Startups

With a Section 1045 Rollover, Founders Can Salvage QSBS Before 5 Years

November 15, 2021 by crystal

This article was originally published on November 8, 2021 on TechCrunch.com. Written by Peyton Carr.

The tax code contains many provisions that encourage investments in the technology startup ecosystem and small businesses. A powerful one is qualified small business stock (QSBS) or Section 1202 stock, which offers the opportunity to eliminate capital gains tax completely if certain requirements are met.

You can learn more about those requirements here, one being that stockholders must meet a five-year holding period. However, not everyone can time when to sell their company. The fact that many acquisitions happen prior to five years leaves some founders and angel investors short of qualifying for powerful tax savings.

In comes Section 1045.

What is Section 1045?

Section 1045 allows a founder or stockholder whose company has been sold prior to the five-year holding period to defer the capital gain by rolling the sale proceeds into a replacement QSBS. It also acts on a standalone basis, deferring gain on the initial sale of the original qualified small business stock.

Benefits and Opportunities

A 1045 rollover means founders, entrepreneurs, tech executives, and angel investors get to take advantage of multiple tax benefits and opportunities they would otherwise miss.

Extended Tax Deferral

With a 1045 rollover, the stockholder can defer taxes on the sale of the original QSBS. Under the right circumstances, tax can be deferred until the replacement QSBS is sold.

If the combined holding period is five years and other requirements (discussed below) are met then no federal capital gains taxes are due. But if the requirements are not met, then taxes will be due on the sale of the replacement QSBS.

This is even more impactful given President Biden’s tax plan, which does not intend to make any changes to the 1045 exclusion.

Shortened Holding Period

Typically, the holding period for all taxable exchanges will begin the day after the exchange. However, the holding period for the replacement QSBS includes the holding period of the original QSBS, allowing for the clock to continue ticking. This means a 1045 rollover, in turn, shortens the next QSBS holding period requirement.

QSBS Exclusion Stacking

Stockholders have the opportunity to multiply—or “stack”—the benefit of a 1045 rollover by spreading the QSBS exclusion to more than one new investment. This is accomplished by rolling the sale proceeds from one QSBS into multiple replacement QSBS companies, gaining the benefit each time.

Specifically, Section 1045 allows for a $10 million exclusion per company. By rolling proceeds into more than one company, the seller qualifies for the $10mn exclusion multiple times over, stacking the benefit in their favor.

Section 1045 Rollover Requirements

To qualify for the tax-deferred rollover of QSBS gain into a replacement QSBS under Section 1045, certain requirements need to be satisfied. Fundamentally, the original company must qualify for QSBS, and the new company must meet the requirements of QSBS both at the time of rollover and after the rollover is complete. In addition to that, you’ll need to pay close attention to timelines and other key qualifying measures.

Section 1045 Rollover Timeline

When it comes to meeting the 1045 rollover requirements, timing is key.

It’s important to note that the Section 1045 election is made on the tax return for the year in which the initial qualified business stock is sold—not when it’s rolled over into a new investment—even if the process extends into the following year. But you can’t delay for long. You only have 60 days from the date of sale of the original QSBS to roll the gain into a new QSBS investment.

Further, not only must the original qualified small business stock be owned for more than six months prior to the sale, but the replacement QSBS must also meet requirements for at least six months to qualify for the deferral on the original QSBS sale. To avoid missteps, you’ll need to pay attention to the calendar.

The 100 Percent Rule

In order to defer 100 percent of the tax, you must roll 100 percent of sale proceeds into the new QSBS. Just rolling the gain isn’t an option.

So if you want to realize the full benefit, you have to be willing to go all-in with the new investment. If you roll less than 100 percent of the proceeds, you only defer a pro-rata portion of the gain.

Section 1045 rollover requirements might seem restrictive. But by diving deeper, you’ll see that what could’ve been a heavy tax burden now opens you up to a whole new world of potential opportunities.

Section 1045 QSBS Strategies for Startup Founders

Now that you know more about Section 1045, you might be wondering if this is something that would be beneficial for you to leverage. It depends on your circumstances, big-picture financial plan, timing considerations, and your willingness to implement advanced tax and business investment strategies.

