From Startup through IPO or Acquisition.

Transcription

1 From Startup through IPO or Acquisition. Wealth planning before and after a liquidity event. Prepared by: Eric J. Smith, Senior Wealth Planning Strategist. In this white paper: 1 Overview 1 Wealth planning before a liquidity event 1 Developing your financial plan 1 How the IPO or acquisition structure can affect you 2 Risks in pre-ipo or pre-acquisition stock 3 Taxation of RSUs, restricted stock and stock options: Income tax rules and incentives for growth company equity 4 Estate planning opportunities 5 Wealth planning after a liquidity event 5 Restrictions on selling, hedging or pledging your newly public stock 6 Charitable giving and planning opportunities 7 Qualified small business stock tax incentives 7 Monetizing, hedging and diversifying your concentrated position of public stock 11 Conclusion 11 Appendix A 11 Financing phases of a typical emerging growth company

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3 From Startup through IPO or Acquisition. Wealth planning before and after a liquidity event. Overview. For founders, officers, employees and investors, an initial public offering (IPO) or acquisition may be the most important financial event in their lives and a critical time to develop a financial plan to diversify or preserve the wealth created through these events. As the dotcom crash in 2001 and recent IPOs remind us, there is no guarantee that a company s stock price will go up after an IPO; it can drop dramatically, wiping out some or all of those paper millions. Maximizing the potential long-term financial rewards of a liquidity event requires strategic financial planning before the event, not just after. This paper provides an overview of financial and investment planning issues for equity stakeholders 1 in early stage growth companies, 2 commonly known as startups. Many early stage private growth companies are venture capital-backed 3 startups in one of several industries: software, life sciences, internet-specific (e.g., social media), industrial/energy (including clean technology), IT services, media and entertainment. 4 While there is a new and growing secondary marketplace for limited trading of private company shares for qualified participants, 5 typically startup founders, employees and investors cannot monetize their holdings until the company has a liquidity event, either through an IPO or an acquisition by another company. 6 Although IPOs get most of the media attention, the vast majority of growth companies reach a liquidity event through a merger or an acquisition. 7 Wealth planning before a liquidity event. Developing your financial plan. During the dotcom boom and bust in the late 1990s and early 2000s, countless startup founders, employees and investors lost paper fortunes by failing to implement financial plans to sell and diversify before their stock lost value or became worthless. Some even had to file for bankruptcy as a result of making poor tax decisions. 8 Financial planning is an important step in helping to grow, protect and transition your wealth. Managing your stock, restricted stock units (RSUs) or options starts with identifying your personal financial goals and issues. These may include long-term cash flow needs, retirement security, income taxes, investment strategy and estate planning. It s also important to take into account legal and company policy restrictions on selling your stock. Developing an integrated plan can help provide a road map for the many tax and investment decisions you will need to make before, during and after a liquidity event. The advisory team approach to planning. An equity stakeholder should have a team of professionals including a tax accountant, financial advisor or planner, investment strategist, trust and estate attorney working in coordination with their corporate legal counsel to help plan for liquidity events and longer term financial needs. Ideally one of these advisors (often a financial advisor or financial planner) will act as a quarterback to coordinate the various team players that will develop and implement the financial plan. This coordinated team approach can help reduce the time spent by the equity stakeholder and help maximize the potential for a successful outcome. Remember: Because time-sensitive tax and investment decisions are important factors in determining whether or when you reach your financial goals, it is important to consider planning well before the liquidity event to try to mitigate mistakes. During and after the liquidity event, you can update and refine the planning. How the IPO or acquisition structure can affect you. Understanding the capital structure of your growth company and the potential outcomes in an IPO or acquisition is essential in developing your financial plan. Growth companies structured as C corporations issue common stock (or options or RSUs for common stock) to founders and employees, while preferred stock is issued to cash investors like venture capitalists (VCs) and angel investors. 9 Prior to an IPO or acquisition, most growth companies raise equity capital in rounds. From Startup through IPO or Acquisition 1

4 Each round raises enough money to fund the company through its next major developmental, operational or financial milestone, and then it raises its next round but at a higher valuation. The final financing phase for most growth companies and liquidity event for existing stockholders is to be acquired by a public company or undertake an IPO. (See Appendix A for more detail on the financing phases of a typical growth company.) IPO structure. An IPO involves a new offering and issuance of common stock by the company. Preferred stock normally converts into common stock immediately prior to the IPO. The IPO process involves a team of professionals including underwriters, attorneys, accountants and company management, and can take anywhere from four months to over a year. 10 The number of shares to be offered in an IPO is determined by several factors, including creating a large enough float (the total number of shares publicly owned and available for trading) to provide liquidity for the stock to trade after the IPO. The final per share price 11 is determined by the company s valuation 12 divided by the number of shares outstanding after the IPO, after giving effect to any forward or reverse stock splits advised by the managing underwriters to achieve an appropriate initial per share price for marketing purposes. 