Here’s how to create a tax-efficient exit for your startup’s shareholders — and why it starts today
For founders, the day someone comes to buy their startup can be bittersweet.
While many startups and scale-ups forge their own independent path as they continue to grow their market share, for others a successful exit will be a huge validation of what the entire team has built over the years.
Given the hard work and financial investment required to build a startup, maximizing shareholder value during an exit will be critical. Price negotiations will be going on with the buyer, that’s what everyone knows and expects. But there is something else that is sometimes overlooked but will nevertheless have a major impact on shareholder value: TAX.
Since the tax is applied as a percentage of the gain, it can quickly add up to a very large number. It is therefore essential that sufficient time and attention be devoted to tax planning. It’s no exaggeration to say that no exit can be truly successful if shareholders lose more than necessary of their wealth to the taxman.
(Note: the following does not constitute tax advice as it does not take into account a taxpayer’s individual circumstances)
Tax incentive for start-up innovation companies (ESIC)
This is a powerful tax incentive because capital gains from years 1 through 10 of qualifying stock ownership are completely tax free for eligible shareholders. When available, it’s a real game changer.
Given the amount of taxes involved and the relative complexity of the ESIC rules, we suggest that startups and their investors devote the time and attention necessary to optimize ESIC eligibility and maintain all required documentation. And the time to do it is now, not at release time when it’s usually too late to make a difference.
See more details here for advice on ESIC.
An oldie but a goodie – 50% capital gains tax reduction
The 50% reduction in capital gains tax is a key factor in an exit for one simple reason: it can cut the tax bill in half.
To benefit from this discount, the shares must have been held at least 12 months before the exit. Other requirements exist, but today we will focus on the problems that come up most often.
Exit must be done “at the right level by the right seller”. This is because only Australian resident individuals and trusts (including investment funds) may be eligible for the 50% CGT rebate.
One of the most frequently asked questions at the start of sales negotiations is whether the buyer will buy the startup shares or the startup strengths.
This is important because of the main legal, commercial and tax differences between the two options.
In a stock sale, the sellers will be the shareholders of the startup. This contrasts with the other scenario where the start-up itself sells its business assets – customer contracts, code, intellectual property, supplier contracts and goodwill – to the buyer.
This would then make the company the taxpayer.
Since companies are not eligible for the 50% CGT reduction, the combined amount of additional tax possibly payable by the company and its shareholders becomes a major deterrent to undertaking an exit in this manner.
There is a natural tension between what the seller wants and what the buyer wants.
Commercially speaking, the buyer will sometimes prefer to acquire only the assets of the startup rather than the start-up in order to avoid the historical risks associated with the company or because there are non-strategic assets which the buyer does not want. not.
Typically, the buyer and seller can come to an agreement once the magnitude of the tax gap between the two approaches becomes apparent and the seller can take comfort in the indemnities and warranties given by the seller.
Other tax benefits
In addition to the ESIC tax incentive and the general CGT reduction of 50%, there are a number of other tax advantages which could significantly reduce the tax payable by shareholders in the event of an exit.
Certificate for certificate tax rollover
Where the purchaser is a corporation and that corporation provides stock as part or all of the purchase consideration for the acquisition of the startup, the key tax relief is the “scrip for scrip” tax rollover (i.e. i.e. shares for shares). If eligible, this can be used to defer some or all of the capital gain realized by shareholders.
The eligibility requirements are complex and it will be essential that the share purchase agreement be drafted in a particular way from the outset. This means that the tax advisor must be involved from the start of the negotiation process.
Often the consideration for the sale will take the form of an “earnout”, whereby the shareholders of the startup will receive consideration in the future that will depend on certain future outcomes, such as the financial performance of the startup.
The arrangement should ideally be structured so that the earn-out meets the tax law definition of a “transparent earn-out right”, as this would allow shareholders to be taxed on such contingent consideration during of a future income year when it is actually received.
This concessional treatment contrasts with the “default” tax treatment whereby a value is attributed to the earn-out and included in the shareholder’s tax return in the year of the sale, potentially long before any value is received. .
CGT SME concession
While this is a great concession for small businesses in “traditional” industries with at most a few shareholders, shareholders of startups and scale-ups often find it difficult to qualify for this concession due to its revenue test of $2 million and net asset value of $6 million. test. Still, at least consider this dealership and cross it off the list of things on your radar.
Become “ready to go out” today
There are clear benefits for shareholders when a startup is “exit ready”. Basically, it’s about making yourself an attractive target for a buyer, who will generally examine the startup closely with the help of a team of lawyers and accountants to find possible “skeletons in the closet”. from a fiscal, commercial and legal point of view.
This is a standard part of the due diligence process. It is highly likely that any past tax issues will come to light during this phase of the negotiations and become a drag on the deal or lead to adjustments that will ultimately reduce shareholder proceeds.
There is rarely a quick fix to these historical tax problems. Therefore, with the startups and scale-ups we work with, to maximize shareholder value, we treat exit as a multi-year process where best practices are adopted by considering the following tax issues in advance:
- Create non-core businesses or assets in a tax-efficient way (thus increasing the likelihood that the buyer will take the startup instead of just its assets);
- Design employee share ownership plans that facilitate – rather than hinder – an exit (see tips here);
- Minimize risks between employees and subcontractors;
- Review compliance with payroll taxes (e.g. has ESOP been included in payroll tax returns?);
- Understand digital tax and foreign sales tax obligations (see details here); and
- Ensure compliance with the R&D tax incentive, including keeping the documentation required by the ATO (see details here).
The common thread is the need to begin the tax planning process years before the actual exit. This will make a real difference in the smoothness of the transaction and ultimately whether founders and shareholders receive what the startup is truly worth.