Below we highlight the most relevant Section 1045 strategies for founders, entrepreneurs, tech executives, and angel investors.

Invest in QSBS Startups

As someone involved in your own startup, the natural next step could be to invest in other QSBS startups. After all, you’re already familiar with the scene, current trends, and have your finger on the pulse of where technology is headed. You’re clearly positioned to use the valuable insights you’ve gained to your advantage.

So if you have a desire to invest in QSBS startups, you’ll need to know how to proceed.

At the most basic level, you’re simply rolling your sale proceeds into buying stock in one or multiple QSBS startup companies.

For example, let’s say you’ve been running your startup for three years, the stock has taken off, and your company is being acquired. Congratulations! The original QSBS was $5 million, but you’ve made significant gains that could be swallowed by a huge tax bill. So you decide to do a 1045 exchange and reinvest into multiple new QSBS eligible startups. By stacking the benefit— with $10 million in exclusions for each company—you’ll see tax savings on your proceeds for a total exclusion of $30 million.

Tip: If you already have investments lined up, this could be a good strategy. But don’t rush to invest just to meet the 1045 rollover requirements. We always tell our clients not to let the tax tail wag the investment dog.

Acquire One or More QSBS Companies

If your startup or the one you invested in early is being acquired, you’ve proven yourself and are likely feeling confident. Maybe you don’t just want to invest in a new venture but you’d like to acquire a controlling stake in a company or multiple companies yourself.

If you are going to use your 1045 rollover to acquire one or more QSBS companies, you’ll need to implement the strategy within 60 days. However, the strategy does allow more time to actually find and make your acquisition. Here’s how.

A newly formed C-corp must be created, and you would need to roll the proceeds of the original QSBS into the new company. This newly formed C-corp can then acquire a new QSBS eligible company.

Keep in mind that in order for QSBS to apply—however long it takes this newly formed “acquisition” C-corp to find a target—the total holding period of the actively engaged new company must be at least 80 percent of the holding time period, including the search timeframe.

For example, let’s say it takes eight months to acquire a company. To meet the 80 percent requirement, the holding period of the actively running QSBS company must be 32 months.

Tip: It’s possible to leverage multiple C-corp entities for diversification and stack the QSBS to claim multiple $10 million exclusions or 10 times basis exclusions, as mentioned above.

Start a New QSBS Company

You don’t have to take your proceeds and invest them into someone else’s big idea. With your experience and track record, maybe it’s time to make a move on your next big idea. For founders looking to jump right into another venture soon after an exit, this self-funding, serial entrepreneur strategy could be the ticket.

Keep in mind, you’ll need to tack on the holding period, get a new $10 million exemption, and defer the gain. And remember the 100 percent rule: If you only roll part of your sale proceeds, you only get to defer a pro-rata portion of the tax. Are you ready to go all-in?

To implement this strategy, you’ll need to form a new C-corp to start a new QSBS company and roll your sale proceeds into the company.

Tip: This strategy can also serve as a layer of protection for you. If the business fails, you have the option to wind down the company and possibly qualify for QSBS to exclude the original gain for any funds returned.

Conclusion

It may come as a surprise that the tax code is written in your favor, but the idea is to encourage business growth, innovation, and entrepreneurship. You’re playing a vital role in the economy. So if you’re worried about taxes eating up the proceeds of your buyout and hard-earned gains, think again. You have a variety of options to stay in the game, fund your fellow founders, or step back and use the insights you’ve acquired to put your money to work for you.

Before implementing any of these strategies, be sure to work closely with counsel to review all of your financials and ensure you are protecting your interests.

The information and opinions provided in this material are for general informational purposes only and should not be considered as tax, financial, investment, or legal advice. The information is not intended to replace professional advice from qualified professionals in your jurisdiction.

Tax laws and regulations are complex and subject to change, and their application can vary widely based on the specific facts and circumstances involved. Any tax information or advice in this article is not intended to be, and should not be, used as a substitute for specific tax advice from a qualified tax professional.