13 Selling stockholder participation. Some existing stockholders may also be allowed or requested to sell shares in an IPO. If the company does not need to raise a large amount of capital, stockholder participation will be important to increase the public float and investor liquidity. Allowing existing stockholders (especially those with large positions) to sell in the IPO also reduces the market overhang (existing, privately held shares which can be sold in the future), minimizing the risk that large blocks of stock may flood into the market and depress the stock price. However, while a growth company typically has contractual obligations to register shares of VCs to be included in the IPO, significant sales by insiders in the IPO can spook the markets by creating a perception that insiders are bailing out. The amount of selling stockholder participation is made in consultation with the managing underwriters in light of these factors. Most employees are typically only allowed to sell a small amount, if any, in the IPO and must instead wait until their lock-up expires 14 (typically 180 days, but can be extended or reduced, in some cases) to begin selling, subject to company or legal restrictions. Merger or acquisition structure. A merger or acquisition is typically structured as all stock, all cash or a combination of stock and cash transaction. But other key terms also come into play, including how much is paid up-font, how much is held back or subject to an earn out, the time period over which it is paid, the treatment of stock options and RSUs, etc. Also, treatment of individual founders and employees may vary dramatically depending on the value the acquirer places on retaining each specific person. Unlike IPOs, acquisitions often happen without much or any advance notice to employees. And what employees receive in the sale is completely dependent on the terms of the negotiated merger or acquisition agreement. Common stockholders are often surprised and disappointed to learn for the first time that because of the liquidation preferences of preferred stock they will receive little or in some cases nothing upon the sale of the company. Risks in pre-ipo or pre-acquisition stock. Being aware of some basic risks to your pre-ipo or pre-acquisition stock is critical in planning for what you might ultimately receive, if anything, in a liquidity event. Stock splits. Many people analyzing the equity component of an employment offer from a pre-ipo startup mistakenly think that a large number of shares equates to a lot of value. But the number of shares outstanding in a private company is arbitrary and many companies implement a stock split prior to an IPO to set a per-share price that is within a range preferred by the public market place. Remember: Focus on the percentage of company ownership represented by your shares (or options or RSUs), and not the number of shares, to help estimate the potential value of your options, RSUs or stock. Dilution. Another factor to be aware of is the dilutive impact of future issuances of stock and options to employees and investors. For example, if an early stage hire is granted restricted stock or options representing five percent of the company, subsequent issuances to employees and investors have the potential to dramatically reduce that percentage by the time of the liquidity event. Potential dilution is very specific to each growth company, and largely depends on how much capital will need to be raised and how many additional employees will need to be hired after an early stage hire s grant of equity before a liquidity event. 2 From Startup through IPO or Acquisition

5 Remember: Be aware that your percentage of company ownership may decrease (be diluted) as more stock is issued to investors and employees after an initial grant of shares, options or RSUs. Preferred stock liquidation preferences. VCs and other cash investors buy convertible preferred stock when they invest in a private startup. The preferred stock has a liquidation preference which means VCs have a choice when the company is sold: either they can take the sale proceeds (cash and/or stock) off the top and get their investment back (often with a specified additional return), or they can convert to common stock and get what the common stockholders get for each share. Since the 2001 tech crash, VCs are also more commonly utilizing two variations to convertible preferred stock. One is a participating convertible preferred stock, which allows the VCs to get their money back (sometimes with an additional return) first and then convert their preferred stock to common stock and share in what is left, if anything. The other method is a multiple liquidation preference which gives VCs an opportunity to get two, three, four, or five times their investment back before common stockholders get any proceeds from a sale of the company. Immediately prior to the acquisition, preferred stockholders may decide whether or not to convert to common stock based on which route pays more. If the company is acquired for a price that is less than what preferred stockholders have invested (plus any additional return baked into the liquidation preference), the preferred stock will not be converted to common stock and the common stockholders may receive substantially less or nothing at all. Note: In most IPOs, all preferred stock is converted to common stock right before the IPO, rendering the liquidation preference irrelevant. 