Following a lucrative 2021 for VentureSouth members, we have spent much of the last few weeks explaining to investors the tax consequences of their exits. We thought it might be useful to share a case study on a recent exit, as it covers the range of tax implications described in the guide.
VentureSouth members made five investments in a company, as follows:
- priced preferred equity seed round in 2015
- a small purchase of common stock from a departing cofounder in 2017
- a convertible note in 2017; this note converted into the next round of equity in August 2018
- priced preferred equity Series A-1 round in 2018, and a further priced preferred equity Series A-2 round in 2029
…and exited when a purchaser acquired our shares in 2021.
Sounds complicated, but this is a typical journey for an early-stage investor. Each of these rounds is an interesting angel investing tax scenario, so let’s take them one by one.
1) Priced equity held more than 5 years
We’ll start with the best. This first round was an investment in Qualified Small Business Stock (“QSBS”), as a a C-Corp running a real business with less than $50M in assets. This is the “base case,” a typical angel investment in a southeastern deal.
As QSBS stock held for over five years, gains on this stock are exempt from capital gains taxes.
(There are, of course, some limitations, like a max gain of 10x or $10M. There are also more…creative… methods (“stacking”, “packing”, and of course “peanut buttering” discussed here), which do not really apply to angel investors but make for interesting reading.)
So the gains on this investment were tax free for our members. Not only was this the best pre-tax return (earliest money in, at the lowest price, so the largest gain); the returns are entirely tax free. What more could you ask for?
2) A purchase of founder’s common stock
The next round was a similarly strong pre-tax return, but had a less favorable tax impact. QSBS only applies to newly-issued shares in a company. If you buy existing shares – as in this case where common stock shares held by a founder were purchased in a “secondary transaction,” or more generally, like when you buy shares in a public company – QSBS does not apply.
QSBS is designed to encourage new investment. While active and liquid secondary markets make investing more appealing – it’s more palatable to buy stock (and found companies) if you can sell that stock one day – QSBS is focused on rewarding new funding of startup companies, and so is limited to newly-issued shares.
Even without the benefits of QSBS, though, this is still fairly appealing as a long-term capital gain taxed at capital gain tax rates.
3) Later priced equity rounds held for less than five years
Let’s disrupt the timeline by next tackling #4, the two recent priced equity rounds.
Both these investments were QSBS: still a C-Corp with less than $50M in assets, still operating, selling newly-issued shares. So you might think QSBS / Section 1202 / Dabo applies. Unfortunately (from a tax perspective), this was, fortunately (from an IRR perspective), a quick win, with capital deployed and returned within five years.
That means the stock was not held long enough to get the Section 1202 exemption. The good news, though, is that these proceeds are eligible for “rollover” under Section 1045 of the tax code. If the proceeds are redeployed into new QSBS within 60 days, no capital gains tax is due on the gains.
Investors then face the decision: do we bank the proceeds (and pay long-term capital gains tax on the gain); or do we “roll the dice again” by reinvesting the proceeds into one or more (sensibly: more) QSBS companies?
Letting tax treatment determine your investing has the tail wagging the dog, but recognizing the net, post-tax returns is a critical part of investing successfully.
4) The convertible note round
The most complicated round of all is the convertible note round in the middle. If you’re familiar with VentureSouth’s soapbox, you know we are generally not fans of convertible notes.
One reasons is taxes. The original investment in the convertible note was not into stock of a C-Corp, so QSBS doesn’t apply. The QSBS “clock” only starts when the note converts – which in this case was several months later, which is typical.
There are other complications too. How much of the “gain” here was from the accrued interest on the convertible note (taxable as interest?)? How much came at the conversion event? How much should each be taxed? This is a bit beyond the scope of this post, but let’s just say the tax treatment might be murkier on notes than on priced equity.
As one hypothetical, notice that if the exit had been in January 2022, a priced round in December 2016 would have been capital gains tax free under Section 1202, but a convertible note at the same time (but that converted in June 2017) would not. (It would have been Section 1045 rolloverable based on the date of conversion, which is good, but it ties up capital for more than six years total to get the treatment you might have received after five. Not so ideal. And no guarantee that the rolled-over money would not be written off!)
Not a bad outcome, of course, but one tangible example of where equity would’ve been better (post taxes) and simpler than a note.
To sum up
One company, five rounds, four different tax treatments. Fun stuff we hope you agree!
We think VentureSouth members benefit from having access to early stage, QSBS-eligible deals; from a steady supply of Section 1045 rollover-eligible companies so eligible proceeds can be reinvested within 60 days; and a full-time team who love explaining the tax implications of investing before and after the investment. Perhaps you will join us for the next one!
PS – Section 1045 in action!
As an interesting aside, some of our members invested into this company using proceeds from a successful exit of another VentureSouth portfolio company.
The prior exit was from a QSBS company held less than five years, and so the proceeds from that exit were eligible for rollover under Section 1045. The successful investors took those proceeds, redeployed them into Company A, and made a further multiple of gain on them.
First company was held for two years; second held for three; added together they passed the five years required for QSBS to apply – so all the gains became capital gains tax free. This is Section 1045 working exactly as advertised! Double win.