Investment advice in this article is based on the general principles of finance and investing and may not be suitable for all individuals or circumstances. Investments can go up or down in value, and there is always the potential of losing money when you invest. Before making any investment decisions, you should consult with a qualified financial professional who is familiar with your individual financial situation, objectives, and risk tolerance.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

Your company is a Domestic C Corporation.
Stock is acquired directly from the company.
Stock has been held for over five years.
Stock was issued after August 10th, 1993, and ideally, after September 27th, 2010, for a full 100% exclusion.
Aggregate gross assets of the company must have been $50 million or less when the stock was acquired.
The business must be active, with 80% of its assets being used to run the business. It cannot be an investment entity.
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.

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.

Is Your Net Worth Too Closely Tied to Your Company’s Success?

July 29, 2020 by eric

What You Need to Know About Selling Your Company Stock

Part 2: The Founder’s Guide to Managing Your IPO Stock

This article was originally published on TECHCRUNCH.COM on July 21, 2020. Written By: Peyton Carr

Now that I’ve offered an overview to help you think through where concentrated stock sits in your overall plan let’s take a closer look at why selling can be challenging for some.

In the following section, I reveal the facts of the concentrated stock “get rich” myths that reside in the minds of many first-time concentrated stock owners, and I show why it is prudent to consider greater diversification.

Keep reading to learn more about the benefits of diversification, discover how much company stock is likely too much to hold, and the options you have when it comes to diversifying strategically.

Dangers of Concentration

There are several hard facts to keep in mind in contemplating maintaining a concentrated position:

It’s stating the obvious, but not all stocks are AAPL or AMZN. Hendrik Bessembinder published research that found the best performing 4% of listed companies explained the returns for the entire US stock market since 1926. The remaining 96% of stocks collectively matched the performance of US Treasury bills.
Since 1926, 58% of stocks have failed to beat one-month Treasury bills over their lifetimes. Forty percent of all Russell 3000 (an index of the 3000 largest publicly-traded companies in the US) have lost at least 70% of their value from their peak since 1980.
Despite all this, broad-based equities have returned 9%+ a year, beating most other asset classes, ultimately due to the top 4% of stocks. Although there is no guarantee anyone can single out any of the top 4% going forward, diversification will guarantee you will own the top 4%.
Even if the concentrated stock you own will be another AAPL/AMZN, both stocks have experienced declines of 90%+ at some point throughout their lifetimes. Most investors would not be able to have conviction and stay invested, especially if that concentrated stock was driving the majority of their portfolio returns and net worth.

Sometimes catastrophic declines are a function of the industry or existential threats that have little to do with the company itself. Other times, it has everything to do with the company and nothing to do with external factors.

The odds of any new IPO being among the top 4% is just slightly better than hitting your lucky number on the roulette wheel. But is your investment portfolio success and the odds of achieving your long term financial goals something you want to spin the wheel on?

Benefits of Diversification

Excess volatility can harm returns. Note the example below that shows the comparison between a low-volatility diversified portfolio vs. a high-volatility concentrated portfolio. Despite the same simple average return, the low-volatility portfolio below materially outperforms the high-volatility portfolio.

Beyond the math, unexpected spikes in volatility can cause significant price declines. Volatility increases the chances that an investor reacts emotionally and makes a poor investment decision. I’ll cover the behavioral finance aspect of this later. Lowering your portfolio volatility can be as simple as increasing your portfolio diversification.

The Russell 3000, an index representing the 3,000 largest US publicly-traded companies, has lower volatility when compared against 95%+ of all single stocks. So, how much return do you give up for having lower volatility?

According to Northern Trust Research, the 5.96% annualized average return of the Russell 3000 is 0.73% more than the 5.23% return of the median stock. Additionally, owning the Russell 3000, rather than a single stock, eliminates the likelihood of catastrophic loss scenarios – more than 20% of shares averaged a loss of more than 10% per year over a 20-year time frame.

If this establishes that the avoidance of overly concentrated portfolios is important, how much stock is too much? And at what price should you sell?

How Much of Your Company’s Stock Is Too Much?

We consider any stock position or exposure greater than 10% of a portfolio to be a concentrated position. There is no hard number, but the appropriate level of concentration is dependent on several factors, such as your liquidity needs, overall portfolio value, the appetite for risk, and the longer-term financial plan. However, above 10% and the returns and volatility of that single position can begin to dominate the portfolio, exposing you to high degrees of portfolio volatility.