15 Remember: Review the details of the preferred stock liquidation preferences and how many shares are outstanding in order to estimate how those liquidation preferences may impact what you ultimately receive for your common stock in a hypothetical merger or acquisition. Vesting restrictions and acceleration triggers. Vesting restrictions are usually imposed on all grants of restricted stock, RSUs or options. If an employee s service is terminated for any reason before the option fully vests (typically over four years), the unvested portion is forfeited. Founders and senior executives commonly negotiate accelerated vesting on a sale of the company, but such provisions do not typically exist in a company s equity incentive plan, which is set for the benefit of all workers and not commonly negotiable by individual employees. Single trigger acceleration means the unvested stock or options vest (partially or wholly) ahead of schedule if the company is acquired. Double trigger acceleration means that vesting is accelerated only if the employee is terminated (or materially demoted) without cause after the acquisition. If your stock options do not have these provisions, you must remain an employee of the acquiring company for the remainder of the vesting period to receive the full benefit of the option grant. In rare cases, the equity incentive plan may even provide that unvested options are canceled upon an acquisition. Remember: To help plan accordingly, determine whether or not your RSUs, options or restricted stock have accelerated vesting in connection with an acquisition. Taxation of RSUs, restricted stock and stock options: Income tax rules and incentives for growth company equity. In developing your financial plan you should be aware of basic taxation rules for restricted stock, RSUs and options. RSUs. RSUs are not taxable until they vest, at which time the entire value of the vested stock is taxed as ordinary income. Most RSU plans allow or require the company to automatically sell enough shares on the vesting date to cover withholding tax and withhold that amount. The value of all the RSUs which vest during the year are reported on the employee s W-2. The only choice after vesting is whether to sell the vested stock immediately in which case no extra tax is due or hold the stock and sell it later. If the stock is held for at least one year after it vests, any gain on sale is taxed as long-term capital gains. The key decision is whether to hold the stock for at least a year in order to pay the lower capital gains rate. This vest and hold strategy must be weighed against the risk of holding a single company stock and failing to diversify investments. Restricted stock. Restricted stock 16 normally vests over time (four years is common) provided the holder remains an employee or service provider. The tax code provides a choice on how restricted stock is taxed. The employee or service provider can choose to file an 83(b) election within 30 days of receipt of the unvested stock and pay ordinary income tax based on the value of the common stock on that date less the amount paid for it. 17 The From Startup through IPO or Acquisition 3

6 83(b) election starts the capital gains holding period. If the holder chooses not to file an 83(b) election, he or she recognizes taxable ordinary income each date any stock vests based on the value of the stock on that vesting date, less any amount paid for the stock. Non-Qualified Stock Options (NQSOs). NQSOs are not taxed at the time they re granted but when they are exercised. The spread the value of the stock at exercise less exercise price is taxed as ordinary income. If the stock received on exercise is then held for at least a year, any appreciation after the exercise date is taxed as long-term capital gains. The potential tax savings of exercising and holding NQSOs need to be weighed against the added exposure to the unnecessary and otherwise uncompensated risk of holding a concentrated stock position. Incentive Stock Options (ISOs). An ISO is neither taxed at grant nor at exercise; however, the spread is an alternative minimum tax (AMT) preference item which can trigger AMT. Except for potential AMT, if the stock received on exercise is sold at least two years after the option grant and one year after exercise, the entire gain will be taxed as long-term capital gains. Consult with your accountant regarding any potential AMT impact before exercising an ISO. If you exercise the ISO and sell the stock immediately (also known as a disqualifying disposition), all gain (the spread) is taxable as ordinary income. The potential tax savings of exercising and holding ISOs needs to be weighed against the AMT impact and, like NQSOs, the added exposure to the unnecessary and otherwise uncompensated risk of holding a concentrated stock position. Planning alert: After the IPO, if your RSUs or options represent a significant portion of your wealth and you are not yet financially independent, you may consider the benefits of exercising and selling these holdings as they vest and investing the proceeds in a diversified portfolio. If you are financially independent (i.e., already have enough wealth to support all your basic needs without working), you may consider being more aggressive in taking the risk of holding a more concentrated position. Estate planning opportunities. The federal estate, gift, and GST tax rates are set permanently at 40 percent. The unified estate and gift tax exemption and the GST tax exemption are now permanently set at $5 million, adjusted annually for inflation. The inflation-adjusted amount for 2017 is $5.49 million. Remember: You may want to consider taking advantage of the current large gift tax exemption, relatively low gift tax rates, and certain wealth transfer strategies before tax laws change again. Benefit of gifting before the IPO or acquisition. Gifting vested stock or options before an IPO or acquisition, when the value is low compared to the potential IPO or acquisition value, can help to potentially increase your and your family s long-term wealth, perhaps for multiple generations. An illustration helps make this clear: John Doe owns stock of ABC, Inc., a pre-ipo company, which is presently valued (by a professional appraiser) at $2 per share. In 2017, John makes a taxable gift of 5,000,000 shares of ABC stock to an irrevocable trust established for the benefit of his three children. He elects to use $10 million of his and his wife s $10.8 million lifetime estate and gift tax exemption for this gift; thus, he will pay no gift tax. In 2018, ABC, Inc. completes an IPO which values the stock at $10 per share, meaning the 5,000,000 shares transferred to the trust are now worth $50 million. In other words, $50 million of value has been transferred free of estate and gift tax. In contrast, if John waited to gift the stock until after the IPO, he would have to pay $15.2 million in gift tax! 18 Note: The value of any stock to be gifted should be determined by a professional appraiser. Note: Charitable giving and qualified small business stock tax incentives are discussed on page 6 and page 7, respectively. 4 From Startup through IPO or Acquisition

