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Keystone Global Partners

Forward-Thinking Wealth Management For Tech Founder

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Investment

Five Key Considerations When Building an Alternative Investment Program for a Client

January 20, 2023 by crystal

This article was originally published on FORBES.COM on December 20, 2022. Written by Peyton Carr.

Alternative investments, once rarely found outside the investment portfolios of the ultra-wealthy, family offices, pensions, endowments, and sovereign wealth funds, have become more mainstream as adoption grows and barriers to entering the asset class are decreasing. Many new players have entered the market over the last five years offering education and alternative investment strategies at lower commitment entry points. NASDAQ reports that by 2025, total alternative investments under management are projected to reach $17.2 trillion—a four-fold increase since 2010.

Also driving this asset class is high inflation, market volatility, and 2022 bond market performance causing many investors and advisors who’ve hesitated to invest in these wealth-building strategies to reconsider other options for diversification. 

Investors have many alternative investment options available to them, and building out such a portfolio or program can improve the overall risk and return characteristics of a portfolio when properly implemented. Still, there are unique challenges in doing so since the unpredictability of private market cashflows can be challenging for investors with liquidity and risk constraints.

Alternative investments are a core asset class for our clients, and below are five key considerations that qualified investors and advisors who invest in alternatives should consider:

Selectivity & Diligence

Alternative investments need to be carefully selected and run through the proper diligence channels. Choosing top-quartile performers is paramount. According to a report from JPMorgan, the spread between top-quartile and bottom-quartile managers is 21.3% for Private Equity, 34.5% for Venture Capital, and 13.3% for Hedge Funds. This compares to a spread of 1.8% for Global Public Equities, for example. According to Blackstone, nearly 60% of top-quartile managers remain above the median of their subsequent funds. Having the right access channels is imperative. I’ve seen too many investors and advisors settle for inferior funds or managers due to their limited access or diligence process. Be selective, diligent, and patient.

Timing 

Building out a private investment program is a multi-year process and requires time and dedication. For a new investor, it can take five to seven years to reach their target allocation. It can take 10+ years for the full maturity of a private equity fund, for example. Money invested is typically locked up and if an individual needs access to liquidity, they may not be able to liquidate their investments. Investors should carefully consider their liquidity needs and understand that this is a long-term strategy that requires planning and discipline.

Cashflows

Because of how a capital call drawdown structure works with some private investments — private equity, for example — the investor needs to model the expected capital call and distribution schedules, as well as the long-term expectations of the asset class and the portfolio. Only then can you optimize your commitment amounts and timing, better estimate future liquidity needed, and achieve your target alternative investment program allocation without overshooting or under allocating. As an example, cash flow drawdowns are typically more concentrated during the first few years, and different asset classes have different drawdown schedules. 

Scaling and Maintaining the Allocation 

Vintage diversification, or rather, investing over a multiyear period, is important. Funds can have good and bad years, impacting returns. Investors just getting started should take care not to over-allocate in a particular vintage year in efforts to ramp up quickly. Equally important is having an annual pacing plan determining what commitments to new funds are required to achieve or maintain the target allocation. When an investor receives a distribution, it decreases the overall allocation and decreases exposure. This needs to be accounted for via a recommitment strategy; otherwise, the total exposure will trail off.

Liquidity and Diversification

A properly designed alternative program should be diversified across multiple strategies and vintages and can range from defensive to growth focused. The calibrated and optimized mix will ultimately depend on the client’s risk tolerance, goals, and liquidity requirements. Determining client level liquidity requirements and stress testing the portfolio to simulate managing commitments through market volatility is necessary to prevent any cashflow shortages or unexpected outcomes. 

Conclusion

Building out an alternative investment program requires a disciplined approach to portfolio construction, implementation, and maintenance. It is very different than investing in public markets where you can quickly and efficiently achieve a target asset allocation. When building out a private investment portfolio, many of the private markets commitments are drawn down over a series of years and returned later. Capital call drawdowns can vary significantly between asset classes, managers, and investment cycles, which is why it is important when investing in alts to fully understand the asset class before including them in an investment portfolio.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Real Estate as an Investment Asset

May 1, 2021 by eric

Tech Founder’s Guide to Real Estate

Part 4: Real Estate as an Investment Asset

This article was originally published on FORBES.COM on March 12, 2021. Written by Peyton Carr.