The company ‘stock’ in your portfolio often is only a fraction of your overall financial exposure to your company. Think about your other sources of possible exposure such as restricted stock, RSUs, options, employee stock purchase programs, 401k, other equity compensation plans, as well as your current and future salary stream tied to the company’s success. In most cases, the prudent path to achieving your financial goals involves a well-diversified portfolio.

What’s Stopping You?

Facts aside, maintaining a concentrated position in your company stock is far more tempting than taking a more measured approach. Token examples like Zuckerberg and Bezos tend to outshine the dull rationale of reality, and it’s hard to argue against the possibility of becoming fabulously wealthy by betting on yourself. In other words, your emotions can get the best of you.

But your goals—not your emotions—should be driving your investment strategy and decisions regarding your stock. Your investment portfolio and the company stock(s) within it should be used as tools to achieve those goals.

So first, we’ll take a deep dive into the behavioral psychology that influences our decision making.

Despite all the evidence, sometimes that little voice remains.

“I want to hold the stock.”

Why is it so hard to shake? This is a natural human tendency. I get it. We have a strong impetus to rationalize our biases and not believe we are vulnerable to being influenced by them.

Becoming attached to your company is common, since after all, that stock has made you, or has the potential of making you wealthy. More often than not, selling and diversifying is the tough, but more rational decision.

Numerous studies have furnished insights into the correlation between investing and psychology. Many unrecognized psychological barriers and behavioral biases can influence you to hold concentrated stock even when the data shows that you should not.

Understanding these biases can be helpful when deciding what to do with your stock. These behavioral biases are hard to spot and even harder to overcome. However, awareness is the first step. Here are a few more common behavioral biases, see if any apply to you:

Familiarity bias: Familiarity is likely why so many founders are willing to hold concentrated positions in their own company’s stock. It is easy to confuse the familiarity with your own company, with the safety in the stock. In the stock market, familiarity and safety are not always related. A great (safe) company sometimes can have a dangerously overvalued stock price, and terrible companies sometimes have terrifically undervalued stock prices. It’s not just about the quality of the company but the relationship between the quality of a company and its stock price that dictates whether a stock is likely to perform well in the future.

Another way this manifests is when a founder has less experience with stock market investing and has only owned their company stock. They may think the market has more risk than their company when in actuality, it is usually safer than holding just their individual position.

Overconfidence: Every investor is exhibiting overconfidence when they hold an overly concentrated position in an individual stock. Founders are likely to believe in their company; after all, it already achieved enough success to IPO. This confidence can be misplaced in the stock. Founders often are reluctant to sell their stock if it has been going up since they believe it will continue to go up. If the stock has sold off, the opposite is true, and they are convinced it will recover. Often, it is challenging for founders to be objective when they are so close to the company. They commonly believe that they have unique information and know the “true” value of the stock.

Anchoring: Some investors will anchor their beliefs to something they experienced in the past. If the price of the concentrated stock is down, investors may anchor their belief that the stock is worth its recent previous higher value and be unwilling to sell. This previous value of the stock is not an indicator of its real value. The real value is the current price where buyers and sellers exchange the stock while incorporating all presently available information.

Endowment effect: Many investors tend to place a higher value on an asset they currently own, than if they did not own it at all. It makes it harder to sell. An excellent way to check for the endowment effect is to ask yourself: “If I did not own these shares, would I purchase them today at this price?” If you are not willing to purchase the shares at this price today, it likely means you are only holding onto the shares because of the endowment effect.

A fun spin on this is to look into the IKEA effect study, which demonstrates that people assign more value to something that they made than it is potentially worth.

When framed this way, investors can make more intentional decisions on whether to continue holding concentrated stock or selling. At times, these biases are hard to spot, which is why having a second person, a co-pilot, or an advisor, is helpful.

Take Control

Congratulations to those of you with a concentrated stock position in your company; it is hard-earned and likely represents a material wealth. Understand, there is no “right” answer when it comes to managing concentrated stock. Each situation is unique, so it is essential to speak with a professional about options specific to your situation.