7 Intentionally Defective Grantor Trust (IDGT). The potential benefit of gifting early can be supercharged by making the gift to a specific type of irrevocable trust known as an IDGT. An IDGT is designed to be complete for gift and estate tax purposes, 19 but defective for income tax purposes. This means that assets held by the trust are excluded from your estate for estate tax purposes, but taxed to you during life for income tax purposes. When you pay the income tax due on assets in an IDGT, you further reduce your taxable estate (without it being considered a taxable gift) 20 and allow the assets in the trust to grow tax free. Dynasty trust. Your irrevocable gift trust can also be established in a jurisdiction like South Dakota or Delaware that permits a dynasty or legacy trust. 21 A dynasty trust can be designed to help mitigate gift, estate and generation-skipping trust taxes, and provide benefits for multiple generations. If structured properly, income which accumulates in a dynasty trust may also help avoid state income taxation, which can be substantial in a state like California. Grantor Retained Annuity Trusts (GRAT). Another common strategy to transfer pre-ipo or pre-acquisition stock to children or other beneficiaries is to use a GRAT. GRATs are also effective for post-ipo stock before it is sold and the proceeds are diversified. See page 10 for a discussion of GRATs. Charitable giving and planning opportunities. See page 6 for a discussion of tax-related charitable planning. Wealth planning after a liquidity event. In order to sell, hedge or pledge your newly public company stock, you typically need to navigate a series of contractual, legal, regulatory and company policy restrictions. The tax impact of various decisions is also an important part of your financial plan. In this part we start with an overview of restrictions on selling, hedging or pledging public company stock. We next discuss income tax planning opportunities and finally provide an overview of strategies for monetizing, hedging and diversifying your concentrated stock position. As always, rely on your financial, tax and legal advisors to help explain these restrictions, any corporate policies, tax rules and strategies for monetizing stock. Restrictions on selling, hedging or pledging your newly public stock. Lock-up agreements. Once your stock has gone through the IPO process or you receive stock in a merger or acquisition, your stock will normally be subject to a lockup period and you won t be able to put it on the market until the lockup expires. As mentioned in the selling stockholder participation section on page 2, underwriters will consider various factors to ensure that shares owned pre-ipo by company stakeholders don t enter the public market too soon after the IPO ostensibly to prevent an oversupply of shares from flooding the market. In an acquisition, the acquiring company may require that the acquiring company stock you receive in the deal be subject to a lock up for a period of time to avoid a large amount of shares hitting the market all at once. The terms of lockup agreements may vary, but most lockup agreements in an IPO prevent insiders from selling their shares for 180 days. Lockups may also limit the number of shares that can be sold over a designated period of time. U.S. securities laws require a company using a lockup to disclose the terms in its registration documents, including its prospectus. Once the lockup period expires, you may be in a position to consider the strategies discussed below, subject to securities laws and company policies. When approximating the right time to enter the market, factor in the theory that a company s stock price may drop in anticipation that locked up shares will be sold into the market when the lockup period ends. Corporate policies on insider trading, hedging, pledging and stock retention. Most issuers have formal policies to help safeguard against illegal insider trading, along with restrictions against hedging and margin loan (pledging) transactions by executives. These policies typically designate blackout periods (when executives are prohibited from conducting company stock transactions) which usually relate to the end of a quarterly reporting period and continue for a specified period of days after the company announces financial results. Planning alert: Company insiders can help avoid insider trading problems by understanding and complying with company insider trading policies, including blackout provisions and preclearance trading rules. This often will include getting advance approval from a designated company officer or counsel before buying or selling company shares and/or adopting a stock trading program. A brief overview of some common securities law restrictions follows on the next page. From Startup through IPO or Acquisitiont 5