For many people, real estate has been the best investment in their lives. However, stocks have actually been far better at generating long-term returns for investors. Why is there such a disconnect?

Misconceptions on Real Estate Returns

Peeling back the layers reveals some of the key factors that make real estate seem like the better investment:

  1. Immense use of leverage – No other common investments will allow an investor to take on the same level of debt to make an investment. Mortgages allow 4:1 leverage with a 20% down payment and even far higher levels of leverage when using smaller down payments. The leverage magnifies even small gains in the property value, but remember, it can cut both ways if the property value declines.
  2. Illiquidity prevents human error – Real estate transactions have high costs and take significant effort. This is usually enough to deter investors from making hasty, panic-induced decisions during market volatility. Poor decisions are more prevalent in the stock market, where selling investments can happen in seconds with no material transaction costs.

Real estate also receives tax benefits from capital gain exclusions on primary homes to rental depreciation on investment real estate; however, this is somewhat offset by holding property tax costs, which stocks do not incur.

Converting a Primary Residence to an Investment Property

When moving on to a new house, some individuals decide to convert their original home into a rental property that becomes an income source.

You can convert your primary residence into a rental property by making a few smart moves. You start by determining your property’s tax basis to calculate depreciation during the rental period. When you eventually sell, this will factor into gain/loss calculations. The conversion date varies in your favor based on whether there was a gain or a loss.

Once you’ve converted your primary residence into a rental property, you must adhere to landlords’ tax rules, but with that, you will gain a number of favorable benefits. You can deduct real estate taxes and mortgage interest on a rental property, and you do not have to pay self-employment tax on landlord income. You can write off your operating expenses, such as maintenance and repairs, association fees, utilities, and lawn care. You can also depreciate the cost of the property over 27.5 years, even if the value increases. This depreciation can offset a significant portion of your rental property income, which translates to very low taxes on this income stream. You may run into issues if you have a tax loss, but you should be able to offset this over time with increasing rents. When you sell the investment property, you can use a 1031 exchange and defer taxes if you “swap” the property with another investment property of like kind and equal or greater value.

It is also important to carefully weigh the costs of being a landlord. To start, rent must cover all carrying costs, as you certainly do not want an asset to cost you money. Also, you need to make an allowance for unexpected periods where you may not have a tenant and would have to float the carrying costs out of pocket. A mistake you often hear of is an investor who over-leveraged and owned ten houses, then had to sell them all at a loss in a downturn.

Perhaps more importantly, you should never ignore the qualitative question of whether or not you want to be a landlord. It can be time-consuming and even take an emotional toll on you as you worry about the property or your tenants. Not everyone wants to deal with late rent payments, requests to fix bathrooms and leaky ceilings, or property damage caused by untrustworthy tenants.

In this four-part series, we covered answers to many of the questions that come up when our tech founder clients consider a real estate purchase.

In Part 1, we offered founders a framework to decide whether renting or buying is the right choice. Part 2 explored how a home purchase could potentially fit into your overall financial plan. Part 3 of the series discussed real estate financing options, taking into account the entire process, including risk, taxes, cost savings, profit, and legalities. And in Part 4, we dove into the topic of real estate as a financial asset, examining common misconceptions and opportunities.

This concludes the series. We hope you’ll find this information helpful as you think through your decisions related to real estate and navigate your next steps.

This article is Part 4 of the Guide to Real Estate series. Click here to read Part 1, Part 2, or Part 3.The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Buying Real Estate: A Personal Financial Venture for Founders

April 1, 2021 by eric

Tech Founder’s Guide to Real Estate

Part 3: Buying Real Estate: A Personal Financial Venture for Founders

This article was originally published on FORBES.COM on February 17, 2021. Written by Peyton Carr.

 

Buying real estate as a founder is a serious undertaking — a venture on its own, not entirely unlike your entrepreneurial endeavors. You will likely want to finance your home with a mortgage, so it is important to know your options and understand the process to properly assess your risks, make sure you have your legal house in order, and position yourself for profit, tax savings, and cost savings opportunities.

