By: Sean Valle
If your company is pursuing a substantial fundraising round, such as a Preferred Stock financing, you might be considering if all of the funds should be allocated to the company’s working capital, or if some of it may be available to the founders personally. Secondary purchases of stock directly from existing stockholders are an appealing way to reorganize the company as part of a financing and to provide cash to existing stockholders.
For existing stockholders, the upside of a secondary purchase like this is near-term liquidity (cash in the stockholders’ pocket) without having to wait until a future exit for a payout. Additionally, some investors want to provide liquidity to founders or other existing stockholders. Purchasing shares from a founder may result in the investor owning a larger portion of the company than if all its funds had gone towards purchasing new stock directly from the company.
Stockholders should work with the company’s accountants and lawyers–as well as the stockholders’ personal accountants and lawyers–to carefully consider the appropriate tax treatment of the gains realized from the secondary sale transaction. If the excess of the fair market value of the shares at the time of the secondary sale over the original purchase price is treated as capital gain, the gain will be taxed as either short-term or long-term capital gains, depending on how long the seller has held the shares. If the shares were held for more than one year, the gains are generally taxed at the rate for long-term capital gains, which is almost always the optimal tax treatment sought by both companies and employees. If the shares were held for less than one year, the gains are generally taxed at the short-term capital gains rate, which can be much less favorable than the long-term capital gains rate.
However, if the investor pays a premium price for the shares in the secondary purchase, or if the facts suggest that all or a portion of the price paid is really disguised compensation, then (1) the gains could be unfavorably treated as income and (2) the company may have withholding obligations.
When the company itself repurchases shares from employees at a premium, the excess of the premium price paid over the fair market value of the shares (reflected by a 409A valuation), is generally considered compensation and therefore taxed as ordinary income to the employee and subject to employment-related withholding obligations by the company. Additionally, substantial repurchases of stock by the company can prevent the company’s stock from being classified as Qualified Small Business Stock (QSBS) for tax purposes. Specifically, any stock issued within a year before or for a year after the repurchase is not classified as QSBS. This includes stock purchased by an investor as part of the current or a near-future fundraising round. As we discuss in this blog article on QSBS, stockholders receive preferential tax treatment if the stock they eventually sell is deemed QSBS. So, investors may avoid investing in a company if their stock will not be classified as QSBS. Preferred stock financing documents often require the company to represent that its stock qualifies as QSBS and that the company will take reasonable steps to ensure an investor’s stock continues to qualify as QSBS. For these reasons, it is generally not advisable for the company to use funds from an investment round to subsequently repurchase shares from existing stockholders.
Where the buyer is a third-party investor, the compensation analysis becomes more nuanced and is based on the unique facts and circumstances of the transaction, including:
- Which (if not all) of the existing stockholders are permitted to participate in the secondary sale. If the premium price is a benefit offered only to employees or a limited group of employees, the IRS may view the payment as disguised compensation.
- Identity of the buyer. If the buyer is an existing investor or other stockholder, gains from the secondary sale might be considered compensation if that investor owns a large portion of the company and/or has access to significant company confidential information, intellectual property, or other strategic value. There is generally less skepticism regarding the payment price set by an outside or new investor.
- The purpose of the secondary sale. Certain motivations and structures are clearly not compensatory, such as situations where (1) no additional dilution occurs through the secondary transaction, (2) an external, strategic investor requires founder liquidity to consummate their investment, or (3) the secondary sale is part of permitting an investor to satisfy a ownership threshold for certain control rights attributed to major investors.
The company’s accountants (and auditors, if the company has ever engaged an auditor) should assist the company in determining the appropriate tax treatment of the secondary sale before closing the larger financing. Secondary sales are commonly subject to IRS review. If the IRS categorizes the gains from a secondary sale as employment compensation, the company will have failed to pay appropriate withholding taxes as well as FICA and unemployment taxes and may be subject to civil and/or criminal sanctions.
In situations where new investors purchase shares directly from founders or other existing stockholders, there are additional Qualified Small Business Stock concerns for that investor to consider. One primary requirement for QSBS treatment is that the purchased stock be issued directly from the company. In a secondary sale, the stock purchased by an investor is being sold from a stockholder–not the company itself. So, investors may not receive QSBS treatment on the stock purchased through the secondary sale. Companies utilizing this form of secondary purchase structure to provide liquidity to existing stockholders should generally avoid representing to incoming investors that the stock sold via the secondary purchase will qualify as QSBS.
There are various approaches to structuring a secondary sale, sometimes involving the sale of stock, the exercise of options, the cancellation of unexercised options, or a combination of these. Each of which comes with its own nuances and legal and financial risks. Be sure to discuss your company’s unique situation with your service providers to position your company and your existing stockholders for the best possible outcome.
Headquartered in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in the Triangle, throughout the Southeast and in Silicon Valley / San Francisco. We also represent venture capital funds and other investors who invest in companies throughout the U.S. The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.