Posted on August 28, 2015 by Jeanne Goulet
This blog is a new tool to provide emerging growth companies / entrepreneurs / founders / investors with smart and timely advice on tax, accounting and finance related topics.
As a well-established accounting and advisory firm that serves the needs of a variety of business sizes and professional sectors, Marks Paneth can provide beneficial expertise and advice that might not be readily available from angel investors, venture capital firms, bankers, lawyers or other advisors.
This initial blog series will focus on a Six-Step approach to managing the life cycle of a growth business — from formation issues through on-going tax and financial planning, to exit via acquisition, merger or IPO.
Our aim is to provide growth companies / entrepreneurs with an overview of tax and accounting issues that can improve net cash flow and help you better manage tax liabilities, which in turn will deliver better returns through the life of the company, and upon exit.
The direct benefits to founders / entrepreneurs / startup firms/ investors will be to limit tax liabilities and unpleasant financial surprises due to improper financial structures and tax planning.
We’ll also share Smart Tax Strategies to help optimize cash flow and exit valuations, and increase long-term wealth building opportunities for founders and early investors.
Tax and accounting issues can be complicated and hard for the average entrepreneur to grasp, especially if they are busy building and running a growth company. So we’ll break this advice down into smaller discussions, sharing hypothetical business situations — with some potentially scary outcomes that can result from bad accounting and tax planning.
The good news is that we’ll also provide “Smart Moves” in each blog post that can act as a road map for tax, accounting and financial planning — to help you make and keep the most value that your growth company has to offer.
Marks Paneth is committed to acting as a strategic business partner and trusted advisor for our clients, offering a full range of professional services, including: Corporate tax services: From establishment of tax-efficient ownership and operational structure to tax planning and preparation of federal, state and local tax returns. Personal tax services and planning for entrepreneurs, including trusts / estates and asset protection. Accounting services / preparation of financial statements. Auditing / Employee Benefits Plans. Litigation and Corporate Financial Advisory: Intellectual property, business valuation, and assistance with capital raising and meeting regulatory requirements.
This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.
Reprinted and used with permission from Marks Paneth LLP
Posted on October 30, 2015 by Jeanne Goulet
When preparing for any equity or debt fund raise — have your CPA evaluate the financial implications of the terms & conditions. In essence, scrub down your term sheet to help get the best fund raising outcomes.
According to Bruce Gibney, formerly with famed Venture Captial firm Founders Fund (http://foundersfund.com/)) “Venture financing turns on three things: Money, power and ignorance.” He went on to note “These variables converge most violently in the term sheet, which proposes the basic relationship between the venture capitalist and the company. Term sheets have a set of short, formalized components, which in combination quickly become exceedingly tangled and opaque.”
In essence the term sheet (http://web.archive.org/web/20130303042811/http://www.foundersfund.com/uploads/term_sheet_explained.pdf) acts as the initial road map for an investment agreement, setting out the broad parameters of a potential investment typically in terms of five key elements: The stock purchase agreement, the investor’s rights agreement, the certificate of incorporation, right-of-first refusal & co sale agreement and voting agreement.
When it comes to term sheets it is important for founders, entrepreneurs and their business partners to have a qualified CPA evaluate their term sheet closely before they are signed. One should clearly understand how the specific terms will apply to them personally, on a financial basis. This careful examination of the terms will allow you to clearly understand the potential financial, tax liability and legal impact of various provisions in the document.
This exercise may show that for founders (and the company at large) that some funding is not worth taking, and taking money based on terms that are unfavorable to your company may reduce its overall value in the long-term. You need to look beyond the “boilerplate terms” that are often included to facilitate a funding transaction by lawyers, venture capitalists and private equity firms.
In particular, the following should be given close consideration when it comes to creating and reviewing the term sheet:
– Stock Restriction Agreements: Are there limitations on transfer of shares? If you are the owner, can you sell your shares? Who can you sell them to, and when?
It may be possible to negotiate terms that are more favorable to founders, like being able to sell their shares at a premium over their cost-basis. This is a good thing in the event the company grows, becoming prosperous, and the company’s share value appreciates as a result.
Vesting schedules (https://www.quora.com/Whats-an-appropriate-founder-vestingschedule) are another favorable term to consider for founders. The most common founder schedule vests an equal percentage of stock (25%) every year for four years on a monthly basis. It may be appropriate for a one year “cliff” (i.e. the founders don’t get their initial 25% share vestment unless they stay with the firm for at least 12 months) especially if the founders don’t have a history of working together.