Financing Your Home

If you’ve come into a big windfall, you could buy your house in cash. But many people choose to finance their home even if they have the money in the bank.

As you are building wealth, it can make sense to keep more of your portfolio invested in the stock market or more liquid investments in case you need it for other purposes. This also allows you to invest and target long-term equity-like returns while borrowing at lower fixed interest rates.

The alternative is to purchase with cash, which can save you in financing costs and make your offer more attractive to sellers, but it leaves you with less liquidity and entails opportunity costs. So think carefully about how to proceed. In a competitive real estate deal, a good backup solution is to have a line of credit that you can access to quickly close in cash, then refinance the property after closing.

Applying for a Mortgage

As an entrepreneur, qualifying for a mortgage presents unique challenges. Even though you have a higher earning potential than most employees, fluctuating income from year to year appears more unstable to banks. You may be taking a below-market salary in exchange for equity ownership; however, most banks will look to income when qualifying you for a mortgage.

If you plan to purchase and finance a home soon, it would be wise to set yourself up to look more favorable from a bank’s perspective. You’ll want to show a stable income, clean business records, and strong personal credit over the last two years of your finances. That said, money trumps most other factors, so if you have a sizable down payment and cash reserves, you will have a far easier time getting qualified.

Start by getting pre-qualified, which gives you an idea of the loan size you will likely get approved for. To get an initial idea of your overall budget, consult a mortgage calculator. The next step is pre-approval, which is the bank’s conditional commitment to grant the mortgage to you.

Types of Mortgages

Many different types of mortgage loans exist. The most common type of conventional loan is a fixed-rate loan. You will make the same monthly payment, with the same interest rate, for the loan’s life. An adjustable-rate mortgage (ARM) typically has a lower interest rate than a fixed-rate loan for the first five to ten years, and then the rate changes based on an index and may go up over time.

Generally speaking, adjustable-rate mortgages are best for people who plan to be short-term homeowners, expect to see a notable increase in income within the next few years, or plan to pay off the loan quickly. Fixed-rate loans tend to be better for people who want certainty in their mortgage payments and plan to hold the property long-term.

Be sure to shop around for the best mortgage rather than sticking with your home bank; doing so can save you a significant amount of money.

Qualifying for a Mortgage

Mortgage loan underwriting is the process your lender uses to assess the risk of lending you money. The underwriter uses a set of criteria to approve or deny your mortgage.

If you fail to meet standard underwriting criteria, you have other options, such as asset depletion underwriting, which allows you to use your liquid assets to qualify. This is a good option for individuals with a decent amount of funds in the bank or investment accounts.

Tax and Cost Savings Opportunities

Many of the top tech hubs are also the most expensive places to own real estate. However, the tax benefits of owning real estate are often touted as some of the biggest advantages of buying versus renting.

The mortgage interest deduction is a tax deduction for the interest paid on the first $750,000 of your mortgage debt, which may reduce your taxable income and cut your tax bill by the amount you’ve paid in mortgage interest throughout the year.

There are also tax benefit opportunities upon selling your home. If you have a capital gain on the sale of your home and you satisfy certain criteria, you may be able to qualify for the Section 121 exclusion which allows you to exclude some gains from taxes when selling your home.

Risk Mitigation and Home Insurance

Homeownership comes with insurance and mitigation costs. Go into any deal with eyes wide open, knowing what it could really cost.

As your home is exposed to the elements, this will call for additional costs to mitigate risks such as shoring up the structure with the right roof, shutters, and other materials. You should know whether the home exists in a catastrophic (CAT) area — a location susceptible to floods, wildfires, earthquakes, or hurricanes.

Ownership Titling

Another factor to consider is how you will hold the title of the home. The way you hold title to real estate is how ownership is conveyed and transferred upon a property’s purchase or sale.

There are five main types of ownership titling — joint tenancy, tenancy in common, tenants by entirety, sole ownership, community property, and corporate or trust ownership — and each method has pros and cons from the perspective of tax, control, and asset protection.

The Bottom Line

A lot of work goes into becoming a homeowner and upholding the responsibilities that come with it, but in most cases, it’s well worth it.

