Entrepreneurs, Investors and Board Meetings: What’s the Right Balance for Start-Up Companies?

June 7, 2011

By Paul A. Jones

Meetings are seldom fun, and board meetings are no exception. Moreover, meetings have a mostly deserved reputation for being unproductive wastes of time and talent. Still, some meetings – including board meetings – can’t be avoided, even by the most social-network enabled start-up entrepreneurs and their investors. So, given that board meetings are going to be with us whether we like them or not, let’s look today at the question of how often should you have them. I’ll talk about board meeting preparation and content in a later post.

While generalizations in this area can be problematic, my own view – based on having been both an entrepreneur and an investor in start-up technology businesses, as well as a counselor to such entrepreneurs and investors – is that most early-stage, tech-driven business should, at least for the first year post-funding, hold regular board meetings on a monthly basis, and that board members within a couple of hours drive time to the company should make every effort to attend in person.

Now, monthly meetings may seem like overkill, particularly if, like me, you dread attending formal meetings, and think of the start-ups anti-meeting culture as one of the things that give entrepreneurial firms a leg up on their more established and bureaucratic companies (most of which hold board meetings no more often than quarterly, or maybe bi-monthly). So, what gives? Why should entrepreneurs who are rightly skeptical of meetings generally want to have more board meetings than their more established competitors?

Several things come to mind. One is the fast-pace of start-up living. Start-ups can – and do – move faster than more established firms. Internal developments, product development, for example, is less predictable in terms of both substance and timing. And even if the external market doesn’t change faster for the start-up than for the more established company, the impact of those changes is often greater on the start-up, and beyond that start-ups are usually on a steeper market knowledge learning curve than the more established players. In short, time is even more of the essence for start-up than for more established companies, and that is one reason start-up boards should as a rule meet more often than boards of later stage companies.

Another reason start-ups should meet more often has to do with the expectations of inside and outside directors in terms of the role of the board and, most importantly, the value add expectations for outside directors and the need for time establishing good working relationships among directors, particularly between the insiders and the outsiders on the board. As noted above, things tend to move faster in the start-up world. Further, important strategic and significant operational issues tend to come up more often. And, finally, even if the financing dance went well, it is likely that it left the entrepreneur and investor(s) a little unsure about each other and, in any case, a bit up in the air in terms of what to expect from each other, in terms of information sharing and value add abilities and expectations. More regular meetings, particularly in the first year or so post-funding, can help address both of those challenges, and in the process foster better intra-board relationships and trust, as well maximize the value add of outside directors.

Finally, more regular board meetings can help a company establish and institutionalize more efficient and productive communications channels among inside and outside directors. The process of preparing for board meetings on a more regular basis – a sometimes frustrating process for senior managers with what seem like obviously more important ways to invest their time – can itself help both inside and outside directors “find their way” in terms of the appropriate timing and sharing of information about the company and it’s business and technology environment. Over time, as intra-board communications become both more routine and less formal, the regular board meeting schedule can be cut back.

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Valuation of the Company vs. Valuation of the Stock: A Venture Capital Paradox

June 3, 2011

By: Paul Jones

One of the first things entrepreneurs learn about venture capital speak is the significance and difference between pre-money valuation and post-money valuation. These are the terms that VCs use when talking about how much a company is worth before and after a round of financing. While investors in public companies tend to think of valuation in terms of how much one share of stock costs, VCs tend to think of valuation in terms of what percentage of the total ownership of the company they can buy for how much capital. So, for example, if a VC buys 1/3 of the ownership of Newco for $1.0 million, the “post-money” valuation is 3 * $1 million = $3 million and the “pre-money” valuation is $3 million – $1 million = $2 million. If say $2 million bought ¼ of the company the post would be $8 million and the pre would be $6 million.

