The power of QSBS and federal tax exemptions in early stage fund investing

Follow me @samirkaji for my thoughts on the venture market, with a focus on the continued evolution of the VC landscape.

Over the last few years, I've spoken to hundreds (maybe thousands) of Limited Partners about early-stage fund investing. 

I've been surprised by the number of people who don't fully appreciate the benefits of having Qualified Small Business Stock (QSBS) investments in their portfolios. For a quick refresher, through section 1202 passed by Congress, investments in certain businesses today offer federal (and state if not located in California, Mississippi, Pennsylvania, or Wisconsin.) tax relief for investors (100% federal tax exemption since 2010). For an investment to qualify for this tax relief provision, the underlying investment must fall under the following parameters:

• The company must be a US C-Corporation and operate in specific approved industries (typical VC investments fall within accepted industries)

• The company must be smaller than $50M in aggregate gross assets at all times before and immediately after the stock issuance (gross assets for most software companies is essentially cash; $50MM does NOT pertain to the company's valuation, which is irrelevant in this context). 

• The stock needs to be held the stock for at least five years from investment.  

If an investment is QSBS eligible, the exemption will eliminate long-term federal taxes (up to 23.8% depending on income level) for up to the greater of a) 10X the investor's adjusted cost basis or b) $10MM. Of course, always check with a tax expert for more details. 

Side note 1: SAFE notes have been widely debated, and while there isn't any formal ruling that I've seen, Post-Money SAFES have a much better argument for getting traditional equity-like treatment. 

Side note 2: If an investor makes a QSBS eligible investment, but such investment exits in <5 years, the investor can "roll over" the gains to another QSBS qualified investment within 60 days (called at 1045 exchange), and the five-year clock does NOT reset. I.e., If an investor buys a QSBS eligible stock on 9/10/2021, which exits four years later and then rolls over into another QSBS eligible investment within 60 days, the new investment can exit in 1 year and 1 day, and all gains would be tax-exempt (up to the limits described above)

Side note 3: On 9/13 a new proposal was introduced which could change QSBS treatment for high earners (worth tracking, and unclear what form it will take) https://www.journalofaccountancy.com/news/2021/sep/tax-provisions-budget-bill-build-america-back-better.html

This benefit is not only for those directly investing in qualified companies but those that invest in funds that invest in qualified companies. 

Here's how it would work. 

To keep the math relatively simple, Let's say an investor is the sole LP in $3MM ABC Fund I which makes three underlying investments of $1MM, all QSBS eligible. Each of the investments returns $10MM to the fund or $30MM in total. At 20% carry, $5.4MM goes to the GP (based on the gain of $27MM), and the total capital returned to the LP is $24.6MM ($21.6MM in profit). 

With QSBS, the investor would pay nothing in federal capital gains tax (and state cap gains tax in certain eligible states). Without QSBS, the investor would pay federal long-term capital gains of up to 23.8% on the $21.6MM in profits, or $5.14MM (after-tax profit of $16.4MM and total return of capital including principal invested of $19.4MM). In this scenario, the benefit of QSBS increased the NET return multiple from a 6.5X to an 8.2X!

For an investor investing in a non-QSBS eligible fund (growth and PE funds), generating a NET return multiple of 8.2X would require a gross fund return of nearly $39MM, not $30MM ($39MM total = $7.2MM carry paid + taxes of $6.8MM on the $28.8MM in taxable capital gains = $24.9MM in total capital returned to LP. 

In other words, the growth/PE fund needs to be a 13x gross vs. a 10X for the same post-tax return of 8.2X! If a premium fund manager charges 25% carry (many do), the total gross return required jumps to 13.7X.

Of course, early-stage/seed investing comes more risk as company failures rates are much higher (albeit power-law and diversified portfolios can significantly mitigate the failure rates). Still, the ultimate risk/return profile of early-stage investing can be highly compelling when viewing through the lens of after-tax gains -— which of course is what ultimately matters.