This article is Part 3 of the Guide to Real Estate series. Click here to read Part 1 or Part 2.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

How Does a House or Condo Fit Into Your Financial Plan as a Founder?

March 1, 2021 by eric

Tech Founder’s Guide to Real Estate

Part 2: How Does a House or Condo Fit Into Your Financial Plan as a Founder?

This article was originally published on FORBES.COM on January 27, 2021. Written by Peyton Carr.

If you are considering buying a house or condo, there is a lot to consider. It’s about far more than finding a nice place to call home. A home is an investment — a major asset to add to your portfolio. So it’s important to explore how your home purchase will fit into your overall financial plan.

Financial and Investment Planning

Buying a home impacts your personal finances in significant ways, so it’s important to evaluate a home purchase from a financial planning perspective. While plans change, you’ll need to be of the mindset that this investment may require a five to ten-year commitment or more.

Transaction costs alone mean it could take years to break even on the purchase. Upfront expenses can add up quickly, such as your down payment, mansion tax (for New Yorkers), other taxes, legal fees, amongst others. In general, it takes homebuyers around five years to recoup this investment. (ref)

As a homeowner, you are tying up your personal cash flow in ways that renters don’t have to consider. You will be committing to a long-term mortgage. Maintenance and upkeep are sure to cut into your monthly budget, and you will need to keep emergency cash reserves to pay for repairs.

You will feel wealthier if you are not using the maximum mortgage you qualify for. Taking on a smaller mortgage gives you more cash flow, which offers more flexibility and freedom. The term “house rich” and “cash poor” comes from people who need to cut back on everyday expenses and travels in order to support their mortgage payments.

You also have to factor in that your home purchase might turn out to be a poor investment. The house could be an unexpected money pit with undisclosed problems. You may inadvertently buy at the height of the market. Neighborhood values could drop. Your income could decrease due to an unexpected rough patch in your business.

From a financial planning perspective, you need a strategy for managing various possibilities should the investment or life go awry. A general rule is to build in a healthy margin of safety. This can take the form of being conservative on your estimates of homeownership costs, taking less mortgage than your max qualification, not depending on the bonus portion of your income, and more.

Is Now a Good Time to Buy?

Whether the economy is up, down, or volatile, much of the trepidation about real estate has to do with timing. Nobody wants to get in at the wrong time or get caught in a real estate bubble. And of course, they want to know if real estate will go on sale.

Trying to time the real estate market may not matter in some cases. If you have the excess capital, your career and family size are relatively stable, and you know where you want to live for the next 5+ years, then there is a bias to purchase a home in most cases.

If, for example, you are renting a home for $6k/month, you would be spending close to $72k/yr in rent. Over five years, that would amount to $360k in rent expense. If you bought a $1.5mn home, even with a market downturn of 10-15%, you would still be breaking even. Anything better than that and you are coming out ahead.

While you can never time the market precisely, look carefully at the history of real estate performance for clues. In San Francisco, the tech bubble burst of 2000 saw values drop by 10%, and the financial crisis of 2008 triggered more than double those losses in some areas. However, historically, a full recovery has come within five to seven years in most cases. (ref) In New York City, the dot-com bubble stopped a real estate upswing, and the financial crisis saw prices in Manhattan drop by 12%, while boom years show steady and sustained increases. (ref)

While this data can’t predict the future, it does show you that riding out a real estate downmarket can take years. Go in prepared to own the home for at least seven years in case there is an unexpected real estate downturn in the near future.

Understanding the real estate market cycle can help you gauge where you sit in the cycle and utilize appropriate smart strategies. During the expansion phase, where growth happens, you may want to get in early and ride the wave. When the market starts to stabilize during equilibrium, it may be a good time to sell, particularly if your home has increased in value. When the market is in decline, this could be a good time to buy a property at a discount. During the absorption phase, when prices stop falling, you can take advantage of good deals in solid neighborhoods. (ref)

Looking carefully into exactly where to buy also makes a difference. Hot “up and coming” neighborhoods may fizzle out during a bust or be slower to recover on the other end, whereas established, central neighborhoods may be affected to a lesser degree and rebound more quickly. Established suburban neighborhoods with aging demographics can be vulnerable to market corrections as well, while strong school districts tend to be more resilient. In short, ask around and get a true feel for where you are buying before committing. Though identifying the right neighborhoods is more challenging to pin down than it was in the past, the importance of “location, location, location” continues to ring true.

