How Tax Can Impact Startup Valuations
- Feb 8, 2024
Key Considerations for Founders and Investors
From non-income based taxes, to due diligence considerations, and the qualified small business stock exclusion—how can you make informed decisions that will help reduce your tax exposure and improve your valuations? This 30-minute presentation is focused on helping founders and investors gain a better understanding of how tax can impact your investment.
Alexandra Colman:Thanks Bella. And hi everyone. My name is Allie Colman. I am a corporate tax partner at EisnerAmper based in our Metropark, New Jersey office, and I am very excited to be talking to you all today about taxes. So specifically about how taxes impact startups and especially how it relates to valuations. So the way that the idea for this webinar came about was that there's a sizable group of us at EisnerAmper that work on startup companies and we have regular meetings and we talk about the frequent questions that we're getting from our founders, from our investors. And I always say that I feel like tax is always such an afterthought for startup companies.
Because generally, as we all know, startup companies in the beginning are incurring a lot of expenses. Sometimes whatever they're going to sell isn't ready yet in the first few years. So in their mind, most founders understandably think that taxes aren't a problem yet. They look forward to the day where they might have to pay taxes, but right now we're incurring losses, so taxes aren't really part of the picture. But I'm here to debunk that and hopefully by the end of this you'll have a tax advisor on your team or someone that you can reach out to help you plan and strategize with tax in mind.
So today in particular, we're going to be talking about how your entity type can impact your valuation, the impact of raising capital, the issuing equity awards and lastly, my favorite, due diligence. So jumping right in, I guess if we talk about evaluation, which is really the impetus for this conversation is that everyone wants to get the highest valuation when you're bringing on third-party equity in the event of a exit, you want to make sure that you're getting a good return. I know that everyone is going to pay a valuation specialist that's going to give you a whole booklet as to how much your business is worth and why.
But at the end of the day, it's very important for us to remember that until you have a buyer willing to pay that valuation, your company is really not worth anything. The highest value of your company is whatever someone is willing to pay for it. And we are all buyers at some point in our life and we always want to get the best bang for our buck. We want to make sure that we're making an informed purchase and to the extent that we find out that there's maybe something wrong, if you're going to HomeGoods and you have a nick in something, you're going to go to the cashier and ask them, "Hey, can you take something off of this?"
And a lot of times what we see is for some reason tax always ends up being an area where we find buyers we're trying to reduce the purchase price. So we're going to start off with a good thing, something that you hope that your company might qualify for if it makes sense to you overall, and something that a lot of founders don't know of is the benefit of having qualified small business stock designation otherwise known as Section 1202. What does that mean? Let's see. I'm a numbers girl. Let's look at it in an example. So let's say you have an investor or you and you purchase your shares, a hundred thousand of them for $50,000 a share. That would mean my basis in my stock is $5 million.
The value of the company at the time of my investment was $10 million, which is relevant for qualified small business stock purposes. And then down the road, seven years later, I'm sell my stock for a hundred dollars per share. I doubled the value. That's great. Every investor's dream, right? So in this scenario, my sales price was $10 million, the basis in my stock is $5 million and I have a capital gain long-term of $5 million. From a federal tax perspective, you're paying 20% at the long-term capital gain rate times the net investment income tax of 3.8%. So to the government goes $1.2 million on the sale of my stock.
I'm happy at the end of the day, I get to keep $3.8 million, but still, who wants to pay tax? And this is where qualified small business stock comes into play. To the extent that your business meets the criteria, you would be able, in this situation, our lovely investor would not be paying any tax at the time of sale. Qualified small business stock allows you to exclude capital gain to the greater of $10 million or 10 times your basis in the stock that you're selling. Did you hear me? You can exclude gain and not pay tax on the greater of $10 million or 10 times your basis on the sale of this stock. That's a huge benefit.
If you are a founder of a company and you're looking to bring on external investors and you know that your business has this designation and when the investor is coming in, the stock would qualify. That should be the first thing in your slide deck in your presentation that you're giving. Because I know at the time of sale as an investor that my return on investment is going to be much higher because I don't have to pay tax on that gain at the end of the day. So this is something that, again, there's a lot of criteria. It has to be original issuance C corporation stock. The value of the company at the time of the investment has to be less than $50 million.
