Top 3 Mistakes VCs Make with QSBS

May 6

5

min read

Chris Harvey

As an emerging fund lawyer, I advise my clients to take advantage of qualified small business stock (QSBS). Too often, I see VCs inadvertently take actions that can easily eliminate this tax windfall. What’s worse is they find out too late and then need to write an unexpected yet substantial check to Uncle Sam. My previous article discussed the best kept secret of QSBS. This article will help you avoid the top three mistakes VCs make that disqualify their investments as QSBS.

Take a look at the chart below provided by Aumni's data analytics platform, which is based on analyzing over 50,000 venture capital financing transactions. It shows the percentages of deals that add QSBS reps and covenants by financing stage:

This chart reveals two interesting insights: 

  • First, the most frequent round VCs add QSBS-related language to their venture deals is not at the earliest stage, but in Series A transactions (58% vs. 52% for Series Seed).
  • Second, QSBS-related language is added to about 30% of Series C deals, even though, according to Aumni’s data, the median post-money valuation of Series C over the past 5 years has been $213 million (in 2021, Series C valuations skyrocketed to $449 million).

So, at what valuation does a startup lose its QSBS status? It’s a trick question because valuation is irrelevant. I explained this in my previous QSBS article: 

To qualify for QSBS, (1) you must acquire original issued shares, (2) directly from a qualified small business taxed as a C-corporation (3) that has no more than $50 million in aggregate gross assets, and (4) hold onto such shares for at least 5 years. The key is whether the company has “aggregate gross assets” of $50 million or less.

“Aggregate gross assets” just means the amount of cash and the aggregate adjusted tax basis of property held by the company. This number is calculated by accountants and most often found on the company’s balance sheets.

However, most startups start to lose their QSBS status after two or three equity rounds, around Series B or Series C. That’s because the total cash invested plus the value of a company’s gross assets is often more than the $50 million threshold “immediately after” such investment.

So this brings us to the number one most common mistake fund managers make.

Mistake #1: Tracking the Wrong Numbers

Recently, one of my fund clients was about to invest $5 million into a Series A round. Its portfolio company was valued over $100 million (pre-money) with $45.1 million of gross assets on the books. Will that investment qualify as QSBS? No, but with a slight change in the investment strategy, it can qualify.

Remember, valuation is irrelevant for purposes of QSBS. What matters is the $50 Million Gross Assets Test. Simply add gross assets (here, $45.1 million) to the total cash ($5 million). Although the investment would be over the $50 million in aggregate gross assets, if the fund shaves off a small portion of its investment ($100,000 to $200,000) and receives guidance from a tax specialist on the net impact of this investment, it can pass the aggregate gross assets test. 

But what if, leading up to the Series B round, your fund invested through a SAFE? This depends on whether the SAFE is considered (1) equity at the original date or (2) a prepaid forward contract until the SAFE converts into shares of preferred stock.

  • SAFE” stands for a Simple Agreement for Future Equity, created by Y Combinator.
  • A “prepaid forward contract” refers to when a buyer (here, the investor) deposits a sum of money with the seller (the company) in exchange for delivery of an unknown number of shares in the future (determined at the time of conversion).

The type of SAFE your fund invests through may be the key factor. Post-Money SAFEs have equity-like features that are missing in the Pre-Money SAFEs voting rights, dividend rights, and a reference to Section 1202 of the Internal Revenue Code, which is the tax statute for QSBS.

However, some tax experts argue all SAFEs qualify as equity for tax purposes. But they also caution “the IRS could argue that SAFEs should be treated as a prepaid forward contract for tax purposes rather than equity.” In any case, proceed with caution and speak to your tax advisers as this area of tax law is unsettled.

If you want to make the best case that SAFEs qualify for QSBS treatment, then you better have records to back this up—which leads to the next mistake VCs make with QSBS. 

Mistake #2: Bad Record-Keeping

Maintain good records!” 

It sounds so simple but it’s easy to miss. For example, Aumni has found that over 30% of the closing document sets it has reviewed have serious errors or are missing critical pages. 

Financial statements and other supporting documents are your ticket to supporting your claim for QSBS. Detailed balance sheets from the start of a company’s existence through the closing date of your investment will show if it has more than $50 million in aggregate gross assets. 

Equity documents are also important. One pro tip is to insert standard QSBS language in your deal documents earlier than the Series A financing.  Here are the three most common clauses:

  • QSBS Rep & Warranty (See Section 2.26 of the NVCA Stock Purchase Agreement)
  • QSBS Covenant (See Section 5.4 of the Investors’ Rights Agreement)
  • Certification and 1-Page Checklist (Annex 1 to the Investors’ Rights Agreement)

The reporting requirements for QSBS benefits are shockingly easy. There is no special filing, elective form or other notice that is required.  Upon an exit, most companies won’t even mention it. Rather, to claim QSBS status, all that’s legally required is for the taxpayer to report the sale of QSBS on Schedule D (of Tax Form 1040) and Form 8949 like any other capital gain. And the IRS generally has three years to come back with an audit or ask you to  “submit such reports to the [IRS] and to shareholders as the [IRS] may require.”

Mistake #3: Assuming QSBS Applies

I’ve seen VCs make a lot of assumptions on how QSBS works. Truth be told, it’s a complicated tax statute riddled with potential pitfalls, including company redemptions, secondary transactions, investing 10%+ of a company’s assets, or investing in a portfolio company that isn’t in an “active trade or business”.

Under Section 1202, companies must meet the active business requirements, which requires at least 80% of its assets to be actively used in a qualified trade or business. Here is a list of businesses that do not meet this criteria:

  1. Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business in which the principal asset of such trade or business is the reputation or skill of one or more of its employees;
  2. Any banking, insurance, financing, leasing, investing, or similar business;
  3. Any farming business (including the business of raising or harvesting trees);
  4. Any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or section 613A (i.e., oil or gas properties subject to depletion); and
  5. Any business of operating a hotel, motel, restaurant, or similar business.

Certain FinTech or InsureTech companies may be disqualified from QSBS if their business is considered within the scope of the disqualified list of businesses referenced above.

However, a new private letter ruling (“PLR”) by the IRS is encouraging on this topic. Although PLRs are not binding on third parties, this may provide helpful guidance to FinTech and InsurTech companies which often have hybrid business models that touch on one or more of the non-qualifying trade or business. 

The business in the PLR was an insurance agency which sold insurance to clients and also provided service to insurance wholesalers. It seems like it might fall squarely within a business of “brokerage services” or “insurance”.  However, the IRS found that a business which conducts “administrative services beyond those that would be performed by a mere intermediary facilitating a transaction between two parties” would not be considered engaged in “brokerage services” or “insurance” for purposes of Section 1202(e)(3). Here, the IRS noted that the insurance brokerage in question reported claims to insurance companies and did not act merely as an intermediary but provided additional services such as cooperation in the investigation, settlement and payment process, along with maintaining records and accounts. Selling insurance and engaging in related administrative activities did not fall under the category of an “insurance” business. Therefore, the company was a qualified trade or business for purposes of QSBS. 

Although qualified small business stock can be an incredibly powerful tax savings tool, there are a significant number of guidelines that must be met. A detailed analysis of QSBS is far beyond the scope of this article, so please consult with your legal and tax advisers.


About the Author

Chris Harvey is Principal of Harvey Esquire, a law firm that represents emerging fund managers and VC-backed startups in early stages. Chris has been practicing law for over 12 years as a venture capital lawyer. He writes a monthly newsletter, Law of VC, where he provides deep insight and personal experience on all things venture law related. Chris is also a top writer on Quora. Follow Chris on Twitter or LinkedIn.