QSBS: The Death Knell for Convertible Notes in Early Stage Investing?

no exit taxThe new tax bill contains a giant incentive for early stage tech investors.  Investment gains on exit, subject to certain conditions, are now exempt from capital gains tax and the investment tax.  This means a reduction in federal tax from 23.8% to zero.  Congress apparently feels that early stage investing in tech businesses is an engine of growth for the US economy and US jobs, and removing the 23.8% tax on gains will be a net positive for the country.  This Qualified Small Business Stock (QSBS) tax treatment has been on and off again for years, but is now a permanent part of the tax code since the Protecting America from Tax Hikes Act of 2015 was passed in December 2015.

So, what’s the catch?

  1. The exemption applies only to the first $10 million of gain (“bummer,” said the angel investor with a smirk)
  2. The stock must be held for at least five years (most successful angel exits take longer than 5 years)
  3. The stock must be purchased after September 27, 2010 directly from the company (investments made in 2016 certainly do qualify)
  4. The stock must be in a C Corporation
  5. The stock must be, well, stock. (It cannot be a convertible note!)

The company must be a qualified small business, as defined by Section 1202.  Some requirements are that it have gross assets of under $50 million, and not be in any traditional business categories like a local restaurant, motel, bank, farm, or doctor’s office.

Consult your tax adviser for more information, of course, but by making this tax incentive permanent, early stage investors and entrepreneur’s have a shared and vested stake in working to make sure their investment structure takes advantage of this, as well as aiming for big gains on an exit after 5 years.

Many angel groups and sophisticated angel investors avoid convertible notes and SAFEs since they typically do not afford the protections and advantages of investments in preferred stock.  This new legislation adds a considerable advantage to equity investment – the prospect of tax free gains on exit.

To begin to get equivalence for investors, the typical “discount” in a convertible note would need to increase from 20% to more than 40%.  And that just might be the death knell for convertible notes in early stage investing.

For more information, see Alan Patricof’s column for TechCrunch, this recent Forbes article, or wealthfront.  The Angels Capital Association has posted a very comprehensive 9 page memo on the details of how to qualify for Section 1202 from accountants Godfrey & Kahn written for Golden Angels.