There are only certain industries that qualify. So yes, there are tests that need to be met, but if it's relevant for you and if your company qualifies, you should know it. So make sure that you're talking to your tax advisors to see whether or not we can put this qualified small business stock designation in your next presentation. So that was trying to bring on an investor. Now let's talk about what could happen upon an exit if you're trying to sell your company. So when you're talking to a potential buyer, you're going to likely go through the avenue of, should I sell the assets of my company or should I just sell equity interests?
And it's important to understand and put yourself in the shoes of the potential buyer as to why they may be negotiating one way or the other. So from a book perspective, when you purchase the assets or the equity of a company, the balance sheet gets stepped up to whatever the purchase price was or fair market value at the time of the sale. That's great because from a startup perspective, most of your IP and goodwill is where all of the value is going to reside, but that isn't sitting on your balance sheet. It becomes on your balance sheet when someone purchases it and this fair market value allocation happens, but prior to that time, those assets are not on your books.
From a tax perspective, the only time that we are going to get that step up in basis that you get for book purposes is in the event that someone purchases your assets. Because when your assets are sold, it's a taxable transaction. Tax is always reciprocal. No one's going to get a benefit unless somebody's paying tax to begin with. So because an asset sale is taxable, me the buyer, I get to step up my basis to fair market value and I'll be able to amortize the assets just as you will for book purposes. However, from an equity perspective, if I were to purchase the membership interest, if I were to purchase the stock, I do not get the benefit of that stepped up basis of goodwill or intangibles.
So putting yourself in the shoes of the buyer in this situation. Because I know on day one that I am going to miss out on a hundred thousand dollars of deductions related to amortization on the intangible assets that I purchased, I know that on day one I'm going to have to pay tax of $21,000 because of the way that I purchased these assets and this business. So the buyer is including the fact that, "Hey, I'm going to discount what I'm willing to pay you because I know and I need to consider that I'm going to pay tax because of the way this transaction is occurring. So when the negotiations are happening, it's important that you understand the buyer's perspective.
If they're really pushing for an asset sale, this could be why. However, buying equity isn't all bad. Yes, you may not get the step-up in basis. However, you do get the tax attributes of the entity that you acquired. "What's a tax attribute, Ali? You're speaking tax talk." A tax attribute is something like your net operating loss carry forwards, your research and development credits. All of those things that have been economically growing as you've been running in your business and getting it ready for this moment. That's something that could lead to a tax benefit to a buyer if they purchase the equity.
But with all things tax, there's always a but. Leads me to our next slide, which is this concept applies not only if you're raising capital, but it's really if there is an ownership change of your business. So when you are bringing on an outside investor, you're doing your series B raise. To date, you've had you and your friend who came up with this idea, you may be brought in an external angel investor for your series A and now it's time for series B and you're in the big leagues now and you're bringing on an external investor. That's something that could potentially trigger an ownership change. An ownership change occurs when there's a greater than 50% change in ownership of your company within a three-year period.
So let's look at this example, very high level. So adding corporation, me and my two friends decided that we want to create this business however we need more money. We know that our business is going to be capital intensive. We need to bring on an external investor on day one, whether it be our parents or a teacher at a university. So the ownership structure on day one is 30%, 15%, 20% between me and the other founders, and then there's 35% owned by what we'll call the public pool. In year two or let's say in year five, there is somebody that's very interested in our business and it's taking off and they want a 55% ownership in it. Sounds great. Our payday is going to be lovely.
We have another business we're interested in. I'm okay with not having majority control. So our ownership changes and investor Y comes in and now owns 55%. My tax brain is going red alerts, fireworks because this is a greater than 50% change in ownership. What does that mean? Well, your net operating losses can be limited because economically the law thinks that the original owners were the ones that really substantiated and economically earned that loss. Investor Y is coming in, should this person get the benefit of the loss that the original founders were the ones that paid for it?