Another thing entrepreneurs learn pretty early in the VC courtship ritual is that VCs typically get some form of “convertible preferred stock” in exchange for their capital. In the most general of terms, “Convertible Preferred” is a kind of stock that (i) has some extra rights that make it “better” than common (for example, liquidation and dividend preferences, the ability to prevent Newco from doing certain fundamental things like selling the company, etc.) and (ii) is optionally convertible into common stock by the holder at pretty much any time, and can be automatically converted in some instances (typically in connection with an exit transaction where the company is sold or completes an initial public offering at a sufficiently high price). Most often, the conversion rate is 1 to 1: that is, one share of Convertible Preferred converts in to 1 share of common. (The rate can be more or less than that, and can change over time, but neither of those facts changes the fundamentals of the analysis in this blog.)

Alas, these two concepts – pre/post-money valuation and Convertible Preferred – combine to create what looks like a valuation paradox. Let’s consider our $1 million for 1/3 ownership investment. And just to make the math simple, let’s say that the investor bought 1 million shares of Convertible Preferred for $1 each with a 1 to 1 conversion ratio, and the founders own all 2 million shares of common stock. In this situation, the post money is $3 million, right? And the 1 million preferred shares are worth $1 million, right? (Right in both cases.) So the 2 million shares of common stock must be worth $2 million, right? And each of the 2 million common shares must be worth $1, right?

Actually, in both the later cases, no. The common is not worth $1 share – how could it be worth as much per share as the Convertible Preferred, which can be converted to common at any time and has a bunch of special rights that add more value to it? If not a problem, we seem to have at least a paradox.

What is going on here? How can both the pre/post money valuation formula work AND at the same time the Convertible Preferred and Common stock have different values? Let’s try and hash that out, starting with the difference in value between the Convertible Preferred and the Common stock. As to the Convertible Preferred, the price, when it is purchased by a third party investor in an arms length transaction (in this case $1) is, by definition, the fair market value of the Convertible Preferred. Which means that the value of a Common share, at the same time, must, given that it lacks various valuable features of the Convertible Preferred, be worth something less than $1. How much less? Well, that depends. Since no one – or at least no third party in an arms length transaction is buying any at the time – it depends on what the Board of Directors, in good faith, determines it is as, for example, when it issues an option to buy such shares to an employee at what the Board says is the then fair market value of a Common share of stock.

Ok, at this point we know that a Common share is worth less than a Convertible Preferred share, and that the fair market value of the Common share is what the Board says it is. How should the Board determine the fair market value of a Common share?

In theory, the answer is simple; in practice, not so much. In theory, the board should (and any good board resolution purporting to establish the fair market value of a Common share will) “consider all relevant factors” to conclude that such value is less than the $1 value of the Convertible Preferred and more than $0. In fact, most boards will want to set a low value on the Common (to make equity incentive shares cheaper for employees and others getting shares of options on shares as an incentive to make the company succeed), but not so low as to attract the attention of the IRS, which is anxious to tax people who acquire assets, including stock, for less than it is worth.

In practice, there are some informal rules of thumb that tend to apply to very young and immature companies, and some explicit IRS/SEC rules that come into play for more mature companies. So, for example, a brand new startup like Newco might reasonably conclude that the value of a Common share was 1/5 the value of a Convertible Preferred share – which is to say the Common share has a fair market value of $0.20. No legal opinion is expressed here, but trust me: lots of companies have said as much without incurring the wrath of the IRS.

Ok, let’s go with $0.20. What, then, is the value of all of the stock – which is to say the value of the company? Well, there are 1 million shares of Convertible Preferred worth $1 per share, which is $1 million of value. And there are 2 million shares of Common worth $0.20 per share, which is $400,000 of value. So the total value of all the shares is … $1.4 million. Which is to say less than ½ of the post-money valuation of the company! Houston, we have a problem.

Or do we? Ok, there is a seeming paradox, but is there really a problem? I don’t think so. Because while the fair market value of the common might, at some level, seem like a more or less arbitrary determination of the Board of Directors, in fact it has to be something less than $1 in the example. And if it is anything less than $1 we will arrive at a total value of all equity that is less than the post-money valuation calculated by the VCs (and typically accepted, in normal conversation, at least, by the management/founders of Newco). The problem – perhaps a better word is artifact – is with the pre/post money concept.

