Newco - VC Confidential
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Transcript Newco - VC Confidential
1. Newco simple start-up
(a) E's proposal
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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VCs
and/or angels
Entrepreneur
("E")
Experience
and future services
$5m cash
Newco
$5m
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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Simple start-up
E's proposal — corp w/ all c/s
VC
E
Amt invested in Newco
$5m
E's experience
and future
services
Newco stock received
40 c/s
60 c/s
• E seeks 60% carried interest ("CI") in both
capital and future profits
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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Problem #1: Code §83
Rule #1: Where service provider
("SP") receives prop'ty
"in connection w/
performance of services"
• SP has OI = spread at
time of receipt
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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E's §83(a) OI
Newco's FV (cash) . . . . . . . . $ 5m
E's % of Newco's c/s . . . . . . 60%
FV of E's Newco c/s . . . . . . . $ 3m
Price pd by E . . . . . . . . . . . .
0
E’s OI . . . . . . . . . . . . . . . . . . $ 3m
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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• Tax at front end (no cash to pay tax)
• OI rather than LTCG
35%
OI rate
15% (or 14%)
vs
LTCG rate
• E's IT at front end =
$3m x 35% fed +
~ 5% state . . . . . . . . . . . . . . = $ 1.2m
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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Problem #2:
Premature Newco liquidation
while $5m still on hand
Cash available . . . . . . . . . . . . . $
VC's c/s % . . . . . . . . . . . . . . . .
40%
VC's liquidation proceeds . . . . $
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
5m
2m
KIRKLAND & ELLIS LLP
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Problem #3:
Favorable Newco sale
after 1 yr at 2x investment
Sales proceeds . . . . . . . . . . . . . $ 10m
VC's c/s % . . . . . . . . . . . . . . . .
40%
VC's sales proceeds . . . . . . . . . $
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
4m
KIRKLAND & ELLIS LLP
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3 solutions to E's §83(a) OI problem
1. Temporal differentiation—E forms Newco
substan'ly before VC agrees to contribute
cash to Newco
2. Qualitative differentiation—VC receives sr
securities, so that E participates only in
future apprec'n
3. E contributes "prop'ty" rather than
"services"
• E is tax-free under §351 on receipt of
Newco stock w/ FV= "prop'ty"
contributed
• E.g., patent, copyright, trade secret,
formula
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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1. Newco simple start-up
(b) VC's proposal
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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VC's proposal
Qualitative differentiation—
corp w/ cheap c/s
VC
Non-convertible subord
deb and/or pfd stock . . . . $ 4,650,000
E
$500k c/s:
70% VC:
70 c/s @ $5k each . .
350,000
30% E:
30 c/s @ $5k each . . . . . . . . . . . . . $ 150,000
Total . . . . . . . . . . . . . . . . $ 5,000,000 $ 150,000
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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VC gives E only 30% of upside
VC gets both sr claim ($4.65m +
accrued yield) and residual 70%
E gets 30% of profits in excess of subord
deb/pfd yield
•Altho E contributes only 3% of equity
capital (i.e., $150k out of $5.15m)
•So E has 27% CI in future profits (not
capital)
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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E's §83(a) OI
Newco's FV (cash). . . . . . $ 5,150,000
VC's sr claims . . . . . . . . . (4,650,000)
C/S FV . . . . . . . . . . . . . . . $ 500,000
# c/s . . . . . . . . . . . . . . . . .
÷ 100
FV per c/s . . . . . . . . . . . . $
5,000
Price pd by E per c/s . . . . $
5,000
E's OI . . . . . . . . . . . . . . . .
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
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KIRKLAND & ELLIS LLP
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1. Newco simple start-up
(c) Vesting
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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Time vesting on E's stock
• Alt've #1: Cliff vesting if E remains
in Newco's employ til 5th anniv'ry
• Newco option to repurchase E's
unvested stock at orig'l cost ($1,000
per share) when E leaves Newco's
employ
• Alt've #2: Pro rata vesting over 5 yrs
so long as E remains in Newco's
employ
• Alt've # 3: Full vesting upon
occurrence of specified achievement
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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Perhaps do:
• Alt've #2 (pro rata vesting) for
E death/disability
• Alt've #3 (full vesting) for
Newco sale or IPO yielding VC
35% IRR
• But certainly alt've #1 (cliff
vesting) if E quits or fired
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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Code §83
Rule #1:
Where service provider ("SP") receives prop'ty
"in connection w/ performance of services"
• SP has OI = spread at time of receipt
Rule #2: Where prop'ty subj to vesting
• apply Rule #1 at time of vesting
rather than at purchase
• so SP has OI = spread at time of
vesting
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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E's §83(a) OI at vesting
w/ 5 yr cliff vesting and no §83(b) elec'n
Apprec'd FV of E's
30 c/s at vesting . . . . . . . $ 30,000,000
Price E pd for 40 c/s . . .
