You better read the news (or some of it) š§
Dear readers-friends,
Yes, this is me! Iām back. The last issue was sent in January and we are almost at the end of the year.
As is the case for many of us, 2022 has been a very tough year - inflation, rising interest rates, and tech-company layoffs put us in a mode of āwhat is next?ā.
Personally I also have been going through a lot, so I had to put some projects on hold. But the books are open now (rs) and weāre back stronger than ever, and ready to face this recession - or canāt we call it recession yet? Letās find out together.
Now, without further ado, onto todayās issue:
Founders and entrepreneurs tend to ignore the news. Especially when it comes to politics and legislation developments. Today Iāll try to convince you that this may not be a good idea, especially when it comes to taxation matters.
If you are building a company that you envision as being venture-backed, a critical consideration to have from the get-go is capital gains taxes. When building a VC-backed business, you become part of the VC industry and need to get familiar with a few key tax-related concepts are critical for your success.
You probably heard about the concerns in the venture capital and angel investing community with the famous āInfrastructure Billā passed last year with the potential cut on the existing US tax benefits on capital gains. Letās begin by breaking down this benefit in the first place. Section 1202 of the IRS defines that US investors in Qualified Small Business Stocks (QSBS) can enjoy a capital gain tax break in their returns, in case they meet a few criteria. So this means that the startups classified as a QSBS are more attractive for investments.
Capital gains are the difference between the price of the sale of the assets (ie. startup exit value) and the value that the investor paid for those assets (ie. startup initial investment). Capital gain taxes are due in event of exit - when the company is sold or there is an IPO.
Investors holding QSBS can enjoy a 100% capital gains tax exclusion up to the greater of:
$10M
10x the original purchase price of the shares
HOW IT WORKS
On a practical example, letās assume a VC made an investment made in a startup of $1M, that is later on sold at a valuation of billions and the investment is now worth $101M, which means a capital gain of $20M. Assuming that the capital gain tax is 20%, tax break benefit would be computed as follows:
Capital Gain Tax Without Benefit: (20% Capital Gains Tax ) x $100M Capital Gains = $20M Total Tax Payable
Capital Gain Tax With Benefit: (20% Capital Gains Tax ) x ($100M - $10M = $90M = Capital Gains under QSBS) Capital Gains = $18M Total Tax Payable
Total Tax Savings: $2M
The infrastructure bill passed in 2021 targeted to cut this benefit by 50% for investors with a net annual income of $400,000. Thankfully, the IRA (Inflation Reduction Act) passed in July 2022 in the Senate excluded this amendment which was a big risk for disincentivizing investment in early-stage companies and the overall entrepreneurship environment.
All of this is to say that entrepreneurs and startup founders need to be aware of the developments in certain regulations in order to better address their fundraising strategies. For instance, if the bill passed included the reduction of the tax benefit, a wise founder would probably target other geographies for seeking funding, or would prepare to receive investments from non-US entities.
Believe me, when it comes to fundraising and Venture Capital, the devil is in the details and increasing your sophistication in understanding the legal and taxation framework will count points in your journey.
š§ Podcast recommendations
ā¶ļø The Drive with Peter Attia: Dietary Protein: amount needed, ideal timing, quality and more with Don Layman, Ph.D. - You guys probably know how much I care about my health by this point. This podcast was eye-opening in terms of how little protein I have in my diet. Highly suggest having a listen.
ā¶ļø Bad Beds: The Unraveling of Trevor Milton - We have a new CEO facing the courts in the US for fraud and the WSJ is following it in this podcast series. Nikola is the startup that wanted to build āTesla for trucksā and at its peak, Nikola traded at higher valuation than Ford, to drop 22x to only $1bn. Fascinating to see how far people can go when they ābelieveā in their ideas so much, that they bend reality to fit into what they want to seeā¦
This is Open Books - a weekly newsletter carefully curated by me,Ā Leticia Souza. Every week Iāll be compiling relevant topics around finance and financial strategy - from choosing your first accounting system to how to successfully close a fundraising round to your business.
In a world full of noise, I aim to bring clarity and direction to your finance processes so you can manage your business in peace. If you find the content useful, do your friends a favor, and please share this newsletter with them.
Have a great week ahead šš¼
Leticia
The tax advantage makes significant impact in investment choice.