8 Securities laws and regulations. Reporting on Forms 3, 4 and 5 for corporate insiders. The Securities Exchange Act of 1934 requires officers, directors and beneficial owners who hold more than 10 percent of a company stock (also defined as reporting persons or insiders ) to file an initial statement of holdings with the U.S. Securities and Exchange Commission (SEC), disclosing their beneficial ownership in the company stock. Also, insiders must report changes in ownership, including hedging arrangements or the purchase/sale of a security-based swap agreement involving such equity security, within two business days of such change. Additionally, within 45 days after the end of the company s fiscal year, insiders must also report any transactions that should have been reported earlier or were eligible for deferred reporting. See the SEC s website for more information on Forms 3, 4 and Short swing profits rule. Insiders who realize any profit from the purchase and sale (or sale and purchase) of any company shares within any period less than six months generally must return all profits associated with the transaction to the company. This short-swing profit rule is highly technical and can apply to transactions made by family members and to trusts set up for their benefit. 23 However, most acquisitions of company stock through company benefit and compensation plans are exempt transactions, and will not be considered matchable for purposes of this rule. Insider trading. Illegal insider trading refers generally to buying or selling stock while in possession of material, non-public information about the stock or company. Insider trading violations can also include tipping such information, trading of the stock by the person tipped and trading by persons who misappropriate such information. The penalties for insider trading can be severe just ask Martha Stewart or Rajat Gupta. Because of the serious consequences of illegal insider trading, most issuers have policies in place to prevent it. Rule 144. Rule 144 imposes restrictions on the resale of stock not registered with the SEC (known as restricted securities) and also to the sale of registered stock by insiders and affiliates of the company. There are holding period, volume limitation, manner of sale and other requirements for a Rule 144 sale. Contact your corporate counsel for more details. For educational purposes only, the SEC s website has a summary explanation of Rule 144 sale requirements. 24 Charitable giving and planning opportunities. Americans are the most charitable people in the world. 25 The U.S. federal tax laws have provided incentives for charitable and philanthropic activities and giving since The tax benefit of a charitable contribution hinges on: n Whether the donation is made to a public charity (including a donor advised fund) or a private foundation, n n What property is gifted to the charity, and Whether the gift is direct (the simplest) or made through a split interest vehicle, such as a charitable remainder trust (CRT), charitable lead trust (CLT) or a gift annuity. The tax benefits are generally greatest for donors who make contributions after an IPO or acquisition when they own stock with a high market value but a low cost basis. The donor may receive an income deduction for the full value of the post-ipo stock without being required to pay tax on the appreciation. Public charities/donor advised funds vs. private foundations. A donor making gifts of cash to a donor advised fund or public charities may deduct up to 50 percent of his or her adjusted gross income (AGI). In contrast, gifts of cash to most private foundations will allow a donor to deduct only up to 30 percent of his or her AGI. In either case, contributions in excess of the maximum deductible amount may be carried forward and deducted for up to five years, subject to the same percentage limitations each year. Planning alert: Consider pre-funding your lifetime giving by making one large, tax-deductible charitable donation to a donor advised fund or private foundation in the year of the IPO or liquidity event when your AGI may be exceptionally high. That large donation can then be distributed to charities by the donor advised fund or private foundation over many years. When contributing stock to charities (or donor advised funds or private foundations) for a year-end tax deduction, start the process earlier than usual as this will take longer to coordinate than cash donations. If you are contributing closely held or otherwise restricted securities (for example, you are an affiliate for Rule 144 purposes), be sure to take all the necessary steps to obtain approval for the transfer prior to making the contribution. 6 From Startup through IPO or Acquisition

9 Donating stock. The potential tax savings increase significantly when you gift long-term capital gains property, such as publicly traded stock held for more than one year, to a public charity. Such a contribution is deductible up to the full amount of the stock s fair market value. But the deduction is subject to a reduced ceiling of 30 percent of the donor s AGI. Also, if the gift is made to a private foundation, the deduction is limited to 20 percent of AGI. Private, pre-ipo stock contributed to a public charity or private foundation generates a deduction that may be limited to the donor s cost basis. Qualified small business stock tax incentives. Certain small business corporation tax incentives allow you to avoid or defer tax without having to make a charitable contribution, if you qualify. According to Forbes magazine, after Marc Andreessen sold his first venture, Netscape, to AOL, he sold $5.7 million of AOL stock to finance his next venture but didn t pay a penny in capital gains taxes. 26 You might be able to do the same thing if you own qualified small business (QSB) stock. Section 1045: Rollover of gain on sale of QSB stock. Section 1045 allows the tax-deferred rollover of gain from the sale of stock of one qualified small business corporation into stock of another qualified small business corporation. A qualified small business is one that has assets below $50 million immediately before and after you acquire your stock and is an active business that is not in certain ineligible lines of work. 27 This tax incentive is a powerful strategy for serial entrepreneurs and startup investors. To qualify for Section 1045, you must acquire your stock directly from the corporation, not from another investor. 