Who or what is this QSBS?
QSBS: Stands for “qualified small business stock” and is a federal tax incentive program that spurs innovation, unlocking up to 100% tax savings on the greater of $10M in capital gains or 10x the initial basis of the investment directly in a qualified small business.
QSBS Rollovers: If QSBS is sold before the 5-year timeline the gains can be rolled using Section 1045 into an eligible QSB(s), maintaining the QSBS clock and current + future QSBS gains.
Venture investing and building startups is an exciting topic until you bring up tax and legal… then it turns into “ask my CPA” because I don’t understand and I really don’t want to. But, what if your CPA or attorney can’t answer your questions? In fact, there is a surprising dearth of subject matter experts when it comes to QSBS, even at the biggest law and accounting firms in the world.
This is a common theme when you blend private equity, M&A, and tax especially for complex situations that involve QSBS. The problem with tax incentives is that claiming them usually takes unreasonably priced tax engagements to solve the various tax code puzzles, turning into a pay-to-save scenario.
This is where the mission of incentives does not align with capitalism but aligns with politics. There is a group of CPAs and attorneys turned entrepreneurs (i.e. Jon Fish, Kyle Richless, and David Stephens) who are building a tech-enabled platform, CapGains, Inc. (first product QSBS Expert), that democratizes tax incentives, starting with QSBS. Their approach accounts for the ongoing eligibility requirements of tax incentives like QSBS, where a single instance of non-compliance can blow every taxpayer’s ability to claim the exemption. As such, CapGains takes a proactive and continuous approach to eligibility monitoring, flagging missteps, and tripwires, such that their clients can course-correct in real-time. And for companies that can get this right, it is not solely the company founders who stand to benefit, but rather all early employees on the cap table, including employees, founders, accelerator funds, and limited partners of investment funds.
QSBS Impact On Accelerator Funds
Scale (now Redbud VC), an accelerator fund and venture studio, is directly affected by QSBS with each investment similar to other early-stage investors. The firm is generally the first money invested into a company, which gives Redbud the opportunity to help educate founders around optimal corporate structure and QSBS compliance. However, there is no way to guarantee that education at the beginning of a company’s life will ensure compliance will in the long term, especially since educating folks on QSBS is time-consuming.
Even if founders are educated with QSBS early on, many tend to forget about its importance until there is a secondary sale or an impending exit. Moreover, there has never been one source of truth for QSBS — let alone QSBS rollovers.. The monetary impact of QSBS is huge if it goes unnoticed.
Let’s assume an accelerator fund invests $100k in 50 companies and expects 1 to reach unicorn status with a 200x return on investment. Therefore, the fund would exit with $20M in gains ($100k x 200). If there were 5 equal limited partners in the fund they would each have a $4M gain ($20M / 5). Assuming the Company qualifies for QSBS they would each save $952k in taxes ($4M x 23.8%) or a quarter of their investment. That’s enough in savings for each LP to make 9 more investments (hence spurring innovation)!
It almost seems too good to be true. What is even more surprising is that many times, accelerator funds and angel investors aren’t aware of QSBS or have no idea how to claim the exclusion — and neither do their attorneys or CPAs..
Another issue is having the tax sophistication to roll over QSBS gains to another investment if the stock is sold before the 5-year QSBS timeline. If a fund can time its cash flows correctly with capital calls and exits, then the fund can roll gains into a new investment tax-free. These issues are also what the founders of CapGains saw and continue to iterate on a product that simplifies the tax code for even your grandma to understand.
QSBS affects everyone on the cap table whether you are Sequoia Capital or the first account executive hire that claimed a Section 83(b) on vesting stock. QSBS is meant to spur innovation but it is a painful process of confusion with an ambiguous tax code, fear to claim the exclusion due to lack of understanding, and hopelessness from a ghost town of experts. In summary, QSBS is a fantastic tool to award those for risking their time and money on innovation, and given the complexities and potential tax savings should be top of mind at all times, not just at an exit.
CapGains Inc. offers a finance software platform enabling investors and individuals to save money & time by simplifying complex tax provisions. The Company’s first product (“QSBS Expert”) empowers users to better understand their eligibility for the Qualified Small Business Stock (“QSBS”) tax incentive, which while designed to spur innovation, is notoriously complex and affects millions of investors, founders, and employees.
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