It starts with having a financial plan, complete with specific investment goals that you want to achieve. Once you have a clear picture of what you want to accomplish, you can look at the facts in a new light and gain a deeper appreciation for the dangers of holding a concentrated position in company stock versus the benefits of diversification, considering all of the implications and opportunities involved in rational decision-making and investment behavior.

What Are My Choices If I Want to Diversify?

Most individuals understand they can simply and directly sell their equity, but there are a variety of other strategies. Some of these opportunities may be far better at minimizing taxes or better at achieving the desired risk or return profile. Some might wonder what the best timing is to sell. I will cover these topics in the final article of the series.

How to Approach Your IPO Stock

June 28, 2020 by eric

What You Need to Know About Selling Your Company Stock

Part 1 of 3: The Founder’s Guide to Managing Your IPO Stock

This article was originally published on TECHCRUNCH.COM on July 20, 2019. Written By: Peyton Carr

Companies like Uber, Lyft, Beyond Meat, Peloton, Slack, Zoom, and Pinterest all made their public market debuts in 2019, creating wealth and liquidity for many of the 2019 IPO class of founders.

However, this year stockholders have seen anxiety-inducing volatility in their holdings, and many realize that they need to rethink their approach to their concentrated post-IPO stock position.

In this guide, I’ll walk through a framework of how to think about post-IPO or concentrated stock holdings objectively. While this is written specific to public company stock, many of the same fundamental concepts apply to private stock and the decision whether or not to sell. Some risks should be understood if you are relying on one stock to achieve all of your financial goals since that subjects you to having ‘too many eggs in one basket.’ Many shareholders in the 2019 IPO class have experienced this risk over the last few months and are reevaluating their situations.

Nevertheless, following my advice may be challenging since we all have heard of someone who made it big by swinging for the fences. The key is understanding the true success rate and risks involved with this approach; it is all too common to hear others share their standout victories, while more common failures are rarely mentioned.

What Do I Do Now?

Usually, I advocate for reducing concentrated positions in IPO stock upon lockup expiration, or via scheduled selling for more significant positions; however, for those that have not sold, it is clear that the unexpected macroeconomic downturn has materially increased the volatility of some high-valuation company share prices. If you find yourself in this position here are a few items to consider:

What is your time horizon? Are your investments intended for the long-term or the short-term?
What are your liquidity needs? Do you need to raise cash to pay for taxes or upcoming expenses? Do you need cash in the upcoming 1-2 years?
What other assets do you have?
How does this impact your financial plan? Can you tolerate possible further declines?

It is not comfortable to be in this position, and decisions at this juncture can be critical in achieving long-term goals. I suggest you find an advisor to talk to if you are unsure what the best choice is. Below we review some considerations which can help build more confidence in your decision.

What’s the Plan?

The decision of what to do with your stock should start at a higher level. Where does this stock fit into your investment strategy, and where does your investment strategy fit into achieving your long-term goals?

Your goals should drive your investment strategy, and your investment strategy should drive the decisions regarding your stock, not the other way around. With the proper goals set, you can use the investment portfolio, and the company stock(s) within it, as tools to achieve your goals.

For example, a goal could be to work ten more years, then partially retire and do some consulting. Defining goals helps you make objective decisions on how to best manage concentrated stock positions. There is a trade-off between maximizing the potential return in your investment portfolio, by maximizing risk with concentrated portfolios, and minimizing the risk of a catastrophic loss, by having a well-diversified portfolio. This decision is unique to each individual. The best way to maximize the odds of achieving your goals is different from the best route to maximizing your portfolio’s return possibilities.

FOMO

In these discussions, there is always an immense fear of missing out. What if this stock becomes a multi-bagger over time? It’s easy to look to the Zuckerbergs and Bezos of the world, who have amassed great wealth through holding concentrated stock, and think that holding a concentrated stock for the long term is the way to go.

There is also no doubt some public stocks have been runaway financial home runs, like investing in Apple or Amazon. If you had invested in those stocks since the beginning, you could have earned a 40,000% or 100,000% return. However, a rational, evidence-based decision process presents a very different picture. A statistical analysis on how IPOs and concentrated portfolios have fared in the past is covered in part two of this three-part series.

