QSBS (Qualified Small Business Stock)
The opportunity to qualify for a QSBS tax exclusion is if a CCorp has assets less than $50M when you acquire the stock. Then you have to hold that for at least 5 years after that. This is another reason to get out of the notes.
I am on note rant again. I absolutely understand the desire to do a note the first round. It is just easier and less expensive on the legal fees. Although there should be some sense of thought process that goes into each note from a founder who is just starting to get a grasp of the legal implications of starting a business and having investors. Off the shelf notes just don’t force a founder to learn. I believe it is part of the process.
I always push to convert a company into equity and not pile on the notes after the first round. The reason is when all the notes convert, it is like a waterfall, particularly when each note has a different cap on it. The founder rarely ends up owning what they think they do and neither does the investor. The second reason is that when these notes do convert, they are rolling into the next raise and the amount of cash that is going into the company isn’t exactly what it sounds like because the note’s cash has mostly been spent. So when a capital infusion of $5m is being made into a company on an equity round and $2m of that is from a previous note there is only $3m coming in as new money. Any more capital would dilute the founder and the investors. Now I am adding the QSBS piece.
The clock doesn’t start ticking until everyone has actual equity in the business. The valuation could still be under $50M but if the notes are hanging out for a few years and the business has been growing for a few years, there is a chance that the company will exit before those 5 years are up.
This just adds to my belief that companies should all convert everyone to stock early on.
Comments (Archived):
Interestingly the founder can get QSBS protection from Day one since they buy their stock early.
.QSBS is extremely complicated, but it is a real thing.https://blog.wealthfront.co…JLMwww.themusingsofthebigredca…
Agree with you. Also, a lot of attorneys don’t put drag along rights in notes. That means individual note holders can screw up the deal when they convert. I detest notes as an institutional investor. I did them as an angel investor. What am I supposed to tell our auditor when they ask me how much of the company we own? When you do the math, doing a priced round is at least equivalent as a note. Understand that you need to pinch pennies at the beginning but the difference in legal costs is minuscule compared to the headaches you save for the entire journey. If you fail, you aren’t going to say “I failed because we did a priced round and our attorney costs were $xxxx more than doing a note.”
Don’t disagree with your argument, however we have gotten informal legal opinions that a SAFE starts the clock as “equity”, expect this to be an IRS ruling at some point. Its a “safe” world and we sort of have to live in it, wish there was a dollar cap. Just had a high profile deal with multiple safes and big step up, it actually turned out well for company and safe holders as the institutional investor leading the round did not count the SAFE shares converting in the calculation of the price per share off the agreed upon valuation, I sure would have!
Legal opinions on my side have said SAFE does not start the clock ticking. And just noting that SAFE documents are about as good as the paper they are written on.
can you elaborate on this comment about safes?
SAFE notes are notes that YCombinator came up with for founders to use as off the shelf convertible note documents. I find them extremely light on legal responsibility. I generally get a side letter from my lawyer when a SAFE document is used in order to make sure that much of the documentation is negated by using language that actually has a responsibility to it.
I have been the beneficiary of QSBS three times. I could not agree more.Price the round. Price it.Now if you want to say, ok, to buy the round at this price you put in a certain amount of debt, and it is true debt. Fine.But all of this financial machinations is silly. You need debt to buy capital items and a bank won’t give it? Fine. Will never do a convertible.
Thanks for this. This seems to be a pretty complicated topic as to how IRS Section 1202 works with respect to holding period and convertible notes (not just SAFEs but all converts). There is a good discussion in this link below, but it seems to contradict itself if you read it closely. If there is a definitive answer I would love to know! Thanks for raising the issue. https://www.arnoldporter.co…