We always recommend partnering with a financial advisor that can help create a plan that includes your house, your portfolio, and your other financial needs. Managing your finances is an art of balancing a portfolio against short and long-term goals while accounting for uncertainty and risk. A comprehensive approach can be beneficial, offering a clearer picture of whether buying or renting is right for you.

This article is Part 2 of the Guide to Real Estate series. Read Part 1 or Part 3.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Rent vs Buy Real Estate: How to Decide Which is Right for You

February 6, 2021 by eric

Tech Founder’s Guide to Real Estate

Part 1: Rent vs Buy Real Estate: How to Decide Which is Right for You

This article was originally published on FORBES.COM on January 6, 2021. Written by Peyton Carr.

When speaking with my clients about financial planning, real estate always comes up early in the conversation. Should I upgrade to a larger house? Should I get more land? Should I leave New York? Is San Francisco too expensive?

This four-part series answers the questions you may have, addresses common myths and concerns, provides critical insights about challenges and opportunities in real estate, and uncomplicates the process. I’ll walk you through a framework to think about how to evaluate a home purchase from a financial planning perspective, the nuts and bolts of the homebuying process, and ways to leverage real estate as an asset.

The company founders I advise are often coming into significant wealth, sometimes for the first time in their life. Suddenly, they can afford a house or condo — a big one, maybe even the home of their dreams. Past generations would’ve jumped all over this opportunity in a heartbeat. Dumping your first hard-earned windfall into your first home was just something previous generations did, without questioning it.

But is buying real estate still a smart move to make? And where should I buy if so?

The answer depends on a number of factors and is something you should not take lightly.

Rent vs. Buy

The decision to rent or buy is one that’s rife with both emotional and practical considerations. On the one hand, most of us have been raised to believe that owning a home of your own is a measure of financial success. It comes part and parcel with achieving the American Dream. So even the most independent thinkers among us are susceptible to the traditional pull of ownership.

On the other hand, the analytical thinking that got you this far in your career knows better than to give in to the conventional wisdom of property ownership. You know that alternatives exist for building wealth. Maybe you’ve noticed some of your peers forgo the real estate route and wonder if there might be something to this trend. Are they simply taking a cavalier YOLO approach, bucking the traditional path of ownership in fear of settling down? Or do they know something you don’t about the risks of getting into real estate?

Perhaps it’s a little of each. If your career is stable and family size won’t change much, buying in a particular locale can be a better choice than renting. However, tying yourself to one place by buying into a particular market can be a hindrance if you want to retain the option to easily move for a different opportunity or if you may need a larger home for a bigger family in the coming years. What if you can’t sell the property or you’re in a down market and lose money on the property? This would be the risk you take.

When you rent, you’re free to go where you please — worst-case scenario, you’re out of pocket for a few month’s rent to break your lease. If your family grows, you can move down the hallway for an extra bedroom. If the neighborhood loses its appeal, you can move across town next year without taking a big hit. Plus, you don’t have to worry about maintenance or upkeep.

Maybe you consider yourself a maverick or disruptor, and that part of your personality is urging you to buck tradition and avoid any anchors at all costs. I say honor who you are, but not at the cost of waking up five to ten years from now having burned through $500k-$1mn on rent that could’ve been directed at building your equity in a home, all because you bought into the idea that homeownership is old school. Buying real estate might not be the right choice for you right now, but go into the decision with the right data and facts.

Ownership comes with other costs and risks that I will address in the next article in this four-part series, but renting also comes with its fair share of drawbacks. Most significantly, rent tends always to increase, and it can increase dramatically in hot markets, whereas mortgage payments can be fixed. And to a certain extent, the old adage is true — when you rent, you’re making your landlord rich — at least relatively speaking. Instead of depositing funds into an asset, you are giving money away that you will never see again.

Use an online ‘rent versus buy’ calculator to help determine where you get the most value depending on your situation.

Deciding whether to rent or buy is not an easy decision; you can lose or gain either way. Before moving forward, think through your 5-10 year plan and do your due diligence.