Concentration involves risks you may not have considered. In part two, I will walk you through critical considerations when maintaining a high concentration of company stock, and things to consider from a big-picture perspective. I also dive into the benefits of diversification, taking it beyond the basics to show you the advantages of having a more balanced portfolio.

You will get an in-depth guide that covers how much stock to hold, when to sell, strategic approaches to take, and tax implications to consider.

The Paycheck Protection Program: A Guide for Business Owners and Startup Companies

April 1, 2020 by eric

WRITTEN BY: CALVIN LO

Quick Take

There has been a tremendous amount of data regarding the stimulus, but I wanted to highlight the following information on the Paycheck Protection Program (PPP) available for business owners and self-employed since it may be very valuable to you or others you know. This is a government package to support all employers (and the self-employed) in retaining staff by offering a loan that may be forgiven if used on payroll, rent, or utilities. Details are still developing on the program, but we recommend that if you are eligible to apply as soon as you are able. Although this package is for $349bn, we believe there will likely not be enough capacity to adequately serve all eligible businesses. There are 30mn+ small businesses alone in the US and loan amounts will be granted on a first-come, first-serve basis. Treasury also urged those in need of funding to apply quickly, noting that the program has a cap and demand is likely to be high.

Application Start Dates

April 3, 2020, small businesses and sole proprietorships
April 10, 2020, independent contractors and self-employed individuals

Who can apply? All businesses with 500 or fewer employees can apply. This includes nonprofits, sole proprietorships, self-employed individuals, and independent contractors.

How large can my loan be? Loans can be for up to 2.5x of your average monthly payroll costs from the last year ($100k/employee cap). Subject to an overall $10 million cap.

How much of my loan will be forgiven? The loan amount you use for payroll costs, mortgage interest, rent, and utility payments over the eight weeks after getting the loan.

Do I need to pledge any collateral for these loans? No. No collateral is required.

Do I need to personally guarantee this loan? No. There is no personal guarantee requirement.

Background Info

Small businesses, startups, and self-employed individuals account for a significant portion of our country’s economy. During a global pandemic, like the one we’re experiencing now, this group suffer some of the hardest hits. On March 27, 2020, President Donald Trump signed the Coronavirus Aid, Relief, and Economic Security (CARES) Act into law, allocating funding to support the U.S. economy and workers through the coronavirus outbreak. The legislation includes a number of proposals aimed at supporting small businesses. For those hit hard due to forced closures and a sharp downturn in foot traffic, this bill may provide some relief.

Bear in mind this is a $2 trillion dollar stimulus program, equal to 10% of GDP, that was compiled and passed in the government in the matter of a few weeks. Broad guidelines were provided but more specific clarifications are being released every couple days. The Treasury has announced one thing then pivoted and revised their statement 48 hours later. It is a fluid situation and banks are doing their best to be compliant yet approve applications under the program. We recommend operating under the most current rules from the official websites in the links below and the guidance of your bank.

In times of concern, it’s important to know your options, including what the recently passed stimulus package includes and how to protect your assets moving forward.

What Does the Package Include?

American small businesses are supported by the recently passed CARES Act in the following ways:

A $350 billion forgivable loan program (The Paycheck Protection Program) designed to encourage small businesses from laying off employees.
A delay in employer-side payroll taxes for Social Security until 2021 and 2022.
50 percent refundable payroll tax credit on worker wages to incentivize businesses, including those with fewer than 500 employees, to retain their current workforce.
Sole proprietors and other self-employed workers may be eligible for the expanded unemployment insurance benefits the bill provides.
A portion of the $425 billion in funds appropriated for the Federal Reserve’s credit facilities will target small businesses.

How Does the $350 Billion Paycheck Protection Program Work?

Under the stimulus package, the Small Business Administration (SBA) will oversee the Paycheck Protection Program. This program will distribute $350 billion to small businesses that meet certain requirements, and the loans will be made available to companies with 500 or fewer employees.

Businesses can receive loans up to $10 million, and these loans will be administered by banks and other lenders. Additionally, the Paycheck Protection loans will carry a 1% interest rate.

