How To Manage M&A Personal Finances For Founders
Many times, founders do not adequately prepare for an M&A exit and how it can potentially affect them financially. To address some of the areas that founders should consider, we spoke with Greg Curhan of Brighton Jones. Here is an edited version of our Q&A interview.
What strategies can founders (or early employees) use when starting a company to provide the best possible tax impacts in the future in the event of an acquisition or other stock sale?
Companies should issue founders stock before the company becomes valuable in order to minimize current tax consequences and consider using an 83(b) election. Also, be sure there’s an appropriate vesting schedule with accelerated vesting provisions for the right circumstances.
Equity can come in all different varieties, with different vesting schedules and some special (or preferred) tax treatment. Get unbiased advice from a CFP, CPA or attorney to help you understand the characteristics of your equity and/or options. In many cases it can make sense to proactively manage your equity compensation in terms of exercising and holding or accelerate when you recognize that compensation for tax purposes. You may want to pay a small amount in taxes today in order to benefit from preferred long-term capital gains tax treatment in the future. A little planning today could save you millions tomorrow.
Can you explain proactive management of equity – 83(b) election or other actions?
Proactive management of the equity you receive from a start up usually is the result of buying the shares offered to you early, before the value of the stock skyrockets, in anticipation of benefiting from preferred long term capital gains treatment of owning the shares outright.
The tactics to be proactive often are dictated by the type of equity being offered (i.e. founders stock, non-qualified or incentive stock options) and once you know the type of equity you can look at different options like an 83b election or exercise your stock option and hold the shares. There can be different federal (and possible state) tax rules depending on the type of equity offering.
We often talk about the benefits to proactive management in terms of income tax savings, but other valuable benefits can come in the form of gifts of highly appreciated securities to charity or valuable estate planning.
We cannot stress enough that individuals should get advice early, well before a transaction is considered because that is when the most effective planning is done. This planning can lay the foundation for a lucrative monetization event where you keep a large portion of the value you created versus paying a substantial amount of that value in federal and state taxes.
What things should founders do to prepare themselves for an acquisition of their company – in terms of preparing for tax consequences, their own stock, etc?
There can be a number of proactive planning opportunities that founders, directors and early employees can take to maximize the value they’ve created in their company. Every transaction is unique and the terms of transaction can have a substantial impact on what you receive and when. Getting advice early is extremely important.
In most instances there will typically be a period that certain individuals are either restricted from selling or have a lengthy vesting schedule. Additionally, it will be important to understand if you’re receiving “registered” securities that are freely tradeable or are they “unregistered” – which is common in many private transactions – and subject to Rule 144 of the 1933 Securities Act which subjects you to additional holding period requirements.
While planning early can yield the most effective results, there are opportunities to maximize value and/or minimize tax drag either before or after a transaction is completed. These opportunities are dependent on the individuals’ unique circumstances, type of equity owned and terms of the transaction. They can range from accelerating vesting and/or acquisition of shares to delaying compensation recognition in to a more advantageous tax year. Deciding the best course of action involves a mix of the transaction parameters, tax law and the individual’s personal situation.
Can you explain accelerated vesting and acquisition of shares as strategies?
The idea behind accelerated vesting is similar to what often happens with the change of control of a public company. If your company is being acquired by someone else, you would like to have all those future shares you were granted vest immediately. With immediate vesting you can either decide you want to stay invested in the new company with the hopes of further appreciation from the combined company or sell and reduce your risk to a company where you may no longer have any control or influence on the decisions being made about the direction of the company.
What are common mistakes or dangers that founders should be aware of in terms of decisions with early stage startups in terms of equity, taxes, compensation, estates or trusts, etc?
Some common mistakes are typically related to being reactive to an increase in value of your company vs being proactive and managing your equity investment before a substantial increase in value. The value of proactive planning should never be underestimated or ignored even though founders and the first employees of a start up are typically busy trying to make the company a success and planning for when it becomes a success gets ignored until a lot of the benefits have been eroded by the growth of the company.
Another common mistake is thinking that all equity incentive compensation is the same. There are different rules for your equity incentive comp and depending on your company and your tax picture some forms maybe better than others. Additionally, if you are raising seed stage angel investments or VC investments later on, be careful about the valuation negotiated and more importantly the type of equity being sold and if it’s a different class of stock and what are the voting and dividend rights.
For more information about how to handle startup equity, see Brighton Jones’ informational document: Equity Compensation Guide