For founders, the day someone comes to buy the startup can be bittersweet.
Although many startups and scale-ups continue to grow their market share and forge their own independent path, for others, a successful exit is a great validation of what the entire team has built over the years.
Given the effort and financial investment involved in building a startup, it will be critical to maximize value for shareholders at the exit. The price negotiation will be done with the buyer – this is what everyone knows and expects. But there is another thing that is sometimes forgotten but has a big impact on shareholder value – taxes.
Since the tax is applied as a percentage of profits, it can quickly add up to a large number. Therefore, it is critical that adequate time and attention is devoted to tax planning. It would not be an exaggeration to say that any exit cannot truly succeed if shareholders lose more of their wealth to the tax office than is necessary.
(Note: The below does not constitute tax advice as it does not take into account the individual circumstances of any taxpayer)
Early stage innovation company (ESIC) tax incentive
This is a powerful tax incentive because the capital gains during the 1st to 10th year of ownership are tax-eligible. Totally tax free For eligible shareholders. Where available, this is a real game-changer.
Given the tax rate at stake and the relative complexity of ESIC rules, we recommend that startups and their investors take the necessary time and attention to facilitate ESIC eligibility and secure all necessary documents. And now is the time to do it – it’s often not at the exit when it’s too late to make a difference.
See more details over here Tips about ESIC.
An oldie but a goodie – 50% capital gains tax deduction
The 50% capital gains tax deduction is a key consideration in the exit for a simple reason – it cuts the tax bill in half.
To qualify for this discount, the shares must have been held for at least 12 months prior to issuance. There are other requirements, but today we will focus on the most common ones.
The exit must be done “at the right level by the right seller”. This is because only Australian resident individuals and trusts (including investment funds) are eligible for the 50% CGT discount.
One of the most common questions at the beginning of sales negotiations is whether the buyer will buy. Startup shares or the Startup properties.
This is due to key legal, business and tax differences between the two options.
In a stock sale, the sellers become the initial shareholders. This initiative contrasts with another scenario where the company itself sells its business assets – customer contracts, code, IP, supplier contracts and goodwill – to the buyer.
This then makes the company a taxpayer.
As companies are not eligible for the 50% CGT discount, the amount of additional tax ultimately paid by the company and its shareholders will be a huge incentive to go this route.
There is a natural tension between what the seller wants and what the buyer wants.
From a business perspective, a buyer sometimes chooses to buy only the assets of a start-up rather than a start-up company to avoid historical risks associated with the company or because there are non-core assets that the buyer does not want.
Generally, the buyer and seller can come to an agreement if the amount of tax difference between the two approaches is shown and the seller can take comfort from the indemnities and warranties provided by the seller.
Other tax concessions
In addition to the ESIC tax incentive and the 50% general CGT discount, there are a number of other tax concessions that materially reduce the tax payable by shareholders on exit.
Scrip Tax Rollover
If the buyer is a company and the company offers shares as some or all of the purchase consideration to acquire the startup, the main tax benefit is a “scrip for scrip” (ie shares for shares) tax transfer. If eligible, this can be used to defer some or all of the capital gains realized by shareholders.
Eligibility requirements are complex, and it will be critical that the stock purchase agreement is drafted differently from the outset. This means that the tax advisor should be involved early in the negotiation process.
See access rights
Often, sales consideration is in the form of “earnings,” whereby the startup’s shareholders receive a consideration that is dependent on some future outcome, such as the startup’s financial performance.
The deal should ideally be structured so that the income satisfies the tax law’s definition of “rights acquired by consideration” because this would allow the shareholders to pay tax on this temporary consideration in the next income year.
This concessional treatment contrasts with “default” tax treatment, which is included in the shareholder’s tax return in the year in which an asset is acquired and sold, which may be well before any asset is realized.
Small business CGT discounts
Although this is a great deal for small businesses in “traditional” industries with at most a few shareholders, startups and stockholders have a hard time qualifying for this deal due to the $2 million business threshold and $6 million net asset value. As tempting as it may be, at least consider this deal and cross it off the list of things on your radar.
Be ‘ready to go’ today
When a startup is “exit ready,” there are clear benefits for shareholders. Basically, this makes itself an attractive target for the buyer, who often closely examines the startup with the help of a team of lawyers and accountants to find any “skeletons in the closet” from the point of view of tax, business and law.
This is a normal part of the due diligence process. Any past tax issues exposed at this stage of the negotiations could drag on the deal or result in adjustments that ultimately reduce the share’s earnings.
There is rarely a quick solution to these historic tax problems. Therefore, with the initiatives and criteria we are working on, the exit to maximize shareholder value as A years-long process Prior to this, the best practice would be to consider the following tax issues:
- Spin off non-core businesses or assets in a tax-efficient way (thereby increasing the likelihood that the buyer will take the startup company, not just the assets).
- Instead of hindering – design employee sharing plans that facilitate the exit (see tips over here);
- Reducing Employee Vs Contractor Risk;
- Assessing compliance with payroll taxes (eg, is the ESOP included in payroll tax returns?)
- Understanding overseas digital tax and sales tax obligations (see details over here); And
- Ensuring compliance with R&D tax incentives, particularly maintaining documentation required by the ATO (see details) over here).
The common thread is that it is important to start the tax planning process years before the actual exit. This makes a real difference in how smoothly the transaction goes and ultimately how much founders and shareholders perceive the startup to be worth.