Currently, the SBA guarantees small business loans that are distributed by a network of more than 800 lenders across the country. The program creates a form of emergency loan that has the potential to be forgiven when used to maintain payroll through June of 2020. In order for the above amounts to be forgiven, the business must maintain the same number of employees (equivalents) in the eight weeks following the date of origination of the loan as it did from either February 15, 2019 through June 30, 2019, or from January 1, 2020 through February 29, 2020.¹ The program also expands the network beyond the SBA so that more banks, credit unions and lenders can issue the appropriate loans.

If your business uses the loan funds for the approved purposes and maintains the average size of your full-time workforce based on when you received the loan, the principal loan will be forgiven, meaning you will only need to pay back the interest accrued.² The primary purpose of these loans is to incentivize small businesses to refrain from laying off workers and ultimately rehire laid-off employees that have already lost jobs due to COVID-19.

What Types of Businesses Are Eligible For The Paycheck Protection Program?

The Paycheck Protection Program offers loans for small businesses with fewer than 500 employees, 501(c)(3) nonprofits with fewer than 500 workers and some 501(c)(19) veteran organizations. Food service businesses are also eligible if they employ fewer than 500 people per physical location.

Self-employed individuals, sole proprietors and freelance or gig economy workers are also eligible to apply for financial assistance during this time. Even without a personal guarantee or collateral, businesses that are struggling can receive a loan as long as they were operational on February 15, 2020.

Eligible borrowers are required to make a good-faith certification that the loan is necessary due to the uncertainty of current economic conditions caused by COVID-19.

How Do I Get a Payroll Protection Loan?

The loan program will provide loans through SBA-approved private lenders. As banks are currently working on implementing this program, it’s important to check with your current banking relationship to see where they’re at in the process. Those that are already approved by the Small Business Association may be quicker to put the loan program into place.

As a small business owner or self-employed individual, it’s always important to be aware of your options in prosperous times and those of hardship. With some assistance and the promise of keeping your workers employed, your small business can continue to thrive.

https://www.sba.gov/funding-programs/loans/coronavirus-relief-options/paycheck-protection-program-ppp
https://home.treasury.gov/policy-issues/top-priorities/cares-act/assistance-for-small-businesses

Liquidity Options For Founders And Early Employees

January 6, 2020 by eric

This article was originally published on FORBES.COM on December 4, 2019. Written By:Peyton Carr

Over the past few years, it’s become more common for founders and early employees of private companies to free up some personal cash by selling a portion of their shares through a secondary transaction, or by obtaining a loan from their company or a third party. This has become much more accepted since private companies are staying private longer, and it’s sometimes even used by VCs to win deals. Generally, VCs and investors want their founders to retain as much equity as possible as the company grows, but are understanding in allowing some levels of personal financial planning.

A Case For Creating Liquidity Before An Exit

You’ve taken a lot of risk in putting your time, energy and often equity into your company. However, the path to liquidity can be years away, and the high cost of living in startup areas like San Francisco and New York can be financially stressful and distracting when living on a startup salary. And if you’re distracted by financial stress, you’re likely unable to focus all of your efforts on scaling your company. Having a little bit of early liquidity can be a smart way to help eliminate these distractions, relieve the personal financial pressures of being a founder or early employee, and enable you to focus on the long-term growth of the company, which reduces the appeal of exiting early — a win for both founders and their investors.

Liquidity Options

When you evaluate your liquidity options, they will usually fall into two categories: a secondary stock sale or a loan from the company or a third party.

You’ll need to keep several tax and future valuation considerations in mind to protect both yourself and your company. These include but aren’t limited to how a stock sale will affect your 409A valuation, who will be permitted to sell, the current and future impact on QSBS, and how a stock sale will impact all current shareholders. All scenarios should be reviewed with the appropriate tax and legal counsel.

Secondary Stock Sales

Below are three of the most common ways in which a transaction can occur.