28 There s no limit to how long you hold your QSB stock, how big the company can grow, the amount you can roll over or how many times you can do a rollover. But you must hold each stock for at least six months and make your new QSB stock investment within 60 days of selling off the old one. Your original basis is carried over into the new investment. Planning alert: Serial entrepreneurs and angel investors who can line up new investment opportunities to meet the 60-day deadline are best able to take advantage of Section Section 1202: Exclusion of gain on sale of QSB stock. Section 1202 allows an investor to eliminate (rather than just defer) up to 100 percent of the tax on gains from the sale of QSB stock, provided the stock was acquired on or after September 28, 2010 and held for at least five years before the sale. For stock acquired before September 28, 2010, either 50 percent or 75 percent of the gain is excluded. Gain which is not excluded is subject to tax at a 28 percent rate and may also be subject to the alternative minimum tax (AMT) and Medicare tax of 3.8 percent on net investment income tax. For anyone with QSB stock qualifying for the 100 percent exclusion, the AMT does not apply. But for other QSB stock, 7 percent of any excluded gain is taxable under the AMT system (in other words, in the case of a 50 percent exclusion, 3.5 percent of the gain is taxable under the AMT). In the case of a taxpayer in the top marginal tax bracket, the effective tax rate on QSB stock held for at least 5 years is: Date Acquired: On or after September 28, February 18, 2009 September 28, August 10, 1993 February 17, Excluded Amount: 100%. 0%. Effective Tax Rate: 75%. 8.44%. 50% %. Limit on excluded gains. For each company in which an investor holds QSB stock, the total amount of gain which qualifies for the exclusion is subject to an overall limitation: the greater of $10,000,000 over the taxpayer s lifetime or 10 times the adjusted basis of the QSB stock. For married individuals filing jointly, the lifetime $10,000,000 gain exclusion is allocated equally between the spouses. In the case of married individuals filing separately, the maximum gain exclusion of $10,000,000 is reduced to $5,000, Section 1244: Losses on small business stock. If your QSB shares satisfy the requirements of IRC Section 1244 as small business stock, married couples filing jointly may be able to treat capital loss (up to $100,000 each year) as an ordinary loss. 30 If you have losses in excess of the $100,000 ($50,000 for individual filers) for the year, the excess is a capital loss. The loss on the stock can stem from a sale, a company s liquidation, or if the shares become worthless. State tax issues. State income taxes may apply differently than the rules discussed above. After 2013, California for example no longer allows beneficial treatment for QSB stock. Other states will have their own rules regarding application of the gain exclusion and rollover rules, and investors should be very careful in taking positions on their state tax returns regarding the treatment of QSB stock. From Startup through IPO or Acquisition 7

10 Monetizing, hedging and diversifying your concentrated position of public stock. Subject to the above restrictions, equity holders should consider the benefits of liquidating concentrated stock positions and diversify if the stock represents a significant portion of their overall net worth, particularly if they are not yet financially independent. Even if after the IPO or acquisition your primary objective is to hold the stock, having an understanding of your options to manage risk and create liquidity when needed can be helpful as you manage your investments in the long term. Some potential options for consideration are discussed below: Liquidation and reposition. The primary objective of managing a concentrated position is to minimize downside risk. But there is a dilemma: the risk of holding vs. the tax cost of selling. IPO stock may have a low cost basis, which translates to a higher gain on sale. The current long-term federal capital gains rate is 20 percent for stock that has been held for 12 months or longer. Short-term capital gains are taxed at ordinary income tax rates. The top federal income tax rate is currently 39.6 percent. Additionally, a 3.8 percent Medicare surtax is now levied on net investment income. The combined result of the federal income tax and Medicare surtax is a 43.4 percent tax on short-term capital gains and a 23.8 percent tax on long-term capital gains. While a concentrated position may be sold all at once affording the means to diversify immediately, gradual sales over a period of time may be a good alternative by creating the opportunity to reinvest proceeds over a longer period of time, allowing you to adjust your diversification strategy as you go. Sales can be staged at designated times, such as mid-month or quarterly, at pre-set share prices and amounts or as indicated by the market. This technique positions potential gains and any resulting tax to be spread over a number of years. Capital gains in any one tax year can be offset by unused capital losses carried forward from previous tax years, as well as by any capital losses realized in the year of sale. If you are considering a sale of a portion, or all, of your concentrated position at a gain, it may be a good time to evaluate, with your investment professionals, a potential sale of loss-producing investments within your portfolio that you no longer wish to hold. The losses triggered can be used to offset the gain on sale of the concentrated position and the portfolio can be rebalanced with the liquidity created. 10b5-1 plans. Corporate insiders have particular challenges with regard to diversifying concentrated positions in company stock. These individuals are generally presumed to have access to material, non-public information and are prohibited from trading when they are in possession of such information. Rule 10b5-1 plans are written plans for pre-planned trading used to provide a defense to any alleged insider trading by allowing an insider to demonstrate that inside information was not a factor in the decision to trade in qualified transactions effected in accordance with the plan. An insider might structure a 10b5-1 plan to sell a certain number of shares, or a percentage of shares at specified time intervals, but the plans can be further customized from the outset to meet varying objectives. Once the prearranged plan is put in place, it is essentially on autopilot. There are limitations in modifying or abandoning any plan once it s established and such actions may jeopardize the defense offered pursuant to rule 10b5-1. Insiders should refrain from entering other transactions with respect to the company stock once the plan is in place and seek guidance from their corporate counsel if