And is there enough cash available for potential buyout options? If one founder decides to leave the business and the other founders want to buy them out, will there be enough cash available to facilitate this transaction? Are there insurance policies that might facilitate this buyout?
– Onerous Liquidation Preferences: They can effect the distribution of the fund raising “waterfall,” including return of capital, different rates of return, and different participation parameters. Founders and early seed investors can get short-changed as a firm moves forward in its fund raising efforts.
Unfavorable liquidation preferences can dictate that later investors (example: Series A vs. Seed round) reap the majority of the economic benefit when a company exits through a sale or M&A activity. This can leave founders and early angel or seed round investors holding the short-end of the economic stick so to speak.
So make sure you understand the terms of subsequent fund raising rounds, decide that you really need the money now, and it’s “worth it” at this point in the life-cycle of your business.
– Terms of Debt Covenants: These terms are a promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out. When expressed in unfavorable terms, they can render an emerging growth company vulnerable.
You should work with your CPA and lawyers to avoid unfavorable repayment requirements, based for example on maintaining a certain EBITDA level, restrictions on business expansions or acquisitions. This can cause a problem because it might require you to pay back a loan before you are ready (or able) to pay it back. It pays to drill down on the details here, like exactly how the lender is going to make the EBITDA calculations.
– Tax Deductibility of Interest Payments: Tax deduction losses, and therefore a higher tax bill, can occur due to applicable tax laws.
The first example is “Payments-in-Kind” (PIKs) where a company pays its loan interest expense in the form of additional bonds, shares of preferred stock, or some other service offered in kind -in lieu of paying in cash. These types of interest payments to lenders are not always tax deductible.
Another pitfall to avoid is known as “Applicable High Yield Discount Obligations” (AHYDO). An example of this is a loan interest rate that is five points higher than the applicable federal benchmark rate. In this case you may not be able to get a tax deduction on the interest expense because the interest rate is considered by tax authorities to be too high.
In this case tax authorities are guarding against excessive interest expense tax deductions — that might be used to fund acquisitions, a vestige from the days of leveraged buyouts.
– Options and Warrants: It’s important to know how the options and warrants will be treated — as these contractual instruments allow the holder special rights to buy securities at a fixed price (exercise price) until they expire.
There is a difference between the two: Stock options are typically associated with compensatory services, while warrants are usually tied to investment transactions.
For example an employee or consultant will typically receive stock options. An investor in a convertible note and warrant round typically receives stock warrants.
A compensatory option will look different from a contractual standpoint compared to an investment warrant. Options are usually granted under an equity compensation incentive plan, have a vesting period and repurchase rights on termination of service. A warrant will not be granted under an equity incentive plan, and usually does not come with a vesting requirement.
In addition, the tax liability differences between compensatory stock options and investment warrants are dramatically different. Be sure you know how these terms are stated in your term sheet, and check with your CPA on the different potential tax liability consequences of what’s being offered.
Tax Liability Risk to Employees
The New York Times reported (http://www.nytimes.com/2015/12/27/technology/when-a-unicornstart-up-stumbles-its-employees-get-hurt.html?emc=eta1&_r=1) in December of 2015 “When a Unicorn Start-Up Stumbles, Its Employees Get Hurt” citing the example of Good Technology, a mobile technology security start-up based in Sunnyvale, CA. The article explains the potentially catastrophic tax liability some start-up employees may face if they invest in a company backed by venture capital, when the company goes south in terms of its stock valuation.
So these are the many types of issues you need to consider when raising money. Careful analysis with your CPA can help to determine if makes fiscal sense to take investment money or loans, or not.
We strongly recommend that you have a qualified CPA review your term sheet to identify both potentially favorable and unfavorable terms. Then if possible you should work to negotiate better terms that will deliver positive financial outcomes in the long run.
This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.
Reprinted and used with permission from Marks Paneth LLP
Posted on September 14, 2015 by Jeanne Goulet
This is a guest blog by Mark Oblad who is the founder and principal developer of Valcu, which provides startups with do-it-yourself tools for incorporating in Delaware, post-incorporation setup, cap tables, financing terms sheets & documents, and private company valuations. This blog originally appeared in the Traklight Blog: (http://bit.ly/2fJlB1a)
Incorporating Your Business: Corporation vs. S-Corporation vs. LLC
So you’ve got your great business idea and you’re ready to get started. Or, maybe you’ve gotten started and you want to make it official. You’ve decided you need an entity. But what kind?