The company repurchases your stock. In some cases, as part of a round, some of the funds raised may be used to repurchase common stock from founders or early employees. This is one of the more tax-complex options for both the company and the seller. You’ll need to work with a professional to coordinate a thorough review of how the sale price of this stock will impact future valuations. Additionally, if more than 5% of outstanding shares are purchased back by the company this might jeopardize your and your company’s ability to qualify for the QSBS exemptions on all future stock sales.
Your stock is purchased by an investor or board member. If a board member or investor purchases common stock at a predetermined price, you’ll have several tax implications to keep an eye out for. The 5% rule for QSBS purposes is not applicable here, but if a board member is purchasing the stock, you may need to treat any premium paid over the 409A as income for tax purposes.
Third-party sale. If you sell your stock directly to a third party as a one-time transaction, you can eliminate much of the risk and complications associated with maintaining the 409A price since the valuation is done by a third party. The seller will likely be taxed at long-term capital gains rates, and if the stock qualifies for QSBS, the seller will get to use the exemption. Keep in mind the transaction will need to be board-approved, as the third party will be added to the cap table, assuming a right of first refusal (ROFR) is not exercised by the company or other transfer limitations do not apply.

A Loan From Your Company Or A Third Party

If you plan to take a loan from your company or a third party to increase your personal liquidity, you need to know what this will be used for and how this will be repaid. For example, a loan from a third party might be used to exercise options to buy stock and start the clock to access long-term capital gains upon selling in the future, at which time you could pay the loan back. If you have a loan from the company to increase cash flow, you might work out a deal where a future bonus after a liquidity event could be used to pay back the loan.

How Much Liquidity Should You Access?

Accessing early liquidity isn’t necessarily about “making it” before you reach a defining liquidity event, and you don’t want to send the wrong message to your investors by selling too much equity and be perceived as cashing out. Instead, it’s more about relieving some of the financial pressure you’ve experienced to make life more comfortable and give you the motivation you need to keep going. You can ask yourself a few questions:

Do I need a lump sum of cash to pay down existing debt?
Do I have specific short-term goals (like buying a house) that this will accomplish?
Do I need cash to exercise options?
Is it time to diversify my investments so that I’m not only invested in my company?

Your personal liquidity needs are just that — personal. If you choose to pursue some early liquidity, you need to have a clear “why” behind your actions. These are conversations that should be had with your personal financial advisor, and also your investors. If done properly, this can be structured so all interests remain aligned, and so it does not send the wrong signals to your current and future investors. From there, you can build out a plan that adequately accounts for taxes and other considerations while freeing up the cash you need to accomplish your near-term personal financial goals.

Startups

What is Section 1045?

Benefits and Opportunities

Extended Tax Deferral

Shortened Holding Period

QSBS Exclusion Stacking

Section 1045 Rollover Requirements

Section 1045 Rollover Timeline

The 100 Percent Rule

Section 1045 QSBS Strategies for Startup Founders

Invest in QSBS Startups

Acquire One or More QSBS Companies

Start a New QSBS Company

Conclusion

What You Need to Know About Selling Your Company Stock

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

Keep in Mind: Lockups and Blackout Periods

Concentrated Stock Strategies

When Should You Sell IPO Stock?

Consider Taxes Before You Sell

Qualified Small Business Stock (QSBS)

What You Need to Know About Selling Your Company Stock

Part 2: The Founder’s Guide to Managing Your IPO Stock

Dangers of Concentration

Benefits of Diversification

How Much of Your Company’s Stock Is Too Much?

What’s Stopping You?

Take Control

What Are My Choices If I Want to Diversify?

What You Need to Know About Selling Your Company Stock

Part 1 of 3: The Founder’s Guide to Managing Your IPO Stock

What Do I Do Now?

What’s the Plan?

FOMO

Quick Take

Background Info

What Does the Package Include?

How Does the $350 Billion Paycheck Protection Program Work?

What Types of Businesses Are Eligible For The Paycheck Protection Program?

How Do I Get a Payroll Protection Loan?

A Case For Creating Liquidity Before An Exit

Liquidity Options

Secondary Stock Sales

A Loan From Your Company Or A Third Party

How Much Liquidity Should You Access?

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

What types of clients do you specialize in?

What services do you provide?

How do you help clients implement their financial plans?

Are your recommendations truly in my best interest?

What are all the different ways you get paid?

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

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

Do you use proprietary funds?

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