For founders, the day someone comes to buy their startup can be bittersweet.
While many startups and scale-ups are forging their own independent path by continuing to increase their market share, for others a successful exit will be a huge confirmation 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 in an exit is critical. Price negotiations will be ongoing with the buyer – this is what everyone knows and expects. But there is one more thing that is sometimes forgotten, but will still have a major impact on shareholder value: TAX.
Since tax is levied as a percentage of profits, it can quickly add up to a very large number. It is therefore crucial that sufficient time and attention is devoted to tax planning. It is no exaggeration to say that no exit can be really successful if shareholders lose a larger than necessary part of their assets to the tax authorities.
(Note: The below does not constitute tax advice as it does not take into account the individual circumstances of a taxpayer)
Early Stage Innovation Company (ESIC) tax incentive
This is a powerful tax incentive because year 1 to 10 capital gains from ownership for qualifying stocks: completely tax free for eligible shareholders. Where available, this is a real game-changer.
Given the amount of taxes at stake and the relative complexity of the ESIC rules, we recommend startups and their investors to devote the necessary time and attention to optimizing the ESIC grant and to complete all required documentation. to keep up. And the time to do this is now – not at the time of departure, when it’s usually too late to make a difference.
See more details here for tips on ESIC.
An oldie but a goodie – 50% off capital gains tax
The 50% discount on capital gains tax is an important consideration in an exit for one simple reason: It can cut the tax bill by half.
To qualify for this discount, the shares must have been owned for at least 12 months prior to the exit. There are other requirements, but today we will focus on the issues that come up most often.
The exit must be made “at the right level by the right salesperson”. This is because only Australian residents and trusts (including investment funds) can qualify for the 50% CGT discount.
One of the most common questions that arise at the beginning of sales negotiations is whether the acquirer will shares of the startup or the startup assets.
This matters because of the important legal, commercial and tax differences between the two options.
In a share sale, the sellers are the shareholders of the startup. This is in contrast to the other scenario where the start-up company itself sells its assets – customer contracts, code, IP, supplier contracts and goodwill – to the buyer.
This would then make the company the taxpayer.
Since companies are not eligible for the 50% CGT discount, the combined amount of additional tax that must ultimately be paid by the company and its shareholders becomes a major barrier to exiting this way.
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 startup’s assets rather than the startup company to avoid the historical risks associated with the business or because there are non-core assets that the buyer does not want.
In general, the buyer and seller can come to an agreement once the magnitude of the tax difference between the two approaches becomes apparent and the seller can take comfort in damages and warranties provided by the seller.
Other tax concessions
In addition to the ESIC tax incentive and the general CGT 50% discount, there are a number of other tax benefits that can significantly reduce the tax payable by shareholders on an exit.
Scrip for scrip load rollover
When the buyer is a company and that company itself provides shares as part or all of the purchase price for acquiring the startup, the main tax benefit is the “scrip for scrip” (i.e. shares for shares) tax rollover. 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 is critical that the Share Purchase Agreement is drafted in a certain manner from the outset. This means that the tax advisor must be involved early in the negotiation process.
See-through Earning Rights
Often, the sale price will be in the form of an “earnout,” where the startup’s shareholders will receive a consideration in the future that is dependent on a future outcome, such as the startup’s financial performance.
Ideally, the deal should be structured so that the earn-out meets the tax law definition of a “see-through earning-out right” as this would allow shareholders to be taxed on this contingent consideration in a future income year when it is actually received.
This favorable treatment contrasts with the “standard” tax treatment where a value is assigned to the earn-out and included in the shareholder tax return in the year of sale, possibly well before any value is received.
CGT Small Business Concession
While this is a great concession for small businesses in “traditional” industries with only a few shareholders at most, shareholders of startups and scaleups often have a hard time qualifying for this concession because of the $2 million business revenue test and $6 million testing intrinsic value. Nevertheless, at least consider this concession and cross it off the list of things on your radar.
Get ‘exit-ready’ today
There are clear benefits to shareholders when a startup is “exit-ready”. Fundamentally, it’s about making themselves an attractive target for a buyer, who will usually scrutinize the startup with the help of a team of lawyers and accountants to find any “skeletons in the closet” from a tax, 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 hinder the deal or lead to adjustments that ultimately reduce shareholder returns.
There is rarely a quick solution to these historic tax problems. That’s why with the startups and scale-ups we work with, to maximize shareholder value, we treat the exit as a: years of process where best practice is applied by looking in advance at the following tax issues:
- Roll out non-core businesses or assets in a tax-friendly manner (which increases the likelihood that the buyer will take over the startup business rather than just its assets);
- Designing employee share plans that facilitate – rather than hinder – an exit (see tips here);
- Minimizing the risk of employees versus contractors;
- Checking payroll tax compliance (for example, is ESOP included in the payroll tax return?);
- Insight into foreign digital tax and sales tax obligations (see details) here); and
- Ensuring compliance with the tax incentive for R&D, especially retention of documentation required by ATO (see details .) here).
The common thread is the need to start the tax planning process years before the actual exit. This will really make a difference to how smooth the transaction goes and ultimately whether founders and shareholders get what the startup is really worth.