The next article in this series will dive into the dynamics of the real estate market, break down the costs, benefits, and risks associated with homeownership in the context of your overall financial plan, explore the ins and outs of real estate financing, and clarify how to incisively navigate the process of buying and holding property.

The Bottom Line

Real estate can be an asset or a liability; it comes with considerable pros and cons as well as tremendous costs and benefits.

As a founder, your ultimate goal considering a real estate purchase is to make a well-informed decision based on quantitative data while factoring in qualitative measures. Knowing what you have to gain or lose makes all the difference, and doing your due diligence will ensure you are making a sound decision.

This article is Part 1 of the Guide to Real Estate series. Read Part 2.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

What You Need to Know About Selling Your Company Stock

July 31, 2020 by eric

What You Need to Know About Selling Your Company Stock

Part 3: The Founder’s Guide to Managing Your IPO Stock

This article was originally published on TECHCRUNCH.COM on July 22, 2020. Written By: Peyton Carr

In a recent article, I covered all of the reasons you might be tempted to hold a highly-concentrated position in your company stock as a tech founder and how it fits into your portfolio. I then followed up with a rundown on why resisting diversification is generally a bad idea and the subconscious biases that hold us back from selling.

So now that you understand the benefits of diversification and have taken inventory of your portfolio, what is the most effective way for you to move forward? I will share with you what to keep in mind before selling, how to decide when to sell, and strategies to execute sales such as options, exchange funds, prepaid variable forward contracts, qualified small business stock, and tax considerations. Now, let’s take a deep dive into strategic approaches to take as a shareholder and important tax implications to consider.

Keep in Mind: Lockups and Blackout Periods

Most tech companies that IPO have a 180-day lockup period that prevents insiders, employees, and VC funds from selling immediately. There is usually language that also prohibits hedging with derivatives (options) during that period. Lockups are intended to help prevent insider trading and provide the company with additional post-IPO price stability.

It is also important to abide by the company’s blackout periods, which prohibit transactions during more share-price-sensitive times, such as earnings or material non-public information releases.

Concentrated Stock Strategies

Ad-hoc Selling – This is the most straightforward and involves the outright sale of your shares. However, this can be difficult for various reasons such as selling restrictions, the perception by others that you are unloading stock, and many psychological biases that act as internal mental obstacles.

Scheduled Selling – Selling all your stock at once could be both emotionally challenging and tax-inefficient. Scheduled selling involves the selling of a set number of shares over a specific period. This selling strategy can help by spreading the tax impact over a few years. It also provides an advantage from a psychological standpoint since the plan is determined upfront, then mechanically executed.

As an example, a founder might plan to sell 500,000 shares over 18 months. The founder is comfortable selling quarterly, which equals six selling periods of 83,333 shares per quarter. In a scenario where a founder is subject to blackout periods, a 10b5-1 trading plan can be implemented and set on autopilot. The company may even allow you to sell your shares during blackout periods with a 10b5-1 trading plan. See the example of scheduled selling below.

graphic

Hedging with Options – Multiple hedging strategies can be implemented to protect your downside; however, some of the more common approaches used are the protective put and the protective collar. Below are basic examples of how these strategies are executed, for illustrative purposes.

graphic

Protective Put– Buying protection against the downside
Collar – Give up some upside, to limit some downside

Each strategy allows the owner to continue holding the stock while providing some downside protection against a stock’s decline. However, these strategies are not tax-efficient and are complicated, so working with an expert is essential. Both puts and certain types of collars would have been extremely expensive to implement during the recent market crisis because market volatility is a factor in options prices. See the below chart of the VIX (volatility index) during peak crisis. However, in some instances, these strategies can make sense.

graphic

Exchange Funds –This strategy allows an investor to contribute their concentrated stock position into an exchange fund partnership alongside other investors who also contribute their stock positions. In return, each investor receives a diversified stock portfolio, selected by an investment manager. This strategy allows the investor to achieve immediate diversification while deferring the taxes that they would have otherwise paid in most situations.

