LPs don’t often talk about QSBS (admittedly not the most invigorating topic of discussion), but it can make a big difference on the tax burden – and thus cash in the bank – to certain tax paying investors, as well as company employees and founders. And while there are some great pieces of content out there about QSBS, we felt the perspective from the LP was missing, so if this is a term you haven’t thought about in a while, now’s the time to tune in. 

I am not an attorney or tax advisor (good news for everyone), but fortunately, we have some very bright legal minds that agree with this piece. First, QSBS is a tax incentive to encourage innovation, and to qualify, certain criteria must be met for the target investment:

Overly-Simplified Qualifying Criteria

• The company must be US-based (C-Corp)
• Shares must be purchased from the company directly (meaning secondaries don’t qualify)
• Shares must be held for at least five years
• The company must be in a qualified industry (most software qualifies)
• The company must have $50M or less of Gross Assets at the time of the share issuance (this includes cash from the financing round, and is different from the company’s valuation)
  • Note: If a company’s assets ever exceed $50M, even if they later drop below this threshold, QSBS will not apply to any future share issuances.

If all of the above conditions are satisfied, US taxpayers (which may include founders, company employees, angel investors, venture investors and LPs) can benefit from significant tax savings. For example, US federal taxes on up to 100% of the capital gains (or the greater of $10M or 10x the cost basis) can be avoided for investments made from 2010 onwards. 

Disqualifying Factors

• The company is not a US entity 
• The company is structured as a pass-through entity (e.g., certain LLCs or partnerships) 
• Secondary purchases
• Transferred shares, such as a warehoused investment transferred into a fund
• Personal services businesses and other businesses in areas like financial services, hospitality, real estate, farming and mining.
  • Note: 80% of the company’s business must be in a “qualified” trade or business
• Certain company redemptions of shares in the 1-2 years preceding and following the investment

A disqualifying event may ruin QSBS status for all or several classes of stockholders. This largely depends on the timeframe, amount paid and other factors.

Theoretical Impact of QSBS

Let’s say we have a founder, Taylor, who develops a novel technology using AI that perfectly applies red lipstick and ensures it lasts at least four hours… or the duration of an overtime NFL game. She initially funds the company (essentially no cost basis, or $0.0001/share) and then raises $5M at a $20M valuation to finish the technology, manufacture and distribute the product. 

An angel investor, Travis, commits $1M, and the hypothetical venture firm KC Capital puts in $4M. Due to high demand for the product, 4 years and 10 months later, Taylor receives an acquisition offer from a consumer goods company for $100M. She wisely negotiates and sells post the 5-year mark. All the investors live in California, home of top innovation and America’s best football team but also high tax rates. Taylor and the investors are able to leverage QSBS status, as shown in the chart below, reducing their gains subject to the federal capital gains tax. 

Just the QSBS provision alone could increase after-tax proceeds (by lowering the tax burden) for Taylor and Travis by $2.0M and $800K, respectively, raising their after-tax profits by 4% and 22%, without any changes to the transaction. KC Capital doesn’t pay taxes on an individual level, but individual GPs and LPs could benefit in the same manner as Travis, potentially adding $3.2M in collective after-tax proceeds. 

And, while the 4% may seem lower for Taylor, remember that her shares have almost zero cost basis, meaning she gets $10M of adjustments. This equates to smaller tax savings compared to her total payout, but hey, $2M is $2M. That’s a lot of cat food for Meredith Grey, Olivia Benson and Benjamin Button. 

It’s important to note that California doesn’t offer an easy QSBS advantage for state capital gains taxes (along with many other states that have capital gains taxes with limited to no QSBS exclusion). This means residents in these locations can benefit from the federal advantage, but cannot then offset state capital gains for investments that qualify under the federal rules. However, if the founder and investors lived in another state, say Kansas, they would potentially have even bigger benefits by decreasing the state capital gain tax burden. The same is true with the Net Investment Income Tax (NIIT) — it depends on the individual’s circumstances, but if the taxpayer is eligible, it could further increase the benefit. 

Of note, it takes some effort on behalf of the company to properly document and track QSBS status, but perhaps the most important consideration is that while tax savings can be very meaningful, the priority should always be what’s best for the company. For example, if the company gets an offer three years after a share issuance, and taking that offer is truly the best decision for the company, the investors should support that decision rather than holding out for QSBS reasons. You don’t want to fall into a “can’t-see-the-forest-for-the-trees” situation. 

Tactical Steps an Emerging Manager Should Take Now

We have discussed QSBS at a high-level, but how can an emerging manager (who already has what probably feels like 10 full-time jobs) take advantage of this in practice? Here are our recommendations:

1. Talk to your early-stage founders about QSBS if they aren’t already aware of it. Simply flagging it will help them be generally cognizant of the provision. Encourage them to consult with their tax advisor or attorneys if they have specific questions. 
2. Documentation is critical. Once an exit happens, it could be too late to take advantage of QSBS as the status needs to be clearly recorded. Therefore, managers should help new founders keep strong records, like stock certificates and detailed balance sheets. Venture firms can also add representations in their stock purchase agreements. Some companies even send out attestation letters prior to an exit. While getting this documentation may feel standard to some, Aumni published some interesting stats a couple years ago showing that only ~50-60% of companies at Seed/Series A had QSBS reps. If companies are already using providers like Carta and Aumni, they should take advantage of these platforms as they can also help confirm QSBS status. 
3. Track and use reasonable efforts to maintain QSBS status if you qualify. Once you have it, you don’t want to lose QSBS status if it’s avoidable. GPs can insert a provision in the investor rights agreement requesting that companies maintain QSBS status within reason, which we consider a best practice, and something the direct investing funds here at Sapphire often do. QSBS status can be impacted by things that may not be top of mind, like share repurchases or exchanges. Distributing shares to your LPs and GPs in kind following an IPO may also help preserve QSBS treatment for those who would prefer to wait until the five year clock is met before realizing a position in a public portfolio company.
4. Communicate to your LPs that you are aware of QSBS and are taking the appropriate steps above to maintain it. 

As we mention in other articles, we believe fund management alone cannot make a great fund (you also need spectacular investments), but good fund management can make returns even better for GPs and LPs. QSBS is a little different as it doesn’t show up in the fund return numbers, but eligible LPs—and even those who aren’t—should appreciate a dedication to fund management best practices.  

Happy QSBS’ing!