The Taxman Always Rings Twice

In the past few years, I’ve worked on an unusually large number of matters requiring complex tax analysis in high-stakes situations. While I’ve always had a healthy respect for the importance of tax issues, these more recent engagements have left me in absolute awe of the risks associated with the tax code. Seemingly harmless transactions consummated years before can dramatically alter your tax position years after.

The notion I wanted to get across with this post’s hopefully catchy title is that there are always at least two occasions on which tax advice is critical for any transaction or business arrangement:  first, at the time of entering into the transaction or arrangement; and second, at the time of exiting the transaction or arrangement.

A corporate and transactional lawyer is, by definition, at least half a tax lawyer — he or she must have enough knowledge and experience to spot issues, and then must have a full tax lawyer nearby. Obviously, tax advice should always be obtained in connection with any venture capital financing or merger & acquisition transaction. But, the tax code is full of other tricks and traps to catch the unwary. Some of the usual suspects in my practice include:

• complex rules regarding limited liability company (LLC) membership interests, including the use of profit interests for purposes of employee or consultant compensation — these issues seem particularly acute when a company wants to superimpose a corporate-style capital structure (e.g., common stock, preferred stock, options and warrants) on an LLC
• complex “change of ownership” rules that can dramatically limit the value of net operating loss (NOL) carryforwards — these rules are specific to ‘C’ corporations (as opposed to pass-through entities such as ’S’ corporations or LLCs) and can pose problems whenever there are meaningful share issuances or transfers; it is important to keep track of the ‘change of ownership’ test on the occasion of each such issuance or transfer
• complex rules governing the use of equity incentive compensation, such as non-qualified stock options (“NSOs” or “non-quals”), incentive stock options (ISOs), restricted stock, and stock appreciation rights (SARs) — the decisions on this topic impact the tax benefits available to the company and the after-tax income ultimately received by the recipient, and often have unintended or at least under-appreciated tax, accounting and financial consequences for both sides
• Section 409A rules that regulate details that must be included in any deferred compensation arrangement (which is quite broadly defined to include most compensation that is not paid in cash at the time it is earned)
• Section 280G rules that greatly complicate “golden parachutes” (i.e., substantial compensation payments due as a result of a change of control transaction)
• Section 83 rules that provide an optional election (under Section 83(b)) in connection with the receipt of restricted property (such as restricted stock or profit interests) that vests over time (while the election allows the recipient to eliminate the tax that would be due at each vesting date, it can result in a higher tax under some other circumstances)
• and others…

Effective tax planning can create substantial economic benefits for a company (or individual), while a lackadaisical approach can result in real tax costs. Although there is a fairly high upfront cost to good tax planning, in my experience it is a fraction of the cost later incurred in trying to fix a tax problem that otherwise could have been avoided. Unfortunately, since most people have not personally experienced a large unexpected tax bill, the risk of such a tax bill is often underestimated; nevertheless, it is quite distressing if and when it comes. Conversely, tax savings create dollar-for-dollar value that is available to fund working capital, growth or distributions to owners. Accordingly, my strategic advice to companies (and individuals) is to discuss tax issues with their legal counsel early and often, no less than on the ‘entry’ and ‘exit’ of every significant transaction.

How Early to Get Your Lawyer Involved

I sat in a conference session yesterday and heard the presenter say that you should negotiate all the “deal points” of a strategic alliance before getting your lawyer involved. Lawyers can be expensive and also might introduce complications and delays into a business arrangement, so I understand the temptation to feel that way. Nevertheless, I strongly recommend the opposite course — discuss your business strategy with your lawyer early in the strategic alliance process.

A business-minded lawyer will be sensitive to cost, complexity and timing issues. But he or she can also guide you on key structural issues arising out of a strategic alliance. In the simplest case, you might negotiate the “deal points” of a distribution arrangement by establishing the price and market area. Your lawyer might then be given those terms, discuss your overall objectives with you, and then recommend an altogether different structure that will serve you better (for example, perhaps you should ask for a long-term license agreement instead of a customary distribution agreement). If you knew that early, you might easily get your business partner to agree; however, after the deal points of an alternative structure are set, it might be tougher to change course.

Similarly, your list of “deal points” and the lawyer’s list might not be the same. There are often issues that a lawyer will identify for you that you might have omitted from the upfront deal point negotiation. Sometimes these issues are more easily solved during the initial negotiation instead of after all the points you thought of have been settled. A trite, but perhaps illustrative, example is that your lawyer might encourage you to negotiate the payment terms at the same time as the price; if you only negotiate the price upfront, and then learn that your partner intends to pay only 60 days after the end of each quarter, you might have wished you asked for a higher price (due to your higher working capital requirements resulting from the payment delay) or even advanced royalties or prepayments.

