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What is qualified small business stock?

Under Internal Revenue Code Section 1202 , a taxpayer (other than a corporation) that recognizes gain from the sale or exchange of “qualified small business stock” held for more than five years may exclude 50% of such gain from gross income for regular income tax purposes.  The amount of gain that may be taken into account for purposes of the exclusion is subject to a limitation equal to the greater of: (i) $10,000,000 (less previ­ously excluded gain attributable to the disposition of other shares issued by the company), or (ii) 10 times the aggregate adjusted basis of the shares. In addition, a portion of the excluded gain is included in the calculation of alternative minimum taxable income.

Under IRC Section 1045, an individual may roll over proceeds from the sale of a qualified small business stock held for at least six months, when the proceeds are used to purchase qualified small business stock in another company. This effectively defers the tax due on any gain on the stock.

However, the maximum tax on long-term capital gains is 15% for most taxpayers and a 28% rate applies to gain on qualified small business stock.  The effective tax rate after the 50% exclusion is 14%.  Therefore, there is no substantial benefit to qualified small business stock unless the gain is rolled over into other qualified small business stock.

Qualified small business stock is defined in Section 1202 as any stock in a qualified small business issued to the taxpayer after August 10, 1993 in exchange for money or other property (not including stock), or as compensation for services. A qualified small business is a domestic C Corporation in which the aggregate gross assets of the corporation at all times since August 10, 1993 up to the time of issuance do not exceed $50,000,000. However, stock will not be considered to be qualified small business stock unless during substantially all of the taxpayer’s holding period the corporation meets certain “active business” requirements. 

Stock issued by an S corporation does not qualify as qualified small business stock (even if the S election is later revoked), although subsequently acquired stock may qualify.

In general, gain from stock issued to “flow-through entities” such as partnerships and S corporations should qualify under Section 1202. However, the amount of the qualifying gain is limited to the interest held by the partner or S corporation shareholder on the date the stock is acquired. This limitation may be significant in certain venture fund settings when the general partners’ interests fluctuate over time.

Please note that certain redemptions, including (i) redemptions of stock from the holder of qualified small business stock (or a related person) and (ii) certain significant redemptions occurring within one year before or after a stock issuance may disqualify any newly issued stock.

[Note: please go ask your own tax advisors any questions about qualified small business stock because I will not answer technical questions in the comments.]

What is an 83(b) election?

Failing to make a timely 83(b) election with the IRS is something that could lead to disastrous tax consequences for a startup company founder or employee.

Founders typically purchase stock pursuant to restricted stock purchase agreements that allow the company to repurchase “unvested” stock upon termination of employment. Similarly, employees may “early” exercise options subject to the company’s ability to repurchase “unvested” shares upon termination of employment.

Under Section 83 of the Internal Revenue Code, the founder/employee would not recognize income (the difference between fair market value and the price paid) until the stock vests. However, if a founder/employee makes a voluntary Section 83(b) election, the founder/employee recognizes “income” upon the purchase of the stock.

Typically, the purchase price for the stock and the fair market value are the same. Therefore, if an 83(b) election is made, there is no income recognized. Thus, a founder/employee should almost always make an 83(b) election. The benefits of an 83(b) election generally are starting the one year capital gain holding period and freezing ordinary income (or alternative minimum tax) recognition to the purchase date.

If the founder/employee does not make the 83(b) election, then he or she may have income at the stock “vests.” The income will be substantial if the value of the shares increases substantially over time.

For example, assume that a founder purchases stock for $0.01 per share (fair market value is $0.01) and the stock is subject to four year vesting with a one year cliff. The founder does not make an 83(b) election. At the end of the one year cliff, if the stock is worth $1.00/share, then the founder would recognize $0.99/share of income. As the remaining stock vests each month, the founder would recognize income equal to the difference between the fair market value and $0.01/share. In addition, the company is required to pay the employer’s share of FICA tax on the income and to withhold federal, state and local income tax.

If the founder had made an 83(b) election, the founder would not recognize any income as the stock vests, as the 83(b) election accelerates the timing of recognition of income to the purchase date.

