How to do company valuation for 83(b) election?

Omer Riaz Social Entrepreneur and Management Consultant (Strategy, M&A, Operations)

May 20th, 2016

I'm joining a startup as a partner in the LLC. The company had $70K in revenue last year, and some money has been raised at close to $1M valuation.

The $1M valuation causes concerns for me, because I'm immediately looking at a tax bills of 10s of thousands of dollars upon joining the company and making the 83(b). While it's one thing to sell investors on the idea of the potential of a company, I don't think we could go out today, and get a buyer to pay even $100K for the business.

Has anyone dealt with this before? Are there any ways around it?

Neil Gordon Board Member, Corporate Finance Advisor and Strategy Consultant

May 20th, 2016

All stakeholders are not created equal. As capital was raised at a $1 million valuation, did the investors get preferences that other, "common" equity holders don't have? You may find that most of the appraised value belongs to the investors.

As mentioned, an independent valuation is a good idea.

James Henderson Business, technology and tax planning attorney

May 20th, 2016

Omer, to the extent you would be reporting some level of income based upon the 83(b) election, you would be well-advised to get an independent valuation of your company, which you could then attach to the tax return to support the value you report to the IRS. Depending on where you are located, you could probably find a local accounting firm or other business valuation expert to prepare a report.

Martin Omansky Independent Venture Capital & Private Equity Professional

May 20th, 2016

Actually no problem. We have seen this situation a lot. First, one can avoid tax on phantom income (that is the IRS name for such situations) by getting options and when there is a liquidity event, one pay that tax on the difference between the option exercise price and the liquidity event price (this does not eliminate the tax obligation, but puts off the tax obligation until a liquidity event occurs. There also may be other approaches using notes or other instruments that put off the obligation to pay any taxes due until there is sufficient value in the stock to justify the payment of a tax. I would suggest you talk to a CPA or other qualified professional before you make a decision.The company can also help in this regard by taking its initial capital in the form of convertible notes - which would put off any valuation for a while. I would be happy to refer you to our own advisers who understand this issue.

Michael Brill Technology startup exec focused on AI-driven products

May 20th, 2016

Omer, to Neil's point, do the outside investors have additional rights that other LLC members don't have? This is less common with LLCs than with corporations selling preferred shares... but it does happen. This can be used to argue a lower valuation for your shares. Also, the size and timing of that investment matters.

e.g., a $500K investment 2 months ago with no additional rights to the investor is more challenging than a $50K investment 2 years ago with extra liquidation rights.

Martin, Omer is trying to avoid the scenario where he has to pay ordinary income tax at exercise... which can be more than twice long term capital gains tax.

Michael Barnathan Adaptable, efficient, and motivated

May 20th, 2016

The preferred and common valuation in a traditional corp aren't equally valuable, so don't use the investors' valuation to establish a cost basis on your membership interest. The investors have rights you don't have.

If you are still concerned, ask for a profits interest at the $1m cost basis. You wouldn't own any of that first million, but you'd own a piece of any growth above that, thus your grant wouldn't be taxable until exercised (because its value would be $0 at grant).

Don Hawley President at DLH Consulting

May 21st, 2016

In an LLC you may issue a different series of units called "profits interests". They should carry no "preferences" similar to the founder units. The units sold at the higher valuation should have certain traditional preferences similar to preferred shares in a C Corp. The profits interests units may be issued at no value and therefore have no negative tax consequence to the recipient. I used this specific vehicle in a previous LLC for certain advisors, consultants and a few key employees. Please review this approach with your SEC counsel. I believe you will find it solves your potential problem.

Gregory CFA Private Equity/Venture Capital Emerging Markets

May 22nd, 2016

This is why equity based (incentive) compensation is typically not made via actual shares but rather option (Incentive or Statutory -different tax implications to the company) as they have what the tax authority call, "significant risk of forfeiture. Thus you have not triggered a taxable event of pecuniary remuneration. Other possible options are phantom stocks and the like, however this form is more like a derivative and does not provide voting rights. This is at least my understanding, I am not a tax or securities attorney, check with one first of course. Finally, I assume your firm is using some form of a vesting schedule, i.e. cliff or stepped.

Todor Velev Managing Partner, EEI Network

May 20th, 2016

Omer, my opinion i sthat attempt to value the company is mainly waste of time. Event for stablished companies a valuations is more an art than a science; for start up with no revenues it is the pure form of speculation.

It does not mean that you should not try to see where the business can get to in near fruture, and make sure you are identifying all your key success factors and risks. But jumping from trying to draft the immediate business future to a valuation is paying for used paper. At the end of the day, huge part of the valuation is based on the terminal value; in your case, either on the next round valuation, or on exit / another round in several years.

Even if you decide to go for a valuation, all coments on the rights attached should be taken into account. At the end of the day, if you value a stake in the company, you are valuing your rights. Professional appraiser should apply discounts for minority shareholding (everthing else being equal) and for lack of liquidity (no quick way out of the investment). If on the top of this you add other different rights....the Michale's comment on clairvoyance, although in another context, applies fully :).

So, do you back of the envelope calculations and decide what you want to get from a team (and investors) that wasted 100K....

Michael Barnathan Adaptable, efficient, and motivated

May 21st, 2016

Be careful about a potential C corp conversion down the road if you go with a profits interest. They're quite useful, but it's a nightmare trying to figure out what happens to them when you convert to C and how to structure that conversion in a way which doesn't result in a taxable event.

A bit more on that is in this article (search for profits interest):

square1bank.com/think-you-stock-options-think-again

Michael Brill Technology startup exec focused on AI-driven products

May 20th, 2016

I think you can assume that tax avoidance is a fundamental human motivation. Timing the exercise of options a year before a liquidity event typically requires the use of a time machine or clairvoyance - both of which likely have more profitable use cases.

Although I'm not an LLC equity expert (or even marginally competent), my understanding is tax treatment of membership option grants in an LLC are treated as NSOs and you've got to pay tax upon exercise, not upon sale of the ownership. That makes the option scenario even yickier.

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