So what happens is the company... What the IRS says to do is you look at the valuation at the time of the ownership change, multiply it by the long-term tax-exempt rate to determine the annual limitation of how much net operating loss frees up each year. There's other adjustments that can happen to this pool if you have unrealized built-in gains, but we're keeping it basic today and let's pretend that this is how our annual limitation results is. We have $240,000 that we can use each year. The way that 382 works is that I had net operating losses of $25 million dollars at the time of the change. All $25 million of those losses go in jail.
Every year $240,000 of loss gets out of jail. What does that mean? It's going to take me 105 years to use all $25 million dollars of those net operating losses. 105 years. I don't think any... Well, some businesses, not a lot of businesses make it that long. So it's very important to understand that even if you are selling all of your company to someone else, or if you're interested in bringing on an external investor, make sure that you're considering the implications of this code section, which is section 382. You may be thinking that for the first five years of our business, "I have these losses.
Your six comes, we're planning on profitability, but I'm going to be able to defer my cash taxes because I have these losses built up so I'm going to be able to offset my income with these losses. It's not in my budget. What's cash taxes? I'm a startup." Not necessarily the case. So always make sure that you keep your advisors and whoever is helping you with your taxes aware of every time that you have a stock issuance, every time that you are bringing on a new investor, that you're keeping track and your cap table is as detailed as it can be because all of those testing dates where new owners come in and out will play into this calculation and determine if your net operating losses are as realizable as you thought.
In addition, raising capital of course is an amazing thing. You need cash to run your business. Cash is king. However, cash also creates an asset. So I've seen it happen where I have a client that closes a series D round in December. And when you close a round, you debit cash for the $30 million let's say, and you credit APIC. What is the impact of that? Your net worth is higher. "Of course Ali, that's great, that's what we're looking for." But a lot of states impose net worth based taxes and they always end up sneaking up when you least expect it. If you're incorporated in Delaware, Delaware's annual franchise tax do March 1st. Plug for that.
There's two methods to compute the annual franchise tax that's due. One of them is based on your net worth. New York, our neighboring state, Massachusetts, Texas, a bunch of states have net worth based taxes where if you have employees in these states, you may be paying cash taxes related to net worth much earlier than you expected even if you're incurring losses. So in my example, I have a book loss and a tax loss, so I don't have an income tax worry. Taxes write it off. But my net worth is $15 million. So let's say in this scenario real life that you don't have revenue yet. So your business, your product isn't ready for sale.
However, you do have your cash in a bank account so you're earning interest income. That interest income needs to get sourced to a state. Let's say, as I said, I'm headquartered in New York, my bank is JP Morgan. That's where my interest income is coming from. That would make my interest income New York source income. I have 100% apportionment factor to New York. A hundred percent apportionment times my $15 million net worth means that all of my net worth is going to be taxable in New York. Yes, the tax rate in New York is favorable.
It's 0.1875%, but I'm still paying about $30,000 in cash taxes to New York. That if that's not in my budget and I'm a startup, that's a problem. So definitely keep in mind that when you're raising capital, the implications to net worth tax could result in cash taxes being paid. It's something that should be budgeted for and you should be making estimated payments related to it so you're not wasting additional cash on penalties and interest. Equity awards are very common in startups. As we mentioned, cash is king and you want to conserve it. So the way that we incentivize our key employees is by giving them equity awards.
I'm going to focus on restricted stock for a second and a way that you, a founder, and you can advise your employees on how they can be smart and strategic when they receive restricted stock, especially when they're one of your early employees. So generally restricted stock vests after a requisite service period or after maybe a liquidating event occurs, which is a time far in the future. Restricted stock if you do not make an 83(b) election is taxable to the recipient in the year that it vests. So let's say I'm employee number five at my company and they give me restricted stock. The value of the company is zero because nothing happened yet.
10 years down the road we sell, a liquidating event occurs and the value of my stock is $10 million. Me, the employee, has to pay tax at ordinary income rates at the time of the vesting at the $10 million. Yes, on one side you're like, "Ali, what are you complaining about paying taxes for? You have something worth $10 million." But still nobody wants to pay tax. So I'm paying ordinary income at the $10 million and then when I sell it in the future, then I'll be paying capital gains tax on the difference between that $10 million I paid an ordinary income tax on and whatever price I sold it at.