At the end, usually seven or more years out, each investor receives a basket of stocks. They pay zero tax if they hold the stocks forever, but if you sell, your aggregate cost basis is equal to the cost basis of the original shares contributed. Some downsides of using exchange funds to consider are lockups, expenses, and sometimes not achieving the desired level of diversification. Below I detail some high-level positives and considerations.

graphic

Prepaid Variable Forward Contract – This strategy enables a shareholder to synthetically diversify their equity exposure by entering into an agreement (contract) with a bank or brokerage firm to receive a loan now, and sell their stock at a future date. The reason it is ‘variable’ is because the amount of stock the shareholder delivers in the future depends on share value upon expiration. The shareholder can also decide in the future to cash-settle (deliver cash) instead of delivering (selling) stock.

This strategy is essentially a combination of a type of equity collar, described in the options section above, and a loan. Because this is an option, pricing varies based on market conditions and the stock involved. If structured correctly, the shareholder does not pay tax until the future sale date.

Fun fact is, recently, it was disclosed in an SEC filing that Vince McMahon had entered one of these covering approximately 3.5 million shares, or $80 million of WWE stock. Many perceived this as him effectively selling about 15% of his shares and questioned whether he was ready to “tap out” for good.

Below is a hypothetical example of a prepaid variable forward.

graphic

When Should You Sell IPO Stock?

Based on an analysis of 258 IPOs, it is usually the most beneficial for shareholders to sell their stock as soon as possible after the lockup period expires. If you look at the performance of holding IPO stocks for the long term versus selling immediately and diversifying, the results may surprise you.

graphic

This chart shows a sample of 258 IPOs from 1990 to 2012, and the four years following their lockup expiration. The data illustrates that the median tech IPO underperforms the S&P 500 index by around 20% after the first year following lockup expiration. Even the best IPOs that fall into the top quartile, still barely keep up with the S&P 500. You must be very confident that your company is an exception to this.

These findings are also consistent with the underperformance of IPO stocks relative to the S&P 500, as reported by Professor Jay Ritter, an academic authority on IPOs. If you’d like to dig deeper like I do, you can download his full data set here.

Consider Taxes Before You Sell

When deciding to sell, it’s important to consider taxes. We realize that concentrated stock often comes with a very low cost basis, which can be another obstacle for investors to overcome before selling.

How you own your stock and how long you have owned it will ultimately determine how you are taxed. Below is a chart showing the different types of taxation on various forms of equity compensation.

graphic

Two important things to consider are whether you will be taxed at long-term or short-term capital gains rates and whether you qualify for the qualified small business stock (QSBS) exclusion. Your income will impact the rates at which you are taxed. Please consult with your advisor before making any decisions.

Generally, we suggest making investment decisions and then optimizing for tax. I always tell my clients not to let the tax tail wag the investment dog. However, there are scenarios where it can make sense to hold your stock for slightly longer to minimize taxes owed.

For example, short-term capital gains (holding period < 1 year) can be far more expensive than paying taxes on a long-term capital gain (holding period > 1 year).

Let’s say you own $1 million of XYZ, a $100 stock, with one month to go before it qualifies for long-term capital gains treatment. In the example below, if the stock maintains the same price for the next month, you can net 27% more in after-tax profits; you get to keep an extra $170,000. Even if the stock price drops 21%, you would still net the same profits as if you had sold it at the previous higher price but subject to the higher short-term capital gains rate. See the example below.

graphic

Careful planning is required, as IPOs can have very volatile share prices. If XYZ sells off significantly over the next month, it is possible you can be in a far worse scenario than having just sold it outright and paying the short-term capital gains. Nobody has a crystal ball, but understanding the tradeoffs is helpful in the decision-making process.

graphic

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Qualified Small Business Stock (QSBS)

If your shares qualify for the QSBS exclusion, you could potentially sidestep up to 100% of your capital gains taxes upon sale. That is not a typo, this is arguably one of the most significant tax opportunities out there. If you are a founder or early employee and you have held your shares for over five years, this is something you should look into.

You can reference the table below to determine the QSBS qualification holding period for different types of equity. This is one of the most valuable and significant tax incentives for founders and early employees, but not everyone will qualify.

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Some further clarification on determining whether or not your shares qualify is below. For a more in-depth discussion on QSBS, you can reference the guide I wrote.