You’ve heard that you should just start with an LLC and that it’s easier. Maybe you’ve heard that you should definitely do Delaware. Or, maybe the opposite, don’t waste your money by paying franchise taxes in two states.
In some cases, the answers may be clear, but in many others, it’s not.
Pass Through vs. Double Taxation
As a baseline, tax rules in the U.S. distinguish between entities that are considered pass through (or disregarded in some cases): entities that don’t pay their own layer of income tax; and entities that are taxable: entities that pay taxes on their own income.
Generally speaking, pass-through entities will still have to keep full records and file tax returns, but rather than paying income taxes, the entity tells all of its partners or members what their share of the income is. The partners and members are then responsible for reporting their share of the income and paying taxes. These taxes would be owed whether or not the entity made a distribution to its partners or members.
Entities that are subject to two levels of taxes have full responsibility for reporting and paying income taxes. The second layer of tax comes in when the shareholders of the entity get money back from the entity, either as a distribution of excess cash (a dividend) or when the shareholder sells its shares, and
pays taxes on the dividend or sale of shares.
With a pass-through entity, while required book “allocations” of income to the entity’s partners or members are taxable events, “distributions” to partners or members are generally not taxable events. Furthermore, partners or members of pass-through entities may be able to offset other income with losses generated by the entity, subject to passive-activity loss, at-risk and other rules.
Limitations on Pass-Through Entities
So, less tax is better. Why not just be a pass through?
In businesses where it is likely that frequent distributions will be made to its partners or members (e.g., consulting and other service-type businesses, businesses earning royalties, etc.), the pass-through entity choice makes a lot of sense.
In some cases, however, restrictions are put on pass-through entities in order to level the business playing field. For example, consider non-profits. If the pass-through entity doesn’t pay any taxes, and its partners or members are also exempt from tax then no taxes would paid on the pass through entity’s business activities at all. This would also mean that non-profits would be able to fund businesses that could operate at cut-rate prices and unfairly compete against taxable businesses without the same advantage. Consequently, non-profit entities have to pay penalty taxes if they generate business income (unrelated taxable business income, or UBTI).
What does this have to do with your business? If you are seeking investment from venture funds or other equity investors who have tax-exempt partners or members, you will likely have to become an entity that is double taxed. Many of the venture funds are pass-through entities all the way up to their limited partners, some of who are non-profits. As such, the venture funds operate under a
Number of governance rules designed to limit the possibility of generating UBTI. In broad strokes, venture funds are unwilling to invest in pass-through entities that are operating businesses, in order to ensure that any non-profit partners or members do not generate UBTI.
Corporation vs. S-Corp vs. LLC
By default, corporations are double-taxed entities (the C-corp.). In some cases, tax rules allow a corporation to file an S-election to become a pass-through entity. The upsides of the S-corporation are pass-through status (though some states and other taxing authorities (e.g., Massachusetts and New York City) may not afford the (full) benefits of pass-through status to S-corporations) while at the
same time enjoying the strong support network around corporations. S- corporations may be easy to get back to C-corporations a well: just fail the rules, by for example taking an investment from, and issuing preferred stock to, an entity.
S-corporations, however, operate under a number of limitations. Some of the principal limitations are: (1) they may only have one class of stock; (2) only individuals and certain trusts may own shares; (3) only U.S. citizens and tax residents may own stock; and (4) they may have no more than 100 shareholders.
Getting in on the game of offering corporate flexibility and limited liability on an entity type that would be considered a pass through, states created the limited liability company (LLC). The downsides of the LLC are that most venture funds will require the entity to convert to a corporation or will have to set up its own corporation to sit in between the venture fund and the LLC. Conversion to a corporation can also be complicated–often done as a merger of the LLC into a corporation, in which LLC interests are exchanged for different series of stock that replicate the differing investments made in the LLC. Members of an LLC may also be required to file tax returns and pay taxes in additional states, and non-U.S. members of an LLC may be required to file tax returns and pay taxes in the U.S.
Despite its double-taxed status, the basic C-corporation may be the end goal in many cases. One possibility for mitigating (or deferring) tax in a C-corporation is when the corporation’s stock qualifies as “qualified small business” (QSB) stock. There are a number of requirements to obtain these benefits, including a 5-year holding period and/or reinvestment into another QSB within sixty days.
