Founders are faced with a mountain of decisions to make about their businesses on a daily basis, particularly during the time leading up to an exit event. This reality does not leave them much time to focus on ways to maximize their individual success in the upcoming transaction. However, with expert advice, careful planning, and properly documented valuations, founders can set themselves, their companies, and investors up for a successful exit.
Most founders have heard about the 409A Valuation, which allows companies to issue equity to employees without triggering the negative tax consequences associated with nonqualified deferred compensation outlined in Internal Revenue Code Sec. 409A. However, many founders are not aware that valuations are needed throughout the lifecycle of a startup company and not just as part of the process of granting equity to employees.
As founders approach exit events, such as significant financing rounds, secondary transactions, M&A transactions, or IPOs, proper valuation documentation becomes a critical part of the exit planning process.
QSBS
For founders and investors who meet the requirements for their equity to be considered qualified small business stock (QSBS), the potential tax savings upon an exit event can be substantial. Investors that hold QSBS can shield gains equal to the greater of $10 million or 10x the basis of their shares from federal, and in many cases, state income tax.
Valuations are necessary to document an individual’s basis in situations where illiquid assets, such as intellectual property, are contributed into a C corporation, most commonly upon conversion of a limited liability company into a C corporation. If the fair market value of the individual’s contribution to the C corporation exceeds $1 million, the investor can potentially benefit from shielding from gain an amount equal to 10x their basis, assuming the company’s assets are worth $50 million or less at the investment date. The result could be a substantial benefit of up to $500 million of gain exclusion, in the extreme example of a single investor with a company value of $50 million on the investment date, and a $0 beginning basis.
Gift and Estate Tax Planning
As early as the company’s formation, founders can choose to gift equity interests in their company to trusts set up for the benefit of their heirs. In the earliest stages, the values of the equity interests transferred should be relatively low. However, as the company approaches a liquidity event, the value of the equity interests could increase dramatically.
Valuations consider the stage of the business, any intellectual property created as of the gift date, any recent third-party financings (including SAFE notes, convertible notes, and priced equity rounds), and the revenue-generating capacity of the business, among other factors. As a company nears a liquidity event, not only does the company value increase significantly, but the discount for lack of marketability associated with the shares declines, further increasing the per-share value. In addition, appraisers must assess what is known and knowable as of the valuation effective date. For example, if the company has received a term sheet related to a possible investment or acquisition, the appraiser must consider the offer as a data point in the appraisal.
Founders need quality gift tax appraisals documenting the fair market value of their gift to file their gift tax return and take advantage of their lifetime exemption, currently set a $13.99 million per individual. Without a contemporaneous gift tax appraisal, it cannot be guaranteed that the statute of limitations will run on the gift, potentially allowing the IRS to challenge the value for an indefinite period of time. The earlier in a company’s lifecycle that the founder gifts shares, the lower the value of the gift and the greater the ability to maximize the use of the lifetime exemption.
Charitable Donations
As founders approach a potential liquidity event, such as a secondary offering in connection with a significant funding round, an M&A transaction, or an IPO, philanthropically minded individuals may want to consider donating equity interests in their company to charity. This donation allows the individual to benefit from a charitable deduction related to the gift and to pass along value to the charity, which does not need to pay capital gains tax in a potential transaction.
Before making such a donation, the individual should consult their tax advisor to avoid triggering assignment of income treatment on their donation. The donation of equity interests needs to be made while there is still a risk that the potential liquidity event might not be successful. If not, any taxable income associated with the liquidity event could be imputed back to the taxpayer. The earlier in the process that the founder can effectuate the donation, the stronger the support for the charitable deduction.
Valuation plays a crucial role in pre-transaction charitable contributions. Valuations at this stage often involve scenario analysis that takes into account the possibility of a near-term exit and documents the risks related to the transaction being successful. A qualified appraisal prepared by a qualified appraiser is required to be attached to the income tax return in which the deduction is taken, along with a signed Form 8283, Noncash Charitable Contributions. Qualified appraisals must meet rigorous IRS standards, and qualified appraisers are personally subject to financial penalties if the IRS determines that their appraisal results in a substantial or gross valuation misstatement. If these requirements are not met, the IRS can deny 100% of the charitable deduction, even if they agree the charity received the donated asset and its value was as reported on an income tax return.
Takeaway
Founders have a number of tools available to maximize their wealth creation and wealth transfer objectives. Careful preparation before liquidity events can enable founders to achieve their desired goals. Quality appraisals play a key role in the process of supporting these objectives.