they would like to modify their plans. Limiting the duration of the plan may afford some flexibility. Managing the risk of retention. Outright sales may indeed meet your portfolio objectives, but other more sophisticated techniques may allow you to hold your hot stock, while you turn down the heat too. There are strategies that will allow you to monetize (provide liquidity), hedge and diversify your risks. Hedging is used to moderate the impact of a concentrated position s volatility and incorporates derivatives utilizing such strategies as puts, calls and collars. A derivative itself is a contract between two or more parties. The value of a derivative is determined by fluctuations in the underlying asset, in this case the stock included in your concentrated position. Diversification allows an investor broader market participation without forcing liquidation of a concentrated position. Diversification strategies include margin loans, exchange funds, derivative strategies such as variable prepaid forwards, and hedging strategies combined with loans. Additional techniques that may help you reach your goals are outlined as well. Many companies have restrictions in their trading policies preventing certain individuals, such as corporate insiders and executives, from entering into derivatives contracts. Thus, many executives will be precluded from hedging or pledging by utilizing strategies such as puts, 8 From Startup through IPO or Acquisition

11 calls and collars. Always consult with your compliance officer or corporate counsel for your company on your company s trading policies. Protective put option. A put is a type of option contract that grants the put buyer, or holder, the right to sell a specific number of shares at a fixed price (the strike price) by a set date. For the price of the put, the buyer obtains protection against a drop in the stock price below the strike price of the put. The put seller, or writer, is obligated to purchase the shares at the strike price regardless of the current market price. The put holder retains full exposure to future price appreciation. If the stock price is increasing, the put holder simply declines to exercise the option. Unless the option is exercised, the put holder keeps the shares, along with the voting and dividend rights. 31 Note that if the stock position is retained, there is no diversification of the portfolio. Covered call. By selling a covered call on currently owned shares, an investor grants the call buyer the right, but not the obligation, to buy shares of a stock at an established strike price by an agreed upon date in exchange for an upfront option premium. The call writer maintains upside appreciation to the call strike price, but foregoes all participation in the share price beyond the option strike price during the life of the option. Option premium received through covered call writing can soften an investor s downside risk but does not protect against the risk of significant loss of share value. Covered call positions can be settled by delivery of cash, or may be structured to allow for diversification of shares at predetermined prices, as shares may be subject to assignment when the market price of the shares exceeds the option strike price. Collar. The sale of a covered call in combination with the purchase of a protective put option is known as a collar. By using a collar, an investor retains the right to limit downside loss to a predetermined value (the put strike or floor ) and agrees to limit upside participation on the upside (the call strike or ceiling ). When the dollar value of premiums of the call and put options equally offset, this is known as a cashless (zero-cost) collar. Collar strike prices may be selected in accordance with the amount of risk reduction and upside participation desired by the investor, and the upfront strategy cost preference. As with call or put options, collars can be settled on a cash basis prior to any notice of assignment. Besides the limit on upside potential, there are some drawbacks from an income tax perspective. As long as there is loss protection under the outstanding put, the holding period requirements for qualified dividend treatment may not be met. 32 Further, the tax straddle rules require that any gains be recognized immediately, while any losses are deferred until the stock is actually sold. By using protective puts separately or with a collar, any dividends received while hedged are taxed as ordinary income and the preferential taxation of dividends at the 20 percent rate is disallowed. Variable prepaid forward contract. The variable prepaid forward is a combination of a cashless collar and a secured loan. Under this strategy, the investor enters into an agreement to sell a varying number of shares at a future date in exchange for a cash loan now. The transaction begins when the investor enters into a cashless collar with a brokerage firm. The broker then pre-funds the future, or forward, sale of shares by paying a significant portion of the stock s current value. Settlement at expiration of the contract occurs by delivery of some or all of the stock based on the value of the shares on the delivery date, or cash or other securities equal to the value of the shares to be delivered. For example, assume you own 50,000 shares of XYZ stock which is trading at $100 per share. You have a liquidity need, but you are bullish on the stock and want to retain it. In addition, you have low basis in the stock and the tax impact of a sale concerns you. You enter into a variable prepaid forward contract which provides a floor at 90 percent of the current market price ($90/ share) for three years. In exchange for the floor, you sell a call option at 130 percent of the current market price ($130/share). You receive 80 percent of the current market value in cash up front. At the end of the three-year term, the number of shares to be delivered at expiration will be based on the stock price at maturity. If the stock is below the floor at maturity, you will deliver all of the shares to settle the obligation. If the stock is above the floor at maturity, you will retain a percentage of the shares. Hence, there is protection on the downside, yet participation in some upside appreciation. The cash received upfront can be used for any purpose, including diversification. The strategy may allow retention of voting rights and dividends, and, if structured properly, tax deferral may be allowed. 33 Note that an investor must have at least $5 million in total assets and $3 million of liquid assets to enter a variable prepaid forward contract. Tax straddle rules may apply and this strategy can be difficult to unwind prior to the expiration. Exchange fund. An exchange fund is a partnership wherein a group of investors each contribute their own securities and in return each partner receives an interest in a partnership holding a managed diversified From Startup through IPO or Acquisition 9