In order for an 83(b) election to be effective, the individual must file the election with the IRS prior to the date of the stock purchase or within 30 days after the purchase date. There are no exceptions to this timely filing rule. The last possible day for filing is calculated by counting every day (including Saturdays, Sundays and holidays) starting with the next day after the date on which the stock is purchased. For example, if the stock is purchased on May 16, the last possible day for filing is June 15. The official postmark date of mailing is deemed to be the date of filing. The election should be filed by mailing a signed election form by certified mail, return receipt requested to the IRS Service Center where the individual files his or her tax returns. If the election is mailed after the 27th day, the individual should hand deliver the letter to the post office to obtain an official date-stamp on the certified mail receipt. A copy of the election should be provided to the company, and another copy should be attached to taxpayer’s federal income tax return for the year in which the property is acquired.

What is Series FF stock?

[Note:  this post will likely get updated in the near future.] 

I’ve been asked by a few people about the Series FF stock that has been advocated by the Founders Fund. Matt Marshall of Venture Beat reported on this invention in December 2006. See here for an Inc.com report in March 2007. Michael Martin blogs about economic incentives associated with the Series FF and founders receiving some liquidity in connection with a venture financing. Series FF stock has also recently received some attention due to the announcement of the Founders Fund raising a $220 million fund in December 2007. See additional coverage from Venture Beat, TechCrunch and the Mercury News.

I’ve reviewed the Certificate of Incorporation of a couple of WSGR clients that have implemented Series FF stock. (Please note that anyone can obtain the Certificate of Incorporation of a Delaware company from the Secretary of State of Delaware.)

The Series FF is an interesting mechanism for founders to obtain liquidity in connection with a venture financing. Below are the main features of the Series FF stock:

• The Series FF is basically identical to common stock except that it is convertible at the option of the holder into the same series of preferred stock issued in a subsequent round of equity financing if the buyer of the Series FF purchases it in connection with the equity financing.
• The conversion into preferred stock can only occur if the buyer of the Series FF pays the same price per share as the shares of preferred stock sold in the equity financing.
• The conversion into preferred stock can only occur if the board approves the conversion.
• The Series FF is convertible into common stock at any time at the option of the holder.
• The Series FF automatically converts into common stock upon a qualified IPO or upon the consent of holders of a majority of Series FF.

By the way, the Series FF preferred stock doesn’t need to be called Series FF.  It can be called Series A, Series Q, Series Z, Series X, etc.  The Founders Fund has managed to do some branding by referring to it as Series FF.

Below are some things to keep in mind about Series FF stock:

• Pricing of the stock is complicated. Generally, stock should be issued at fair market value (otherwise, there may be deemed income from the company to the founder). If the Series FF is not issued at initial incorporation, then issuing the Series FF stock at a later point in time will require the founders to pay more than a nominal amount to purchase the shares. As I will describe in a later post, founders stock is typically issued at a very nominal price per share, such as $0.001, so that the company may initially issue 10,000,000 shares for $1000.
• If the Series FF is issued immediately prior to the Series A financing, then the price per share of the Series FF probably should be at least the same as the Series A. In some respects, the Series FF may be more valuable than the Series A in the future if it can convert into a later round of preferred stock with a liquidation preference greater than the Series A. On the other hand, there is significant risk that the holder never receives liquidity because the board might not allow a conversion to occur (or investors may not be willing to purchase).
• Legal fees incurred in issuing Series FF may be higher. This is because the Series FF receives some amount of custom drafting and tweaking compared to a typical incorporation. In addition, many attorneys are not familiar with the concept and there are costs incurred in “reinventing the wheel” and getting everyone comfortable. The additional costs involved in setting up the Series FF may be wasted if the future board does not allow the founders to obtain liquidity.
• It is unclear whether venture funds are willing to allow founders to sell a portion of their stock in connection with a venture financing. Implementing the Series FF before an equity financing sends a message to potential investors that the founders want liquidity in connection with an equity financing. This may not be a good thing to mention when looking for early rounds of financing. However, venture funds may be willing to allow founders to sell in the following situations:
  • The venture fund has to agree to it because there are multiple terms sheets in a competitive deal.
  • The company is doing well (i.e. valuations above $100M and nearing an IPO) and the founders would rather sell the company that wait longer for liquidity.
• Investors prefer to purchase newly issued shares supported by a legal opinion, representations and warranties and various contractual rights. I’m not sure what benefit the company receives by facilitating the sale by the founders as the company does not receive the funds from the investors.
• Other mechanisms exist to allow founders to receive liquidity in connection with a venture financing. Companies can repurchase founders common stock for cash, subject to various limitations. The main issue that the Series FF solves is the price difference between preferred stock and common stock. If common stock is repurchased by the company at the same price as preferred stock is being sold to investors, then the fair market value of the common stock for option pricing purposes probably should be the preferred stock price. However, in a company nearing an IPO, the common stock FMV will likely be very close to the preferred stock price anyway. Therefore the Series FF stock probably only incrementally solves for a situation where founders want liquidity and want to preserve a significant price difference between the common stock and preferred stock in an early stage venture financing. (I’ll write a future post about option pricing and 409A in the near future.)
• Because the Series FF will likely only be issued to founders due to timing and pricing issues associated with issuing the Series FF, other employees may be upset that founders are receiving some liquidity.
• There is some risk of claims against the founders that sell (and the board) if the company never reaches a liquidity event. The other stockholders (including disgruntled employees) might argue that the company should have issued new shares to the investors and received the funds that the founder received from selling the stock.
• Despite carefully drafted releases, venture funds may reluctant to purchase the shares due to potential claims by disgruntled founders that they were forced to sell their stake at a low price compared to the price in an eventual liquidity event.

