The following method for providing founders liquidity has been very popular during the last three years: An investor buys common stock from founders during a preferred financing at the preferred price. Those same common shares are then magically exchanged by the investor with the company for the most recent class of preferred shares, which is what the investor really wanted the whole time.
I saw this secondary purchase plus exchange structure for the first time around the end of 2019.[1] Now I’ve seen it about perhaps forty times with various AmLaw 100 firms signing off on it.
Popular opinion as to the feasibility of this structure has started to wane, however. The accounting firms have started policing it, and as recently as today I’ve heard that DLA Piper, a large law firm, also has decided that the delta between the post-investment 409A valuation and the purchase price of the common stock needs to be reported as compensation and to be withheld on.
Below, I discuss the tax risk associated with this structure. For purposes of the below, I am assuming the company is taxed as a C corporation and that the founder is an employee.[2]
Potential Compensation
Risk #1: There is a risk that the IRS will consider the amount received by the founders in excess of the common price as compensatory.
Let’s assume the 409A valuation which is to be effective immediately after the Series A values the common at $.40 per share. But the Series A price is $1.20.
The IRS could argue on these facts that $.80 of the $1.20 to be paid to the founders per share is compensatory. In fact, Treas. Reg. 1.83-6(d) specifically states that if property is transferred by a shareholder of a company (i.e., the investor) to an employee of that company in consideration of services performed, that it will be treated as a capital contribution by the shareholder to the company, followed by a bonus from the company to the employee. Said another way, if there is a compensatory intent, the company would have a withholding obligation with respect to the $.80 and would report such amount on the founder’s W-2.
Despite this risk, in almost all of these secondaries that I saw between 2019-mid 2022, the parties took the position that the entire amount paid for the common stock represented purchase price. For parties who took that position, folks believed it helped if they could show that:
- The founders were paid reasonable compensation even without the purchase.
- The investor had no intent of sneaking the founder compensation, rather just really wanted more stock.
- Every common holder was being offered the ability to participate at the same price.
My impression is that now, even if you can show the above good facts, that accounting firms are starting to require that the delta between the 409A valuation of the common stock and the amount paid by the investor for the stock is treated as compensation.
Qualified Small Business Stock
Risk #2: There is a risk that the IRS will consider the structure to actually be the investor purchasing preferred from the company followed by the company redeeming the founder’s common stock. Such recharacterization could cause a QSBS black-out window.
Qualified small business stock (QSBS) is stock received directly from a qualified small business, which can, if held for more than five years, result in 0% federal income tax on a sale. [3]
Generalizing a bit, a qualified small business is a domestic C corp that is a non-service business that has never been worth more than $50M.
If the company is a qualified small business, then you’ll usually want to avoid what is considered a “significant redemption.” A significant redemption occurs when a company repurchases its own stock, other than incident to the retirement or other bona fide termination of an employee or director, and the aggregate repurchases in a rolling 2-year window (one year back and one year forward from any testing date), exceed all of:
- $10,000;
- 5% of the value of the company as of the beginning of the 2-year window; and
- 2% of the value of the company, valued as of the date of each repurchase.
The consequence of a significant redemption is that any stock issued in the 2-year window will not be QSBS.
There is also an individual test which uses a 4-year rolling window. If a repurchase violates the individual test, a 4-year black out window (2 years back, 2 years forward) applies to that stockholder, such that any stock that stockholder has received or will receive within the 4 years will not be QSBS.
Two tax partners at K&L Gates shared with me that in their view “it would be difficult for the IRS to recharacterize the transaction as an investment followed by a redemption; this would involve inventing a step without a purpose, which is not permitted under case law applicable to the IRS’ authority to apply substance over form. Further, the legislative history of 1202 makes clear that the purpose of the redemption rules are to prevent taxpayers from circumventing the original stock issuance requirement. If the investor purchases shares from the founder, and the shares are converted to Series A either immediately prior to or immediately after the purchase, those shares would not be QSBS, so there is no abuse.”