On the downsides of a C-corporation, if there is a reason to convert the entity to an LLC, there may be a large tax bill as a result of such conversion. Furthermore, if the company exits through a sale of assets (more often occurring during a fire-sale of the company) rather than a merger or stock sale, the full brunt of double taxation will likely be borne: the entity realizes gains and has to pay taxes on the
sale of assets, and the remaining proceeds dividended out to shareholders are subject to dividend tax.
Delaware?
States charge franchise taxes on entities created in their state and benefit from having as many entities as possible paying these taxes. This also means that states compete against each other for franchise tax, by among other things adopting laws meant to foster business, investing in a sophisticated court system that interprets corporate rules and investing in the administrative arm that processes filings for the entities. The state that has fared best in this game is Delaware. There is also a snowball effect where case law becomes the most developed, law students studying corporate law nationwide focus on Delaware law and large law firms nationwide maintain their forms to accommodate Delaware law.
Your Jurisdiction
Every time a company touches a new jurisdiction, there is a new possibility for tax leakage, or the obligation to pay taxes in that jurisdiction. If you’re in another U.S. state, your business will likely also have to qualify to do business and pay annual qualification taxes locally in addition to Delaware. For some small businesses with competent advisors who have ready-built forms around local law, it may make sense to save on the franchise taxes. Furthermore, if you and your business are not in the U.S. and are aimed at a non-U.S. market, subjecting your company (or yourself) to taxes in the U.S. may not be a great idea in the long run. The possibilities for venture financing in the U.S. may, however, counterbalance this consideration.
Some Common Myths
Myth: LLCs are easier. Truth: LLC documents tend to be less standardized. LLCs with more than one member generally must also file tax returns and distribute K-1s to their partners or members. Single-member LLCs (disregarded entities) may also be subject to additional IRS scrutiny. The Delaware franchise tax may be lower for a Delaware LLC, but in states like New York, the (Delaware or other)
LLC is hit with $2k publication requirement.
Myth: LLC-to-corporation conversions are easy. Truth: simple tax reclassifications (e.g., form 8832) may cause a capital shift and don’t change the corporate law. Merging an LLC into a corporation can allow for a matching of the capital accounts while avoiding triggering most assignment clauses in contracts.
Myth: Incorporating in a low (income) tax jurisdiction will save taxes. Truth: many jurisdictions will look at where the business is operating in addition to the place of incorporation to determine taxability.
Myth: LLCs don’t have shares and don’t have option plans. Truth: the LLC is very flexible and limited liability company agreements can be written to mimic corporations with shares and multiple classes (though these LLC agreements can be complicated). LLCs can also adopt option plans (though options granted through the plan would not be treated as Incentive Stock Options (ISOs)). Note that profits interests granted through, or the exercise of options under, such an option plan, can make the holder a member of the LLC, and consequently reclassify the holder from a W-2 employee to a K-1 partner.
Myth: C-corporations and S-corporations are incorporated differently. Truth: C-corporations and S-corporations generally start out as a basic corporation and are treated differently by tax rules when they make tax elections.
Takeaway
If the plan is to build a fast growing company that is using any cash generated to fuel growth and will likely raise venture funding, a Delaware corporation may be the best fit. Holding companies and cash-generating companies usually fit well in a Delaware LLC. Businesses with less clarity may have a more difficult cost-benefit analysis.
FOR A NUMBER OF REASONS, THIS POST IS NO SUBSTITUTE FOR, AND IS NOT AND SHOULD NOT BE CONSTRUED AS, LEGAL OR TAX ADVICE.
Many thanks to Nicholas J. Guttilla from Gunderson Dettmer Stough Villeneuve Franklin & Hachigian, LLP, James “Jace” Clegg from Ropes & Gray LLP and Jeanne Goulet from Marks Paneth LLP for helpful discussions and pointers.
Mark Oblad is the founder and principal developer of Valcu Inc. (valcu.co). Mark cut his teeth at Gunderson Dettmer, picked up the CFA designation on the weekends and attended law school at UVA. Valcu provides automated tools for incorporating startups in Delaware and running the post-incorporation setup (appoint directors and officers, adopt bylaws, issue founder stock with vesting and generate founder consulting or employment agreements with IP assignment). Valcu also has a number of other web tools under development to help professionals and startups, including capitalization table maintenance tools, term sheet and financing document generators (accommodating the full deep structure of the documents) and valuation tools.
This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.
Reprinted and used with permission from Marks Paneth LLP
FOCUS YOUR FINANCIAL PICTURE FOR IMPROVED OUTCOMES.