And this is it. Buried in the pre/post money calculation is a very important assumption; namely that the VC post-money calculation assumes that the company will have a favorable – e.g. north of $1 per share (and probably at least 3x or more of $1 per share) – exit price when the company is sold or goes public. In which case all of the Convertible Preferred will convert into Common – and suddenly the assumption that they are worth the same amount … works.

It’s not elegant. It’s more than a little arbitrary and capricious. But it (more or less) works.

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Compensation for Directors of Startups

June 2, 2011

By: Paul Jones

One issue that comes up fairly early for most start-ups – certainly by the time of the first outside funding if not before – is how members of the Board of Directors should be compensated. Every situation is unique, but what follows is my take on the generic question.

As a preliminary matter, Directors can fall into several categories, and compensation is most often tied to those categories. Inside directors include the founders and management team. Investor Directors are those who are associated with, or themselves are, material third party investors. The classic example is a director who is appointed by and affiliated with a venture capital investor or angel investor group. A significant “lone wolf” angel investor would also fit here (more on that later). Finally, everyone else – typically people who bring industry expertise or contacts, or are mentors for the management team – is pooled together as Independent Directors. Independent Directors may have made small investments in the business, but are not significant in terms of their capital contribution.

Ok, what do all these folks get for their Board service?

Let’s start with the easy ones. Insiders typically get nothing for their service on the Board. These folks, being founders or members of the management team, are already well compensated for their service. Being on the Board is a reward (of sorts) in itself, and simply goes with the territory.

Investor Directors are more or less in the same boat. They are by definition material investors (or represent material investors) in the business and serving on Boards of portfolio companies is part of their job, just as part of the CEO’s job typically includes serving on the Board. If the investment does well, they will be amply rewarded by the people or fund they represent.

That leaves the Independent Director. The easier cases, here, are the truly independent director who is not affiliated with or representing an investor group and has made no independent investment, or has made only a token independent investment. Depending on level of experience and perceived value add, these folks may get something in the twenty-five to two hundred basis points range – something between 0.25% and 2.0% of the equity, typically vesting over two years. Beyond expense reimbursement, you should not have to pay these folks any cash compensation (beyond expenses), at least not until the company is actually generating cash in the business.

While these are good general rules, there are some common situations that sometimes don’t fit within them so easily – or at least the Director in question might think they don’t. The first of these situations, and the easiest to deal with, is the “superstar” director. For example, if Steve Jobs tells you that he is really excited about your iPhone applications company and would be willing to serve on your board of directors for a hefty chunk of equity, don’t feel bound to tell him that the most you can offer is two hundred basis points.

In my experience the most contentious Board compensation issues arise when a Director affiliated with a fund of some sort, typically a group of angels, wants an independent equity stake for serving as a Director. My own view, and I think the majority view in the major venture capital centers, is that these folks are in the Investor Director camp and should not “double dip” in terms of their equity compensation. If the angel group they are affiliated with wants to provide them with some deal specific incentive compensation they should do it by carving out a piece of the equity they purchased. That said, in tight capital markets; in places (like Wisconsin) with limited risk capital access in even good times; or in situations where the capital-affiliated director is in fact going to be an active contributor above and beyond the level expected of the typical outside director, this is an area where entrepreneurs are often either (i) forced to cave on the principles of the matter to get a deal done in the first two cases, or simply recognize the realities of the situation in the later instance. If the “independent investor” insists on compensation, try to keep it under 100 basis points.

Board compensation for start-up companies is as much art as science, and the above guidelines are just the thoughts – albeit based on 25 years in and around these deals with multiple experiences as an Inside, Independent and Investor Director – of one man. But as a starting point, I think they will serve startup companies well.

