Considerations When Selling Company Stock in a Secondary Sale

Over the last several years we have seen many V.C’s put money into many of our clients’ companies and allow the founders to “take some of the money off the table” at the same time. For example, they agree as part of their financing, that they will buy some shares directly from the founding team. There are, however, many tax and business issues that come up during these transactions that one must be aware of.

Here is a very typical fact pattern… V.C’s have agreed to put $20 million into your startup. As part of that financing, they have agreed that the founders can take $5mm “off the table” and sell some of their shares, and the remaining $15mm goes into the Company. They will buy the founder’s common shares at the same price as they are paying for the preferred stock they are acquiring.

Below are just some items you should be aware of:

1. There is a potential that the price that the founder shares are sold for in the secondary will have a dramatic impact on the 409a valuation study or new price set to other employees for their option pricing going forward. As a result, all the common shares will be valued higher due to your buyout price. This is an event you probably don’t want to be impacted by the sale of your stock.
2.  There is an issue that the auditors will consider some of the purchase price as “excess comp” in your audit above the current 409a price that will “hit” your P&L for GAAP purposes. If they treat it this way, it opens up the question of how the corporate tax returns should be prepared and whether it will be compensation to the seller as well.
3. The most impactful concern is the fact that some of your purchase price “could” be considered as compensation, rather than all capital gain, by the IRS and other taxing authorities. Let’s look at the reasons why and potential ways you can reduce these risks:
   1. Firstly, where I usually start, is determining whether the founders have, or will you have, potentially 1202 or QSBS shares that could be considered non-taxable. The non-taxable piece, if qualified, is the lesser of $10 million or 10 times the founder’s basis. Please refer to some of the other blogs by KN+S on this subject. This is usually a huge benefit of the sale, if treated as capital gain, is all exempt from tax.
   2. Your goal is to have ALL of the purchase price to be treated as long-term capital gains classification. The very real potential though, is that the IRS could consider the additional amount paid for your common shares above the 409a price as compensation to you. What can you do to reduce this risk? Let’s dive a bit deeper:
      • If the purchaser or V.C “needs” to buy your shares and is willing to pay a “premium” above the 409a price because he/she requires a certain % of shares, then this helps your case that the premium is NOT being paid as deferred compensation to the founders. Don’t forget to document these discussions in your board minutes too!
      • If the purchaser of your shares is a new lead investor, you can potentially help plead that your premium is not for “past“ compensation, as they were not holders in the past. It helps strengthen your argument to treat the excess as all capital gain classified.
      • If the purchaser is willing to keep these shares as common shares, and does not exchange the common shares immediately into new preferred shares, it does not look like that the excess was indeed a premium.
      • If the Company offered the same deal on repurchase pricing to not just the founders, but opens the deal to the majority of the employees with shares, then it looks less like deferred compensation to the founders.

While the trend is that secondary amounts paid over the 409a price can be treated as capital gains classification versus ordinary income, there are definitely some facts and opportunities that could cause issues if your situation does not fit the fact patterns above. KN+S is ready to assist you and your legal team to address these issues if you need.

Jeffrey Solomon, CPA, CVA, Managing Shareholder at Katz, Nannis + Solomon, P.C. If you have any questions or would like to speak with one of our tax professionals, please contact our office at 781-453-8700.