Be sure to focus your financial picture before an audit, exit talks or IPO, because you get one chance to make a great first impression with your financial statements, and you can improve your outcomes as a result.
Tomasz Tunguz – a venture capitalist at Menlo Park, CA based Redpoint Ventures characterized financial statements as “A Rosetta Stone for startups.” He went on to observe in his blog “They reveal the strategies and the tactics of how to bring a product to market.”
Tunguz identified ten key metrics he looks at when sifting through a startup’s operational model, whether he is considering an investment or in a board meeting. They ranged from revenue growth to net income, gross margin to customer acquisition payback period and sales efficiency.
Consider the massive downside financial valuation impact of poorly prepared financial statements, as seen from the Groupon fiasco of April 2012.
Groupon offers deals and coupons for restaurants, retailers and service providers. It made a big splash back in 2011 when its IPO was issued raising $805 million. Investment banks, including Goldman Sachs, made millions in fees.
After an audit revealed “material weaknesses” in its internal controls over financial reporting, specifically in terms of accounting for customer refunds, the company’s stock dropped a precipitous 17% in one day.
The company was then forced to restate its 4th Quarter 2011 financials, and in the end the stock tanked by 44% and $350 million in equity valuation simply vaporized. Groupon’s equity valuation has never fully recovered.
Could this have been avoided? Certainly yes, had these problems been rectified prior to the financial audit by engaging in thorough pre-audit preparation.
Here are some key areas to examine in terms of your company’s financial statements, in order to maximize your selling price and to minimize potential hold-backs.
Hold-backs occur when there are issues with your business that potentially have not been properly managed. As a result the buyer may be interested in setting aside money in the event that these risks materialize, and result in tax liabilities and penalties that will potentially need to be paid out.
These business issues of concern to a potential buyer usually come out during the due diligence process. They can include: failure to file federal, state, local and foreign tax returns – with potential taxes being owed; failure to collect and remit sales tax; and improper characterization of independent contractors. These are are all common triggers for hold-backs.
It is extremely important to work with a qualified CPA to rectify these potential problems prior to exploring exit options, so the issues can be corrected and the valuation of the company can then be optimized.
Another important task is to evaluate your company’s valuation under alternative structures and then prepare a negotiation position.
For example, explore the potential consequences of selling assets vs. stock. Buyers often prefer to buy assets over stock because it allows them to avoid taking on liabilities and business issues or risks facing your company. And buyers can then step up the valuation basis of the assets and then depreciate from a higher level, usually reducing their tax liability in the process.
As the seller, you may face a high tax rate (65% rate) that you can perhaps negotiate and have the buyer pay part of the tax bill. If the buyer is willing to buy the stock and then can’t get the lower tax rate, they may in turn offer you a lower price. There are also tax-deferral strategies, including installment sales and earn-outs.
So it pays to take all these variables into consideration, and develop an exit strategy that will work best for you.
You will also need to identify the information requirements for potential buyers and their respective due diligence process, as different buyers will likely have different requirements. Consider the view of Venture Capital or Private Equity firms who want a company that can stand alone, versus a strategic buyer who plans to integrate your business into their existing business structure.
It’s important to have all the relevant information a buyer may need readily available in advance, because good first impressions are important to help foster the best exit negotiation outcomes.
“Be prepared to discuss detailed and pointed questions about company information, strategy, growth plans and operations, as the buyer will pick through your balance sheet and income statement” as Tomasz Tunguz points out.
Identify and highlight major deal issues from an accounting and financial perspective, and either remedy or prepare a response for the issues for the buyer’s due diligence inquiry. Examples include revenue recognition methodology, aging of accounts receivable, unfavorable contract terms with significant customers or system limitations. Develop potential solutions that will help minimize the impact of these issues on your exit negotiations.
On the positive side, be sure to identify and highlight potential upside indicators for the business that can enhance the value. If you have expansion plans, or the buyer has a particularly good fit with your business model that will enhance the growth trajectory of both companies – this is the time to bring it up.
Also consider impediments that might slow down the deal – for example if you need to transfer key contracts to the new owner you may need customer approval to do so. Transfer of outstanding loan liabilities may require the lender’s approval as well. You may even need to deal with structural issues for the company that will help facilitate the sale. Any number of these issues can and will have an impact on the final valuation of the company.
If you are selling at a multiple of earnings, say for example 10X, any significant reduction in the company valuation can have a big material impact on the final sale price of the company.
In other words, any problems with your financial statements can cost you plenty in the end!
This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.
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