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Grant Money: When “Free” is not “Free”

April 6, 2011

By Paul Jones

In a down VC market, in the heart of flyover country, it is perhaps inevitable that the lure of free money – SBIR grants, stimulus funds, etc. – would be compelling for Wisconsin’s life sciences entrepreneurs.  And if “free” meant, well, “free” I suppose that would be a good, as well as inevitable, thing.  But, alas, “free” does not always mean “free.”  In fact, from a strategic business building perspective “free” all too often means “a lot more costly than you think.”  So, before you spend another dollop of time, energy and, yes, even money pursuing the next too-good-to-be-true free money from the good folks in Washington and Madison that dole out all those tax dollars, consider a few things.

1) What, ultimately, do the vast majority of folks that offer free money to life sciences and other technology companies look for in grant apps?  The answer: good science with very early stage commercial potential that consenting adults, with cash to invest, won’t invest in.  What, on the other hand, makes for a good commercial project worthy of financing from a business perspective?  Projects that can generate products – and revenue – sooner rather than later.  You know, the kinds of projects that investors want to fund, rather than the kind that scientific/academic researchers want to fund.

2) What time does business run on these days?  Internet time.  What time do public agencies and grant programs run on?  Government time (or, worse, academic time).  Seriously, how often do grant application, consideration and funding timelines come even close to matching the timelines imposed by financial and consumer markets?  Almost never.

3) Do grants scale?  Well, sort of.  If your Phase I SBIR goes well, there is a big step-up at Phase II.  But seriously, how big?  Not relative to the puny Phase I, but relative to how much capital will actually be needed to get something to the market: something that a freely consenting adult will actually pay for? 

4) Just how much bandwidth does your team have?  In terms of how much talent/time can you profitably afford chasing grants?  And if the answer is “lots of talent/time” is available for hunting down “free” money what does that say about the commercial prospects of where your business is headed?

5) Just because the academics on the team are good at finding and writing grants is no reason to apply for grants.  Indeed, grants too often end up blinding the lab coats running a startup to the realities of the market, to the ultimate regret of all concerned – including even the lab coats themselves when they eventually find out that customers don’t care about peer-reviewed research, they care about value adding products.

Now I am not suggesting that grants shouldn’t be part of a good start-up’s financial model.  But the financial model should serve the needs of the business and it’s investors, not the needs of grant writers.  So by all means, use grants – sparingly – to establish credibility.  And, if from time to time you run across a grant opportunity that actually dovetails nicely with your real business needs and timing, by all means go for it.  But if you ever find yourself thinking that getting grants is what your  business is all about – well, don’t tell that to your investors.

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Cheaper…but still expensive

April 4, 2011

By: Paul Jones

Conventional wisdom has it that it takes a lot less capital to build a startup tech company these days – or at least a web-based startup tech company – than it did say 10 years ago.  Many folks think that this should make it easier for flyover country entrepreneurs to compete with their counterparts in the major venture capital centers: that having big VC funds close at hand is no longer a pre-requisite for entrepreneurs in places like Wisconsin to compete with entrepreneurs in places like San Francisco.  Well – I am not so sure. 

As with much that passes for conventional wisdom, there’s an element of truth in the notion that it takes less capital to build a web-based startup today than it did in the past.  The cost of building the tech in these startups is indeed a small fraction of what the cost was a decade back.  But there is also an element of naiveté in the conventional wisdom, because while building out the tech may be cheaper, building out the company still takes, in most cases, the kind of capital that is still scarce here in Wisconsin.

These thoughts occurred to me a couple of days back when I saw that San Francisco-based Limos.com recently raised $10 million, courtesy of Austin Ventures, to become the Travelocity (or whatever) of the private limo business.  That’s ten million dollars to … build a web site to book limos?  Not really.  The site was already built (presumably with some of the $5 million previously invested by Canal Partners).  The new money will be mostly invested, presumably, in building the brand.  Because the idea that “if you build it, they will come” only works, with any regularity, in Hollywood.  In most other places, having built it you then have to tell people about it.  A lot of people.  A lot of times.  You have to build a brand, and that still takes real money.  It might even take more money today than a decade ago, when the noise level on the web was a small fraction of what it is today.  And that’s sobering for entrepreneurs (and angel investors) in places like Wisconsin, where the number of firms that can invest $10 million in a “we have the technology, now let’s build the brand” play like Limos.com can be counted on the fingers of one hand, with digits to spare.