It is true, that if the transaction is not recharacterized, the Series A stock received in the purchase plus exchange by the investor, would not be QSBS.
However, I’m not convinced there is no risk of a redemption recharacterization here, which could in turn affect the QSBS status of all the stock issued in the Series A. I don’t think I am inventing a step as much as I am worried the cash flow skipped the middleman. The company is in fact issuing preferred stock and the founder is getting paid the preferred price for his or her common. I’m just worried the IRS might say that the investor sending the cash directly to the common holder doesn’t alter the economic reality that the cash actually was due to the company (because it issued the preferred) and the company chose to send it to the common holder to pay for his common (which under the actual facts the company cancels). After all, doesn’t this recharacterization mirror Treas. Reg. 1.83-6(d) discussed above? That said, Treas. Reg. Section 1.1202-2(c) specifically tries to distance the significant redemption rules from Treas. Reg. Section 1.83-6(d)(1) in a slightly different context, which perhaps indicates these laws are not intended overlap in this manner.
Corporate Waste
Risk#3: There is a risk that the shareholders might sue the company for corporate waste. In 2015, Digital Ocean was sued by a shareholder.[4] Why? Because Digital Ocean repurchased common from founders at the preferred price and then turned around and issued options at a much lower price. The shareholder argued that either the company wasted funds by repurchasing at a price in excess of the fair market value, or granted options at a price below fair market value in violation of the equity incentive plan terms and in violation of Section 409A of the Internal Revenue Code. The similarities are apparent. It’s hard to explain why a company in the structure we’ve been discussing is exchanging an investor’s common shares for preferred without receiving any consideration.
Variation that Reduces Risk
I’ve run across a variation of the above which I like better. Assume the investors were going to purchase shares of common stock from the founders at the preferred price for an aggregate of $2M. Instead, have the investors purchase the founders’ common stock for some acceptable fraction of that, like $1.8M, and then the investors pay the remainder (in this case, $200K) to the company for the privilege of having their common stock exchanged into preferred. Finally, the company pays the founders, if desired, the $200K as a bonus, which will be subject to ordinary income and employment tax. In my view, this reduces the below described risk that the IRS might recharacterize the cross purchase as a redemption, and the risk that the IRS might recharacterize any of the intended repurchase price as compensation. The exchange right may need to be structured as an option to ensure that the receipt of the $200K by the company fits into the exception from tax found in IRC Section 1032.
Between 2019-mid 2022 this variation was not very popular, rather the plain vanilla version was what I saw 9 out of 10 times. I do wonder if this variation would be enough to satisfy the accounting firms’ recent concerns about the structure, and if so if we might see people start using it, or if instead this secondary “purchase + exchange” structure is simply going to die off in its entirety.
Mike Baker frequently advises with respect to the tax consequences of secondary purchases. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] A prior version of this structure that has been used for years (though it was more common some years ago) is FF stock which is common stock issued to a founder that has a right built into it from the outset allowing it to convert into preferred stock, so a founder can sell it to investors at a future financing round. I think that FF stock does a better job of avoiding the risks described in this article. The fact that FF stock has fallen out of popularity, in my opinion, is simply that to be most effective it needs to be put in place at formation, which is a a time when founders may not yet have involved counsel and in any event are likely cash strapped and wanting to avoid any extra complication.
[2] These same considerations will apply if the founder is an independent contractor of the company, except that the company isn’t at risk of having a withholding obligation and any compensatory amount would be reported on a Form 1099-MISC instead of on a W-2.
[3] Higher rates apply to stock issued prior to September 28, 2010. Also, for the favorable QSBS rates to apply, in addition to avoiding significant redemptions, the company must run an active business during substantially all of the stockholder’s holding period. Finally, the House just today passed a version of the Build Back Better bill, which if passed by the Senate and signed into law, would reduce the 100% QSBS exclusion to 50% in years where a taxpayer’s adjusted gross income exceeds $400,000.
[4] The shareholder also sued Digital Ocean’s outside counsel and the valuation firm.