Qualified Small Business Stock (QSBS) encourages investments in small businesses by exempting up to $10M in gains if the investment met certain criteria.
Potentially huge tax savings for employees of Series A companies.
Founders and early employees of startups have an opportunity for huge tax savings. It is possible to exempt the greater of 10M in capital gains or 10x the invested capital from federal taxes if the investment (exercising stock options counts as investing) is held at least 5 years.
This is possible due to an exemption in the tax code called Qualified Small Business Stock of QSBS. Basically, if you exercise stock options in a company worth less than $50M and hold the stock for 5 or more years, you can exempt up to $10M in capital gains. Meaning you likely won't owe any taxes when you eventually sell the stock!
What is Qualified Small Business Stock (QSBS)?
Qualified Small Business Stock (QSBS) is part of the federal government's Internal Revenue Code (section 1202). A company qualifies as a small business if it is a US based C corporation that has less than $50M in assets. Some sectors of companies do not qualify for QSBS such as hotels, banks, farms and more.
The rules applying to QSBS were designed to encourage investments in certain small businesses; however, the exemption does not apply to California income taxes post 2012. Some entrepreneurs contemplate leaving California before their M&A or IPOs are completed, but be warned, as this must be a bona fide intention to move and is subject to audit for at least 3 years. Other states should be reviewed on a case by case basis.
The main factors to qualify for QSBS status and tax benefits are:
- The stock must be purchased directly from the company as opposed to a secondary market.
- The company needs to be a C corporation.
- The stock had to be issued after August 10, 1993.
- Company issuing the stock has had less than $50 million in capitalization continuously from inception or August 10, 1993 through the point where the investment was made.
- Certain redemptions can retroactively eliminate QSBS status.
- Company must be a qualified trade or business. Many service businesses, hotels, banks, insurance companies, farms, etc. are not eligible for QSBS treatment.
- If you have not yet met the 5 year hold period threshold, you can do a qualified rollover into another QSBS until the 5 years has been achieved.
What does QSBS mean for a Series A employee?
Per Fundz.com, a typical Ser A company has a 30M post-money valuation compared to a Ser B at 90M. This jump in valuation rules out the QSBS exemption, meaning as a Series A employee you have about a year to two years (ballpark time between rounds) to exercise your stock while the company is a Qualified Small Business.
There is certainly risk that comes with investing in a Series A company. According to Techcrunch only about half of Series A companies even make it to a Series B and an even smaller number exit through an M&A or IPO.
So while there is risk, a typical Series A exercise is likely not that expensive and requires paying little or no tax (unless you are an exec or early employee with a large option block and a very low strike price compared to the current FMV).
Here is an example of the advantages of QSBS:
Employee A, B and C all work for a Series A company worth $33.33M, so their options are eligible for QSBS if they exercise now and hold for 5+ years. Let's say they each have identical grants of 100,000 NSOs priced at $0.50 per share and the 409a value at the moment is also $0.50 per share (in reality, the options are more likely to be ISOs, but NSO taxation makes the math easier!).
Employee A wants to take advantage of QSBS so they exercise, knowing the company is doing well and may raise a Series B soon. Employee A's option exercise costs them $50,000.
A couple months later the company raises a Series B, valuing them at $100M (post-money), three times their Series A valuation. QSBS is no longer on the table for Employee B and C. The 409a goes up by a multiple of 3 like the valuation (to keep the math simple) to a value of $1.50 per share.
Employee B hears from Employee A how they locked-in a lower tax basis and wants to exercise before the value goes even higher. Employee B's options exercise costs them $50,000, but they owe taxes on $1 per share of gain (aka $100,000 of income). To keep it simple, let's say Employee B owes 40% or $40,000 in taxes.
Here is a summary of where the three employees stand:
Employee A: Spent $50,000 and owns shares.
Employee B: Spent $90,000 and owns shares.
Employee C: Spent $0 but still only owns options, not shares.
Fast forward 5 years and the company is finally ready to IPO at a whopping $1B valuation (10 times the Series B valuation). Again, in order to keep the math simple, well use an IPO price of 10 times the Series B 409a or $15 per share (in reality it would likely be more than this, because the 409a is discounted from the price Venture Capitals pay for their stock. Meaning the Series B valuation of $100M would be tied to a higher per share value than $1.50).
After 180 days of lockup the stock rises to $20.50 (again for the sake of easy math). Employee A and B both decide to sell 100% of their stock. Employee C also decides to sell it all but must exercise first. Here is how each scenario plays out:
Employee A: Sells 100,000 shares at $20.50 for $2.05M, giving Employee A a gain of $2M ($2,050,000 minus the $50,000 exercise). Employee A owes $0 in taxes because they exercised stock in a Qualified Small Business and held for longer than 5 years. Employee A nets $2,050,000 from the sale!
Employee B: Sells 100,000 shares at $20.50 for $2.05M, giving Employee B a gain of $1.9M ($20.50 sale price minus $1.50 basis from the exercise equals $19 per share of gain). Since Employee B has held their stock for longer than 1 year, they qualify for the lower Long-Term Capital Gains rate of 20% (the rate is 15% for less than $434,550 of income per investopedia). Employee B owes $380,00 in taxes and nets $1,520,000 from the sale.
Employee C: Exercises and sells 100,000 shares at $20.50 for $2.05M giving Employee C a gain of $2M ($2,050,000 minus the $50,000 exercise). Since Employee C did not hold the stock for longer than a year, they owe short term income tax on this exercise/sale, call it 40%. Employee C owes $800,000 in taxes and nets $1,200,000 from the sale.
Moral of the story?
There are two major takeaways here. 1) the power of Long-Term Capital Gains and 2) the even greater power of QSBS.
Most people are aware of long-term capital gains and factor it into their investment decisions. By qualifying for LTCG, Employee B saves $320,000 compared to Employee C, but had to fork up $90,000 in order to exercise (this money was illiquid for 5 years compared to Employee C who could have invested it elsewhere during that period).
Not as many people are aware of QSBS, but in this case it is just as, if not more, important. By exercising while the company still qualified for QSBS, Employee A saves $480,000 compared to Employee B (not to mention saving $40,000 on exercise costs) and $800,000 compared to Employee C. If the employees were to all sell at $40.50, Employee A saves $880,000 compared to Employee B and $1,600,000 compared to Employee C.
So the moral of the story is this: Long-Term Capital Gains is great, but QSBS is even better. If the right situation presents itself where you can exercise options in a company that qualifies for QSBS, the tax savings can be immense. If you are confident in the company and know that a Series B is on the horizon, these savings can in many cases be worth the risk of investing in a Series A company. It is at least worth considering, especially if you plan to exercise the options at some point down the road. NOTE: you don't need to exercise 100% of your options to take advantage of QSBS. One smart tactic would be to exercise as many options as you can safely afford and then wait to exercise the remainder of your grant.
If you work for a Series A company (or any private company worth less than $50M), but cannot afford to exercise, contact ESO Fund to cover the cost of exercise risk free. While ESO will take a portion of the upside, we will work with you to make sure that you stand to save more on taxes than we take. The best part is all ESO deals are 100% non-recourse, so the risk of investing in an early stage company is eliminated.