I guess my point here is not that it’s impossible for entrepreneurs in places like Wisconsin to compete, in terms of building meaningful web-based businesses, with places like Silicon Valley, or Boston, or even Austin.  We have the technology, so to speak, and we have sufficient (there’s never enough) seed risk capital to make it work.  But we still don’t have regular access to the high seven and eight figure capital rounds that it usually takes to build a world beating brand.  Until we do, don’t look for the next Limos.com here in the Badger state.

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Back to the Future with Watson

February 17, 2011

By: Paul Jones

When I began my career way back in 1985, in Silicon Valley, artificial intelligence (AI) was one of the trendier technology plays.  I always had – and still have – a problem with the notion of artificial intelligence, mostly because I don’t think we can really define intelligence.  And, in fact, the AI folks in the 1980s pretty much agreed, if only reluctantly, and it did not take long for the more practical AI folks to scale back their grander talk of machine intelligence to the narrower concept of the “expert system.”  Expert systems were basically programs that included all of the known (including in the best cases probabilistically known) information about a particular field (say searching for oil) with the idea that they could then answer – to the extent current knowledge included an answer – any question about that field of enquiry.

The venture community financed a bunch expert systems startups in the 1980s, which were premised on the idea that while machine sentience – more or less (there is not generally accepted definition of sentience) the idea that a machine could not only “manipulate” (“remember” if you are of a Platonic bent) but “create” knowledge was impractical, machine manipulation of knowledge was itself sufficient to create value, if not new knowledge.  Alas, the underlying computer technology of the time was on the whole not up to the task of creating commercially exciting machines that could outperform human experts even in relatively narrow fields, and by the early 1990s, AI and its less ambitious expert system cousins had pretty much disappeared from the commercial technology landscape.

Which brings us to 2011, and IBM’s Watson, a computer system that more or less handily defeated the two most successful human champions of the popular game show Jeopardy.  It was quite an accomplishment, one that some observers are suggesting heralds a new era of AI research and in the not too distant future AI commercialization.  But does it?

My own take is that Watson does not herald the re-emergence of AI, but rather the re-emergence of expert systems, this time powerful enough to be commercially useful managers of knowledge.  But managers are not creators.  Manipulating data, even vast amounts of data, accurately, more or less precisely (Watson made some humorous mistakes, for example suggesting that Toronto was a city in the United States) and blazingly fast, is not the same thing as discovering heretofore unknown information.  Watson, in other words, may be able to parse the writings of a Shakespeare, but Watson, at least the Watson I saw playing Jeopardy, did not impress me as being able to write original literature of Shakespearian proportions.  Watson is no more (or less, I think) sentient than the best expert systems of the 1980s, which is, finally, to say it is no more intelligent than those systems.

Which is a good thing.  Personally I am glad that Watson heralds a new era of expert systems that are robust enough to be useful servants of mankind.  A sentient Watson, on the other hand, would be a more problematic prospect.  How far out that is, now there is a, if not the, question….

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Some Thoughts on Investment Banks

February 4, 2011

By: Paul Jones

In my previous post, I suggested, in my customary direct manner, that when it comes to finders and their fees, most early stage high-impact entrepreneurs should say no.  I wanted to clarify that my comments in that post are directed towards individuals that are not licensed brokers and are not intended to apply for investment banks.  Specifically, there are situations where it is advisable for emerging companies to engage a professional investment bank to assist with financing.  