In short, I’ve found almost universally that early intervention by an attorney can both (1) save money and (2) yield better outcomes by helping clients design the right structure first and resolve the right issues early. Conversely, where I’ve been brought in late, clients often grew to regret that fact because we were severely hamstrung in our ability to structure and negotiate the deal. That led to sub-optimal results for the client.

In conclusion, I recommend talking with your lawyer as early as possible in the process. He or she might give you insights that are invaluable, but only practical if you get them early.

A Short Primer on Business Financing

Basic Financing Principles

Unlike not-for-profit organizations, for-profit businesses are typically unable to rely upon government funding or private grant sources to meet their cash requirements. Therefore, they generally must raise capital by either selling equity or borrowing debt in order to finance their activities. A few of the major uses of cash by for-profit businesses are described below:

• Businesses must incur start-up expenses, such as for research and development, in order to first make the product or service ready for sale to customers.

• For ongoing operations, the cash expenses to run the business and produce the product or deliver the service must generally be paid before the cash income from sale of the product or service will be received.

• When the business is growing, the need for cash is often the greatest because the investment necessary to achieve growth usually occurs before the generation of revenue from new sales.

Risk vs. Reward

The basic rule for all business financing is that there is a direct relationship between risk and expected reward — that is, investors or lenders expect higher returns on their money when the risk of losing their money is high, and accept lower returns on their money when the risk of losing their money is low. Two additional factors often affect start-up financing:

• The risk of losing money in a start-up business is generally greater than the risk of losing money in an established business.

• The risk of losing money that is not secured — or backed — by assets of the business (such as inventory, receivables from customers, equipment or real estate) is greater than the risk of losing money that is secured by such assets. (The equivalent distinction in personal finance is that between a home mortgage loan, which is secured by the borrower’s house, and credit card debt, which has no such security.)

Debt vs. Equity

The two basic building blocks of corporate finance are debt and equity. In general terms, from the financier’s point-of-view, the major differences between debt and equity are as follows:

• Debt entitles the holder to receive back a fixed amount of money, plus interest at a specific rate, at a specific time.
• Equity allows the holder to receive back an unlimited return on its investment depending upon the success of the business. The two basic types of equity are described below:
  • Common stock – does not entitle the holder to any specific return, but provides the unlimited right to share (based on percentage ownership) in the eventual success of the business.
  • Preferred stock – shares the best features of debt and common stock, in that it first entitles the holder to receive back a fixed amount of money plus a specific return, and then provides the holder the unlimited right to share (based on percentage ownership) in the eventual success of the business. Convertible preferred stock is similar to regular preferred stock except that it may be converted into common stock in the future on specified terms.
    • Repayment priority – in case the company goes out of business, this important factor entitles the holders of debt to be paid before those of preferred stock, and the holders of preferred stock to be paid before those of common stock.

In practice, the difference between debt and equity is really a continuum, since an unlimited variety of instruments can be created that blend the basic features of debt and equity in different ways.

From the point-of-view of the business (rather than the financier), debt is ordinarily considered more risky than equity because the business is obligated to repay the debt at a specific time, when it may be inconvenient or impossible to do so. However, if the business is successful, debt is considered less “expensive” than equity because the debt holder is only entitled to a fixed payment rather than an unlimited participation in the success of the business.

The Importance of Venture Capital Financing

Venture capital financing is an important type of financing for early-stage businesses, which typically need funds before they have assets to obtain sufficient asset-based financing, and before they are large enough to raise public financing. Venture capital firms generally purchase convertible preferred stock in the companies in which they invest, in order to reduce their risk relative to the entrepreneurs but still be entitled to participate in the success of the business.

Venture capital usually refers to financing provided by the 2,000 or so traditional venture capital firms in the country, as opposed to early-stage equity financing provided by less formal (often individual) investors, who are sometimes called “angel investors” or “adventure capitalists.” In fact, traditional venture capital financing is a small fraction of total new venture financing in the U.S. However, since traditional venture capitalists comprise the most prominent and sophisticated group of investors that provide capital for emerging business opportunities, their activities in a particular industry are often regarded as important predictions about the future of that industry.Traditional venture capital investments typically have high risks of loss associated with them, and therefore must offer similarly high opportunities for success to attract the attention of the venture capital investor. Venture capitalists earn their livings by identifying emerging opportunities, companies and industries that they believe will achieve extraordinary success over the next five years or so. Accordingly, venture capitalist attention to a particular industry is often a sign that the targeted industry is likely to expand in the coming years.Venture capitalists often assist companies in which they have invested to go public or be sold to a larger business once the companies have achieved sufficient size. In addition, venture-backed companies may decide to expand themselves by acquiring other businesses. For this reason, an increase in venture capital investment in an industry today is often associated with an increase in public offering and merger & acquisition activity in that industry in a few years.