12 portfolio. Investors shares must stay in the fund for seven years. 34 In exchange for giving up returns on the individual securities contributed, investors are able to participate in the potential return of a pool of securities. The contribution can consist of a concentrated position, resulting in immediate diversification. The contribution is not treated as a sale for tax purposes, so tax is deferred until expiration of the seven-year term. 35 Because the investor s basis in the new fund is equivalent to the basis in the contributed stock, the greater the unrealized capital gains in the stock being exchanged, the greater the benefit of this technique. Lack of control and lack of marketability discounts 36 may be applied to the value of the partnership interests, providing estate planning benefits. On the downside, this strategy is illiquid due to the seven year tie-up and may provide little to no current income. There is no guarantee of investment performance and investors have no control over the assets contributed. Investors must pay a percentage of the value of their contribution as a placement fee, and such funds have ongoing expenses that are much higher than most mutual funds. Upon expiration of the fund term, investors receive a pro-rata share of the diversified holdings, so the nature of the original investment and its total upside will be foregone (of course, the downside risk is mitigated as a result). Ignoring placement fees, in the end, you win if the stock you contribute performs worse than the average of all the stocks held by the exchange fund. Not all shares are eligible for contribution to the fund. Proxy hedge. When certain investors (insiders, board members, executives) are unable to sell their positions due to Rule 144 restrictions, contractual prohibitions or other impediments such as company policy, a synthetic proxy hedge strategy may be considered. A synthetic hedge involves a marketable asset or basket of marketable assets that are closely correlated to the restricted stock such that the hedge mirrors the behavior of the restricted stock. Typically, the correlated assets are either sold short or the investor purchases put options on them. The underlying asset included in the proxy hedge is generally similar to the concentrated position to be protected. A classic example involves an insider in a particular industry, such as automotive, purchasing puts on Honda while employed by Toyota. Charitable Remainder Trust (CRT). A CRT is another consideration for implementing a hedging strategy for a concentrated stock position. Basically, a CRT is a gift plan defined by federal tax law that allows a donor to retain an income stream or direct it to other non-charitable beneficiaries. When appreciated stock contributed to a CRT is sold, any capital gains will avoid recognition for income tax purposes. Post sale, the trustee reinvests the gross proceeds and pays an income stream to the donor or named income beneficiaries. This effectively provides diversification for the donor without triggering a capital gains tax. Thus, the income stream is based on the full value received for the stock without reduction for taxes. This income stream may continue for the lifetime of named beneficiaries, a fixed term of not more than 20 years or a combination of the two, and may either be a fixed dollar amount or a fixed percentage based on the current value of the trust. The donor may be eligible for income, estate and gift tax deductions. Note that income and capital gains taxes will be recognized by trust beneficiaries as distributions are received from the trust. There are some drawbacks to this strategy in that the property transferred to the trust is inaccessible and only the income stream, not the original assets, will return to the beneficiaries. In addition, private foundation rules will apply for tax purposes, and a professional valuation of the trust may be required annually. However, if the investor is charitably inclined, this strategy can provide added value by helping to meet legacy goals. Concentrated GRAT. Transferring your concentrated position to a GRAT can provide some benefits for estate planning purposes. A GRAT is a tax-advantaged wealth transfer technique wherein an individual transfers property that is expected to appreciate into an irrevocable trust in exchange for a series of payments based on the life of the trust and an interest rate set by the IRS. The grantor wins if the property appreciates above the IRS imposed hurdle rate because the appreciated property passes to the named trust beneficiaries with no additional transfer (estate or gift) tax cost. Because the stock is now out of the grantor s estate, the appreciation escapes tax there as well. If the property does not appreciate, the trust will ultimately return all the property to the grantor. If this happens, the transfer tax advantage is lost, but the real downside consists of only the costs incurred to establish the trust and any gift tax paid or lifetime exemption applied on the initial transfer of the stock. If the GRAT was zeroed-out by structuring the payments so that no assets are expected to be left for the beneficiaries, no gift tax will have been triggered. The trust term must be set with mortality risk in mind. If the grantor dies during the trust term, the assets will be included in the grantor s estate for estate tax purposes. Obviously, a shorter term is less risky here. 10 From Startup through IPO or Acquisition