When might engaging an investment bank for an early stage risk capital financing make sense?  In my experience, an appropriately experienced investment bank can add the most value in situations with some of the following characteristics: 

  1. The CEO (or other senior-most executive) lacks experience and/or time for a significant role in raising funds. 
  2. The company has a particularly esoteric story, either in terms of technology, markets, business model, financial structure or other important factor.  Good investment bankers – and here “good” means, among other things, experienced in the particular parts of the early stage client’s story that are most unusual – can bring both unique expertise and targeted investor networks to the table.
  3. The company does not see traditional venture capital funds or more established/visible angel funds as likely or desirable investors.  In these situations, investment banks can be very valuable in developing relationships with a broader investor base
  4. And, finally, as an additional complicating factor, investment banks can be a good choice if the market is very soft for the kind of deal being offered, either generally, or in terms of geography. 

Again, I stand by my assertion that most early stage high impact entrepreneurs should say no to finders.  However, there are situations where engaging an experienced investment bank can be beneficial.

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Are Video Game Companies Recession-Proof?

January 27, 2011

By: Chris Davis

Prior to becoming an attorney, I spent five years employed as a video game programmer at Electronic Arts, publisher of such game franchises as Madden and The Sims.  At that time it was an article of faith within the video game industry that video games, much like movies, were relatively immune from broad recessions.  To be sure, video game companies have their own cycles with which to contend; each new generation of consoles wrecks havoc with game sales, for example.  In theory, during a recession, consumers would use their limited discretionary funds on the relatively inexpensive sources of escapist entertainment available to them.  Historically, both movies and video games have tended to do well during recessions, at least in part, for that very reason.

The recent recession has seen commentators declaring the industry both booming and busting.  After a disappointing start, 2009 was filled with reports of layoffs and closures within the industry.  Conditions were perceived to be changing after the video game industry saw its best month ever in December 2009.  Sales this past December, however, dropped 8% from that lofty height and video game stocks have declined on the news.  What gives?

Essentially, it is just another year in the life of a game developer.  The game industry, again like movies, is fueled by consumers.  It is foolish, therefore, to believe that the industry is completely insulated from the broader economy – I imagine that people losing their house are less likely to buy a new Playstation 3.  However, as seen in the rapid game-sales cycles within the recent recessionary period, game sales are affected by a lot more than just the broader market.

As noted by video game-focused blog Kotaku, the game industry has seen a lot of closures and layoffs in the past couple of years.  This was likely due, at least in part, to developers facing reduced access to credit.  Small businesses are more likely to be damaged by a cut or reduction to their line of credit.  This is magnified in the video game industry where small studios often have only one or two games in development at any given time and may only publish a video game once every couple of years.  Recent sales numbers appear to support this theory, a larger-than-usual percentage of which came from large publishers.

Such bad news can present an opportunity for ambitious entrepreneurs.  Budding game developers, like any other new business, need a great business plan focused on keeping their overhead as low as possible.  Thanks to the recession, start-ups have access to inexpensive talent, facilities, and hardware – all waiting to be used to realize the next great idea.  There is no better time than the present to start making video games, but remember that video games, like every other business, will be shaped by the forces of the economy.

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Posted by Chris Davis

Milestone or Millstone? Financing, that is.

January 26, 2011

By: Paul Jones

As a lawyer, I’ve counseled many an entrepreneur, and even an occasional angel or venture investor, who thought so-called milestone-based financing rounds might bridge an especially irksome entrepreneur-investor gulf on valuation.  And, indeed, if you’ve been around the high-impact startup game awhile, you are bound to have seen some of these deals done.  You might even have seen some of them work out.  But as attractive as the idea of punting on valuation and/or funding timing pending the future achievement (or not) of some pre-defined milestone can be, more than a few words of caution are in order.

The kind of milestone financing I am talking about typically looks something like the following.  An investor agrees to put in some money up front, with the valuation thereof, and/or the provision of an additional sum of money, determined at some later time, when the company has (or has not) accomplished some defined milestone(s).  In theory, this structure can be a good mechanism for bridging otherwise intractable differences about valuation and funding requirements between entrepreneurs and investors.  In practice, though, this approach can be quite problematic.