(150,000)
E's OI at vesting . . . . . . $ 29,850,000
• Where no Code § 83(b) elec'n
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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• Tax at vesting not sale (no cash to pay
tax)
• OI rather than LTCG
35%
OI rate
15% (or 14%)
vs
LTCG rate
• E's IT at vesting =
$29.85m x 35% fed
+ ~ 5% state. . . . . . . . . . . = $ 12m
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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Code §83
Rule #1: Where service provider ("SP") receives prop'ty "in connection w/ performance
of services"
• SP has OI = spread at time of receipt
Rule #2: Where prop'ty subj to vesting
• apply Rule #1 at time of vesting rather than at purchase
• so that SP has OI = spread at time of vesting
Rule #3: Where SP files timely §83(b) elec'n
• ignore Rule #2 and
• apply Rule #1 as if no vesting (so measure
spread at time of receipt by ignoring vesting)
• Short fuse (30 days) to file w/ IRS
• §83(b) elec'n nec'y even where SP pays FV
for stock subj to vesting
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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1. Newco simple start-up
(d) Use of executive
options
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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What if E not willing to risk $150k?
• Perhaps grant E option on 30
Newco c/s @ $5,000 per share
exercisable for (e.g.) 7 yrs
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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1. NQO tax aspects
• E has no OI at grant
• So long as NQO not in-money
at grant — Code §409A
• But E has §83 OI at exercise =
spread at exercise
• Unfortunately, §83(b) elec'n to
calculate OI at grant not
allowed
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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If FV of 30 c/s at
option exercise . . . . . . . . $ 30,000,000
And option exercise
price . . . . . . . . . . . . . . . .
(150,000)
E's OI at exercise
(under §83 Rule 1) . . . . . $ 29,850,000
E's IT @ 35% + 5% . . . $ 12,000,000
• And no §83(b) elec'n allowed at
option grant
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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2. ISO tax aspects
{
No OI at grant or at exercise
Excellent
tax result
LTCG at stock sale = proceeds less cost
2 hurdles frustrate ISO rules:
• ISO exercise produces AMT income =
spread at exercise, so E doesn't exercise til
ready to sell
• ISO disqualified unless exercise > 1 yr
before sale
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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2. Newco complex start-up
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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Newco complex start-up
10 Newco salespersons
10 Newco machinists
10 Newco secretaries
("SPs")
E's 10 relatives
E's 10 golf buddies
E's 10 neighbors
("F&F")
5 VCs
and/or angels
E
Newco
corp, p'ship, or LLC
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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SEC regis'n
Newco must register w/ SEC
issuance of securities
• subord debs
• pfd stock
• c/s
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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SEC regis'n causes:
(1) substan'l delay
(2) substan'l expense
(3) public dissemination of
Newco's game plan
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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2 exemptions from SEC (and
gen'ly state) regis'n:
1st exemption: Private placement
to ltd # of wealthy/sophisticated
investors
• Reg D safe harbor
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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SEC reg D exemption
1. Offering does not exceed $1m:
• No SEC problem
2. Offering exceeds $1m:
• Unltd # of AIs
• Indiv'l w/ either $1m NW or $200k income
• Entity w/ $5m assets
• Newco exec officer or dir
• Up to 35 non-AIs
• Extensive POM required for any non-AI
• Sophistication (alone or in conjunction w/
purchaser representative) required for nonAI, if offering >$5m
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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2nd exemption
SEC rule 701 sale to Newco SPs
1. Unltd # of Newco SPs
2. Compensatory plan
3. Maximum amt = greater of:
• $1m
• 15% Newco's assets
• 15% o/stdg class of stock
4. No sophistication requirement
5. No POM requirement
6. No integration betw rule 701 and reg D
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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Application of SEC rules
to Newco complex start-up
SEC rule 701
•E
• 30 Newco SPs
SEC reg D
• AI: 5 VCs and E
• Non-AIs: 30 F&F
Same result whether Newco is corp,
p'ship, or LLC
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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3. Newco choice of entity
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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Newco start-up—choice of entity
VCs
E
and/or angels
Newco
{
Choice of Newco entity
• C corp
• S corp
• Ltd p'ship
• LLC
• Consider tax ramif'ns (1) each yr and (2) on exit
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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C corp disadv'ges
(a)Double tax on Newco annual
earnings
• Corp-level tax at rate up to
35%
• S/H-level 2d tax at 15% on
earnings:
(1) div distribution or
(2) LTCG on sale
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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(b) On Newco's ultimate sale,
delivering asset SUB to
BuyerCo = double tax to sellers
S/Hs
Newco
C corp
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
BuyerCo
KIRKLAND & ELLIS LLP
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Struct'g Newco as
flow-thru entity (SCo, p'ship, LLC)
Adv'ges
(a) Only 1 level of tax on Newco annual
earnings
• For indiv'l equity owner, at rates up
to 35%
• Equity owner's outside stock tax
basis increases by amt of entitylevel income taxed to equity owner
• Non-control equity owner should
seek mandatory IT distrib'ns
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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(b) On Newco ultimate sale, can
deliver asset SUB to BuyerCo
w/ only 1 level of tax on sellers
Equity
owners
Newco
flow-thru
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
BuyerCo
KIRKLAND & ELLIS LLP
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(c) Loss pass through
• Subject to tax limitations (e.g.
§469 passive activity loss
rules)
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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Disadv’ges
•UBTI for TEO
•ECI for FP
•Each equity owner must file state
tax returns
Several LLC adv’ges over SCo or
p'ship
•SCo arbitrary restrictions
•P’ship liab’ty issues
NWU Entrepreneurship Conf — ©2006 Jack S. Levin
KIRKLAND & ELLIS LLP
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