in a C Corporation that was originally issued after August 10, 1993. Further, the stock must be held as an investment for five years, and the taxpayer must acquire the stock upon original issue in exchange for money, property other than stock or as compensation for services. The corporation must be an eligible domestic entity and engaged in an active qualified trade or business. Also, the aggregate gross assets of the corporation cannot exceed $50 million immediately before and after the issuance of shares.
We know that, unfortunately, many investments end in losses. Then what?
For the most part, these capital losses are limited in that they only offset capital gains. If an investor has no capital gains to offset there is a minimal carryforward period before these capital losses expire. However, when dealing with investments in Qualified Small Business Stock, Section 1244 provides that these investment losses to individuals (and in some cases partnerships) may be treated as ordinary instead of capital losses. Ordinary losses have the potential to offset other sources of investor income, including business income and wages up to $50,000 in a single tax year (double that if filing jointly). There are specific requirements to qualify, and the benefit may not be as attractive as an outright exclusion of gain, but this tax strategy helps mitigate an investor’s downside.
Working with as many tech companies as you have, what would your advice be to someone looking to invest in their first tech start-up?
Investing in a technology start-up can be rewarding in many ways but can also be a risky proposition. As with any major business decision, conduct due diligence and understand what you’re getting into. For every company that becomes a success and ends in a lucrative sale, there can be nine others that fail and take investors’ money with them. Before investing, take a close look at the company’s prospectus and listen carefully to what the founder and other key management employees have to say. Are they realistic, and do you feel good making a bet on the people as well as the technology? Does the company have growth potential? Has leadership considered the timing of an exit, and is there a plan to get there that meets your investment goals? Most importantly, work closely with your financial advisory team to be sure if the investment and the related risk fit into your overall diversified financial portfolio.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.