  1. Your company is a Domestic C Corporation.
  2. Stock is acquired directly from the company.
  3. Stock has been held for over five years.
  4. Stock was issued after August 10th, 1993, and ideally, after September 27th, 2010, for a full 100% exclusion.
  5. Aggregate gross assets of the company must have been $50 million or less when the stock was acquired.
  6. The business must be active, with 80% of its assets being used to run the business. It cannot be an investment entity.
  7. The business cannot be an excluded business type such as, but not limited to: finance, professional services, mining/natural resources, hotels/restaurants, farming, or any other business where the business reputation is a skill of one or more of the employees.

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Deciding whether or not to sell your company stock or when to sell it, is not a decision to enter into lightly. Rather than simply cashing in your stock for a quick payday or holding it in a highly concentrated position, dreaming of a potentially huge payday in the future, I encourage you to look deeper — at your big-picture financial goals, your overall investment portfolio, details and strategies specific to employee shareholders, and important tax implications. A rational, evidence-based approach will produce the best path forward.

Want to learn how to handle your stake in company stock with a sharp focus on achieving your personal financial goals? Download our In-Depth Guide, The Founder’s Guide to Managing Your IPO Stock.

Information in this article does not constitute personalized financial or legal advice. The contents of this article are for informational purposes only and should not be relied upon without specific professional legal or financial advice.

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Will you help me solve any and all financial problems I may encounter?

Yes, and it’s likely we’ve helped others solve similar problems as well such as business sales, QSBS, tax minimization, estate, 401(k) plans, IRS audits, family deaths, disability, real estate, debt, social security, Medicare, health insurance, college, gifting, and most other financial issues.

What types of clients do you specialize in?

We work specifically with tech founders.

What services do you provide?

A relationship with Keystone involves comprehensive financial planning around retirement, insurance, estate planning, tax planning, and investment management.

How do you help clients implement their financial plans?

We firmly believe that even the best financial plan is of little value until it’s implemented. To help you achieve your goals without feeling stressed or overwhelmed by the noise along the way, we will work together to make the necessary decisions then we take care of the execution.

Are your recommendations truly in my best interest?

As an SEC Registered Investment Advisory firm, we are held to a fiduciary standard, which legally requires us to do what is in our clients’ best interests. This differs drastically from some of our competitors who are only held to the “suitability standard,” meaning that our competitors can make recommendations that are suitable but may not be in the clients’ best interests. Our commitment to an honest and ethical culture has allowed us to build deep, trusted relationships with our clients.

What are all the different ways you get paid?

We are only paid via one management fee. We believe this allows us to have an unbiased framework to select the best investments for you and to give you advice tailored to your needs, not ours. We believe compensation drives behavior, and the way someone is paid influences the work they do. Many financial firms have complex fee arrangements; we do not.

Why would I choose you as my advisor and not do it myself?

There’s certainly a possibility that if you put enough focus and energy into it, you could do it all yourself. But like everyone else, your time is limited and most people prefer to focus on family or business. We’re here to free up your time while leveraging our wealth of experience in addressing concerns, presenting solutions, and working toward your financial goals.

What are the benefits of working with an independent advisor compared to a bank or large advisory firm?

Our independent and conflict-free approach allows us to find the best solutions for our clients. This gives you the advantage since larger firms might be compelled to make specific recommendations, sell proprietary products, or may be restricted in the advice and services they offer. We offer guidance customized to your needs and goals which is a personalized level of service, care, and attention larger firms just can’t provide.

Do you use proprietary funds?

At Keystone, we do not use proprietary products. We do not receive commissions or backend fees from any third parties. We do not earn compensation for recommending one fund vs. another. We believe this allows us to have the most unbiased framework to select the best investments for you and to provide advice tailored to your needs, not ours.

Where do you keep my money and how can I see it?

For your convenience and safety, we use Charles Schwab as the custodian for the majority of our client assets. Schwab administers more than $7 trillion dollars and we selected them to care for yours as well based on a variety of criteria including safety of assets, financial strength, and ease of use. As custodian, Schwab holds your funds and provides direct reporting to you. Your funds will be held in accounts under your name and can be viewed anytime online at Schwab.

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Email: contact@keystonegp.com

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