The benefit of an 83(b) election is that you can elect to pay tax on the value at grant date rather than when it vests. It's a chance. You're taking a risk. For the gamblers on the line, maybe you love it because you're hedging. You think that the value of the restricted stock is going to go up by the time of the vesting. You also are taking the bet that you're still going to be employed by the company and still be a holder of the restricted stock at the time of the vesting. So when you have restricted stock, if you make an 83(b) election and the value of the company is zero, you pay zero tax on day one. Upon vesting, you pay zero tax.
But when you sell it in the future, your entire amount is taxed at capital gains rates. So you are still paying tax on the full amount of income. I just want to make that clear. You're still paying tax. The benefit comes in is that you are saving an ordinary income tax rate and you'll have more of your income tax at a capital gains tax rate. So 83(b) elections can be really valuable and really tax savings if you plan it correctly and honestly, if your business hits and you have restricted stock, it's definitely worth taking a risk I think. And it's not just restricted stock. The other two very common awards that we see given out are incentive stock options and non-qualified stock options.
Again, all of these slides are accessible to you all. But very quickly, incentive stock options can only be issued to employees, but the reason we call them incentive stock options or someone names them that, is because whoever receives them doesn't have to pay tax on them at the time of the exercise. That's a big incentive. Non-qualified stock options, however, can be issued to independent contractors, employees, former employees, anybody. And the, not downside, but the other side is that you are paying ordinary income on your non-qualified options at the date of exercise. And you're going to be paying tax on the difference between the fair market value at the exercise date, less what your exercise price was.
So again, definitely different tax implications to the recipient, also to the employer because as I mentioned earlier, in order for something to be deductible for tax purposes, somebody had to pay income on it. So incentive stock options generally do not result in a tax deduction for the employer, but non-qualified stock options do. So that's just the difference. A lot of times people... I'll hear my founder say we have options. I'm like, "Okay, well what type of options?" Because it makes a difference. Due diligence. So due diligence to me is kind of like going through your inspection on your house.
The potential buyer is coming in, they're doing a buy-side due diligence and they hired a team. They are going under every rug, every nook and cranny. Everything you've tried to hide generally comes out to play when due diligence is happening. So state and local taxes, especially for a startup company are very relevant. If we think about it from an income tax and a sales tax perspective, what gives us nexus in a state? Well, if you have a physical presence in a state, if you have an office, if you have a storage facility where you're holding your inventory, if you have fixed assets in a state, that is going to give you nexus for both income and sales tax purposes.
The place where people get tripped up is where you have employees. So a lot of us during Covid have put... We've become virtual companies. We don't have a headquarters. We don't care where anybody is working because for us, there's no in-office presence anyway. However, wherever you hire an employee, you're going to be registering for payroll taxes even if you're using a PEO, and that's going to give you nexus for income tax and sales tax. Even if you're in losses, don't forget our enemy, net worth taxes. So if you have an employee that you're hiring in Texas, you've never had a presence in Texas before, now your business is subject to the Texas franchise tax.
If you have two equal candidates, one is in a jurisdiction where you already have an employee and one is in a new jurisdiction, it's something worth considering. And that should be a part of your thought process because it may cost the company money just to have an employee hired in a new state. Sales also, we all remember the Wayfair case. I don't even remember what year it was, but generally speaking, to be wholesome on this thought is that if you have a total... If you have $200,000 in sales to a state, most states have economic nexus where you will also have nexus there from an income and a sales tax perspective.
The other issue that comes up on due diligence that catch people off guard are sales tax from terms of whether or not you have exemption certificates. A lot of our clients sell for resale. You create a product, you sell it to Target, Target then sends it to the end user. We all know Target's the one responsible for collecting the sales tax, but if you don't get that exemption certificate, the sale for resale certificate from Target, that due diligence person's going to come in and say, "Well, you don't have the resale certificate, so how do we know?" And then they come in and they come up with some outlandish potential exposure.