The problems with milestone funding are basically as follows.  First, the parties too often leave the definition of what constitutes achieving the milestone subject to interpretation.  Some milestones are in fact hard to define with precision.  Beyond that, precision itself in terms of defining a milestone can be problematic if, as is often the case, success or failure in achieving a milestone can take forms not contemplated at the beginning of the enterprise.  Second, and particularly where the milestone is more distant in time, market conditions can change so that one party or the other inevitably ends up feeling like they are being held to a deal that no longer makes sense.  Finally – and this, for me, is the biggest issue with milestone funding – is that what seem like the best/most pressing milestones today might be overtaken by events before they are achieved.  Most technology-based startups evolve rapidly: what looks like the best use of limited resources at, say, the first closing of a milestone financing, might look like a less than optimal use of resources a day, week, month or quarter later.  But with a milestone financing clock ticking, the various parties – founders, managers and investors – can find themselves with confused and conflicting priorities.  At best, in this situation, you will have a serious management distraction on your hands.

Milestone financing structures can be good tools in the right situations.  Considering the real world risks, however, they should be considered as if not last at least late-in-the-day resorts.  And, when used, both sides should be careful to pick milestones that can be achieved sooner, rather than later, and defined, appropriately, with precision.  And then everyone should still cross their respective fingers that the business – technology, markets, competition, etc. – stays reasonably stable at least until the milestone is achieved.

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Posted by pajones1

Recent Tax Bill Provides Incentives for Startup Community

January 6, 2011

By: Hamang Patel and Craig Johnson

Exclusion for Gains on Small Business Stock
Back in October, we wrote a blog post titled Incentive to Invest (Now!) in C-Corporation Startups summarizing an exciting provision of the Small Business Jobs Act of 2010 (“SBJA”) that was passed at the end of September.  Well, the incentive is now to Invest (Soon!) in C-Corporation Startups due to a year-long extension by the recent tax bill signed into law on December 17, 2010 (the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, referred to herein as the “Bill”).

The tax incentive at issue allows gains from the sale of certain small business stock to be excluded from federal taxes.  The exclusion traditionally applied to 50% of qualifying stock purchased by an eligible investor, but has been recently expanded to: (1) 75% of qualifying stock purchased in 2009 through September 26, 2010, by the American Recovery and Reinvestment Act of 2009, (2) 100% of qualifying stock purchased during the remainder of 2010 by the SBJA and (3) 100% of qualifying stock purchased through 2011 by the Bill.  Some of the several qualifications include:

  • Investors that are corporations are not eligible for the incentive;
  • The stock must be that of a C-Corporation and purchased at original issuance from the company or an underwriter;
  • The company’s aggregate gross assets cannot exceed $50 million prior to or immediately following the issuance; and
  • The stock must be held for more than five years.

While a provision for completely tax-free gains was exciting on its face, the SBJA only made it available for qualifying purchases made within a very narrow window.  In practice, we expected this to serve more as a windfall to investors who were already planning to make an investment, rather than encouragement for investors sitting on the sideline. 

However, the Bill extended the 100% exemption for purchases made between September 27, 2010 and December 31, 2011, hopefully creating a welcome stimulus in the investment and startup community.  

Extension of Individual Tax Rates
Most of the focus on the Bill related to the extension of current tax rates for individuals, which includes the investor-friendly reduced maximum tax rates of 15% on capital gains and dividends. 

Retroactive Extension of Tax Credits
The Bill also retroactively extended a couple of important tax credit programs that had expired at the end of 2009.  The Research Credit, or R&D Credit, offers a business tax credit equal to a percentage of qualifying research expenditures and has been extended by the Bill through 2011.  In addition, the New Markets Tax Credits program offers business tax incentives in designated geographic areas and has been allocated an additional $3.5 billion for each of 2010 and 2011, whereas the previous allocations ended with $5 billion in 2009.

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Posted by hamangpatel

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