By: Eric Evans
Entrepreneurs and early investors, including VC investors, are faced with many challenges. An overarching challenge is to scale a business using what is often limited debt and equity financing, prior to being cashflow positive.
What is more, they do not typically have the background to be able to understand each of the US tax regime structures available to them, to operate the venture business in a tax-efficient manner after paying taxes, during their operation, scaling, and eventual ownership exit.
Given their limited tax technical background, they often-times rely on advisers to help them decide what US legal and tax structure to utilize. However, the considerations and factors required for an appropriate analysis, and in some cases a necessary detailed-modeling exercise, can be extremely nuanced.
Over the lifetime of their venture ownership, from launching their start-up through the final year when they exit the venture (Year 5, 6, or more), the US / State employment and income taxes can vary by several millions of dollars or more depending on the US tax regime(s) chosen. And in some cases, starting utilizing one regime structure, and switching to another can make a lot of sense.
In summary, short-sighted advice received at the outset can cost entrepreneurs and their investors a lot of after-tax cash, that for example, could have been invested in venture #2. Specifically, there is even an ability to “roll” sales proceeds into venture #2, #3, or more, for example, on a tax-deferred basis (similar to Section 1031 real estate property exchanges). Additionally, with a combined holding period of five years, entrepreneurs can realize $2.5M (or possibly exponentially more) in permanent Federal and State income tax savings under Section 1202.
Please reach out if you would like to learn more, I would be happy to discuss further with you or your portfolio company founder to ensure each shareholder can take advantage of an optimal tax structure.
Eric Evans, Tax Partner