If you have $10 million in sales to New Jersey, New Jersey is a 6.6% average sales tax rate. That's $660,000 plus interest and penalties that the due diligence team is going to say, "We think you should hold that in escrow fire because what if New Jersey comes in and assesses this tax?" Then the onus is on you, the seller to say... The onus is on you, the seller, to prove them wrong. To say, "No, our sales aren't taxable. It is sale for resale." And then you're emailing Target the day before you're trying to close your deal, trying to get the exemption certificate to keep your valuation and to keep the purchase price where it was without something in escrow.
Next, employment taxes. Just make sure you're being smart about whether you're keeping someone on your payroll or if you are having someone on your team as an independent contractor. If you have someone that only works for you, you are their full-time employer, but you pay them with a 1099, looks fishy. The potential exposure with that is related to income-based taxes. I'm sorry, withholding taxes. You need to make sure that if it's an independent contractor, we all know they get a 1099 and that's it. If you have someone as an employee, that requires many additional costs from the employer perspective.
The IRS cares most about the withholding taxes related to that. So two big things that come up a lot of times in due diligence that often catch founders by surprise. So to summarize, we want to make sure that you are getting your highest valuation possible, so identify your team of advisors early. Having someone from the tax side is always going to be beneficial because you want to set future you up for success, which brings me to the next point of be thoughtful on the type of entity you're creating. Don't say, "Oh, well my neighbor Joe, he had an LLC, so that's the way that I should be." Or you could say someone that you know or you read online that S-corps are popular.
Every business has different facts and circumstances that could potentially lead to a different type of entity decision. So make sure that you're consulting. You consider the implications of section 1202 upon exit. Do future you a favor. Understand the benefits of your tax attributes because if you know them, you're able to put that in your presentation and tell your buyer, "Hey, not only is the business we're creating amazing, but look from a tax perspective how much benefit you can get from investing in our business." Plan ahead for cash needs. We all saw companies not make it through Covid, unfortunately.
And every company is just trying to maintain their cash to keep their business up and running. So the last thing we want to surprise any of our clients with is, "Oh, you owe $200,000 to New York for the capital base tax. Sorry, that wasn't in your budget." We know some startups need $200,000 to make payroll. So make sure that we're keeping your advisors involved and up to speed on all of the transactions that are happening with the company so we can make sure we're best advising you and setting you up for success and letting you know that if there's a cash tax, you can plan for it. Lastly, prepare for due diligence prior to when you get that email saying, "Here's your four-page due diligence checklist.
Let's get on a call next week." It's never a bad idea to be prepared. You know that when you're having those conversations with future and potential investors that you need to strike while the iron's hot. And if they lose interest during the due diligence process, you're one on a list of a hundred entities that are looking for money. So if you were to do a due diligence readiness prior to that time, when you know you're getting ready to that point where you need it. That will go a very, very long way. A so in closing, oftentimes when I'm at events speaking to founders, they're like, "Oh, EisnerAmper, you're too big for us." And that's certainly not the case.
As I mentioned, there is a large team of us across service lines that service startup companies. We like working with you when you're at the early stages so we can grow with you. It's exciting for us as well. If you don't need tax assistance, we're able to assist with HR. We can do outsourced accounting services. We can even help you get your pitch deck together. So EisnerAmper has a lot of service offerings we can provide, and I know that my email address is available through here if you want to find me on the website or even mention in your evaluation comments that you're interested in hearing from someone from the startup group, and we would be absolutely happy to reach out and talk to you.
I do have some Q&A in the box and I'm not ignoring you, it's just I'm being conscious of time and I'm at a half hour. So please know that I will reach out to everyone who has submitted a question and I will get you an answer. But with that being said, thank you everyone so much for your time and for joining us today. I hope you learned a little bit more about taxes, understanding that taxes are definitely relevant in all stages in a life cycle. And I will pass it back over to Astrid to close us out.
Transcribed by Rev.com
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Alexandra Colman is a Tax Partner serving clients in the life sciences, biotechnology, manufacturing and distribution, and retail industries. Allie works with large corporations, both public and private, on multistate returns and tax provisions.
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