I am curious to see whether the Founders Fund has managed to invent something that will be broadly accepted or just a novel feature that is occasionally used by companies that have a connection to the Founders Fund.

I will likely update this post (without warning) with more thoughts as I hear feedback from various people.

What should the vesting terms of founder stock be before a venture financing?

I think that founders stock before a venture financing should be subject to the same general vesting terms as one would expect after a venture financing. A typical vesting schedule is four year vesting with a one year cliff. This means that 25% of the shares will vest one year from the vesting commencement date, with 1/48 of the total shares vesting every month thereafter, until the shares are completely vested after four years. The vesting commencement date can be the date of issuance of the shares, or an earlier date, in order to give the founder vesting credit for time spent working on the company prior to incorporation and/or issuance of the shares.

Some founders want to accelerate vesting upon a termination without cause or a constructive termination. (I will get around to defining these terms in future posts.) I’m not sure that this is really in the best interest of the founders. It is extremely difficult to terminate someone for cause, so termination of a founder will generally result in his/her shares being vested. For founders that have never worked with each other, I would generally counsel against acceleration of vesting upon a termination without cause or a constructive termination. If personalities clash or things don’t work out and a founder needs to be forced out, the remaining founder(s) will kick themselves for allowing the departing founder to leave with a significant equity stake.

If there is acceleration upon a termination without cause or constructive termination, I think the amount of acceleration should be similar to the amount of severance that a person may receive in the same situation. If six to 12 months of severance might be justified if a person is terminated without cause, then six to 12 months vesting acceleration seems reasonable. Of course, the typical norm in technology companies is that there is no severance in any situation.

In addition, some founders may want to accelerate vesting upon a change of control. Single trigger change of control vesting means that the shares accelerate upon a change of control. This isn’t in the best interest of investors because the fully vested founders have little incentive to continue to work for an acquiror after a change of control. In order to incentivize these people, additional options may need to be granted, which increases the cost of the acquisition to the acquiror, potentially to the detriment of the investors. Double trigger change of control vesting means that the shares accelerate upon a change of control AND the founder is terminated without cause or a constructive termination occurs within 12 months of the change of control.

The amount of shares that accelerates upon these events can be 100%, or written as a certain number of months of vesting, such as twelve. I’ve had one VC express a strong opinion that the amount of vesting upon one of these events should not be 100%, but rather 12 to 24 months of vesting acceleration, due to the fact that it is extremely difficult to terminate someone without cause. I think that double trigger 100% acceleration for founders or certain executives is fairly accepted among investors. However, extending that protection to rank and file employees is not common.

In any event, VCs are likely to impose their own vesting terms and acceleration upon a Series A financing, so it may not matter what terms are implemented when the initial founders shares are issued. However, reasonable vesting and acceleration terms may survive the Series A financing, especially if it would be difficult to renegotiate with a critical founder in a team with multiple founders.

Should founders stock be subject to vesting before a venture financing?

Generally yes.  Even though the founders stock is issued and outstanding, the company can have the right to repurchase the shares.  The right of the company to repurchase the shares will lapse over time or upon certain events, similar to vesting of options.  There are two primary reasons for subjecting founders stock to vesting even before a venture financing.

1.  If there is more than one founder, then each of the founders should want the company to be able to repurchase the unvested shares if one of the founders leaves.

2. If the terms of founder vesting are reasonable, there is some chance that the terms of the founder vesting may survive the venture financing.

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