One of the hot issues that are recently emerging out of financing transactions in the high-tech industry is the sale of stock by founders of a company, as part of an investment round in the company (“Secondary Sale”).
In short, most of the early stage high-tech companies are initially bootstrapped i.e., financed by their founders, and sometimes also by friends & family, and angle investors. Because companies lack significant finance sources in their early stages, the founders usually withdraw minimal salaries from the company as compensation for their services. The first time when founders meet with significant finance sources is upon a later financing round. Thus, in many events, upon an investment event the founders insist on getting (or the investors propose to allocate) some amounts from the investment, to make a Secondary Sale and to allow some liquidity for the founders. In some later financing stages, investors offer to purchase common stock in addition to the preferred stock in which they are investing, either because they want to own a larger percentage of the company or the investors may do this because some of the founders have expressed a desire for liquidity.
As in most investment rounds, investors get preferred stock for their investment (while founders hold common stock) they expect to receive the same through the Secondary Sale. One way of achieving such outcome, is by the conversion of founders’ common stock into preferred stock, prior to the sale, and in the frame of the investment transactions.
The issues arise because in many cases, the value of preferred stock exceeds the value of the common stock (due to liquidation preference, participation rights, or other benefits, which are only attached to preferred stock), and as a result, the founders get an additional benefit from the company upon the conversion of the common stocks to preferred stocks. For example, let’s assume that the fair market value of a common stock is $10 per stock and the fair market value of the preferred stock is $13. That means the founder gets a benefit of $3, from the company, for each stock that is being converted. This create two main tax exposures:
- If such sellers also serve as employees or service providers of the company, such conversion may deem this additional benefit as a consideration for the sellers’ employment or services to the company, and therefore, the excess value of the preferred stocks may be taxed as ordinary income rather than capital gain.
- As companies usually have no valuation of their common stock, the tax authority may challenge the fair market value of such stock. As aforementioned in the example above, we assumed that the fair market value of a common stock is $10. Absent valuation, the tax authority may challenge such internal valuation and determine that the fair market value of the common stocks should be lower, increasing the compensation component of the consideration.
- Another risk relates to US companies. In the United States, in many cases, Israeli companies that employ U.S. employees, are required, under law, to have a valid and updated valuation of their common stock (as part of the requirements to comply with the U.S. incentive stock option rules). Assigning the value of the preferred stocks to the common stocks may temper the 409A valuation, which will cause a cascade effect on U.S. grantees. Note that the definition of “fair market value”, is probably stronger than the 409A valuation, and it provides the true value; however it also the fair market value of a different stock (transferable, unrestricted, fully vested, etc.) than the common stock that are subject to the 409A valuation.
There may be some measures that may be taken in order to reduce the tax exposure in such events:
- Payment of the fair market value of the common stock (based on a valid valuation). Under this alternative, the founders will sell common stock in consideration for the fair market value of such stock, and the company will undertake to convert the stock now held by the investor, post transaction, into preferred stock in exchange for additional investment (the excess between the price per stock in the deal and the FMV of the common.
- Purchase of the common stocks from all other stockholders, pro-rata to their holdings. Under this alternative, and under the assumption that there are stockholders who are not employed by, and do not provide services to, the company, the founders, who are employed by the company, will receive the same per stock consideration that other stockholders, who are not employed by the company, receive for their stocks. Thus, it would be harder (though not impossible) for the tax authority to challenge the classification of the founders’ consideration differently than the other sellers’ consideration.
- Founder Friendly Preferred - Issuing, at inception of the company, common stock 5%-10% of which would be fully vested common, convertible to preferred stock (FF Preferred). The FF Pref. should mostly have the same attributes as common stock with the exception that they can be sold by the holder only in connection with an equity financing being conducted by the Company, to the same investor, or investors, that are investing in a particular round, and prior to the sale, the FF Pref. are converted into stocks of the same series of preferred stock that the Company is issuing in the financing.
If the above alternatives are not applicable (for example, the founders would like to receive the PPS of the preferred stock and the investor would like to purchase only the founders’ stocks, and not from anyone else, and if the founders have not been granted FF Pref.), there are other steps that might be taken in order to reduce the risk, which depends on the circumstance of each transaction. The analysis and the resulted outcome depends, among other things, on whether the conversion occurred prior or after the investment, whether all stockholders participated in the Secondary Sale (through their co-sale arrangement or otherwise), whether no other stockholder was willing to sale their stock, other than the founders (forced sale), and so forth.
It should be emphasized, that as the Israel tax authority has not published it position with respect to the taxation convertible secondary transactions, there is always a risk that the tax authority would challenge such transactions, even where steps are taken in order to mitigate the risk.
We highly recommend consulting with the tax department upon any event of convertible secondary transactions in order to try and avoid adverse tax consequences.