In the second post of this exclusive guest series, Timothy R. Damschroder of Bodman PLC, a 2017 Silver Service Provider Member, outlines ways Michigan can support angel and venture investors. If you haven’t yet, check out the first post of the series on preventing tax burdens for high-growth companies!
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We are all keenly aware that early stage investing is the lifeblood of a thriving startup ecosystem. Angel and venture capital investors should be incentivized to make the calculated risk of funding a young company. There are various ways to invest in a young company, including options, warrants, convertible debt, and preferred equity.
While most people understand the basic tax treatment of these investments, there are some pitfalls. For example, with convertible debt, the investor is taxed at ordinary income rates for the interest portion of the debt that is converted into equity. This causes “phantom income” (ordinary income recognized by the investor without being paid cash to pay the resulting tax). Another pitfall involves how the warrant is handled upon liquidation. If the original warrant position and the liquidation of the warrant are not both structured properly, the investor can suffer ordinary income treatment on the realized value.
In order to streamline and standardize the landscape in early-stage investing, we propose:
Reforming all rules relating to investing in small businesses (revenue under $5m) so that capital gains treatment is provided no matter what type of investment is made. Although this should not include actual cash interest paid (which should remain ordinary income – don’t want to ask for too much), it should include interest converted into equity, liquidation of a warrant or any other investment instrument in a small business.
Alternatively (or in addition to the above), we propose a modest extension of a principle that is already in place: Qualified Small Business Stock (QSBS) tax treatment. QSBS tax treatment allows an equity investor in early stage companies to avoid some or all of the tax on the gains they receive when they sell their stock. Congress could extend that principle by ensuring that QSBS treatment extends to proceeds received from the disposition of an investment in a small company even if the investment was in the form of a warrant, a convertible note or otherwise.
This change to existing tax laws and regulations would allow investors to lock in the preferable tax treatment they expect and help mitigate regulatory risks associated with early stage investing.
About Bodman PLC
Bodman law firm is best known for providing sophisticated, creative and practical solutions to some of the region’s most successful companies and wealthiest individuals on a broad range of issues. The firm’s Emerging Companies and Venture Capital practice assists venture capital funds and angel investors who are looking to invest in and partner with promising companies. As business advisors, Bodman attorneys can provide emerging companies with pragmatic, down-to-earth advice that is aimed to place clients in the best position for future success.