Cheap Stock To Employees And Promoters: The Eat-'Em-All-Up Preferred Stock Approach
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
Again to state a fundamental proposition, there is no available cash in an early-stage financing with which to pay federal and/or state income taxes. Consequently, anything that smacks of a taxable event is verboten. The norm, however, is that the founders will obtain their interests in the new entity in consideration of past services and/or the capitalized value of the founders' talents and services to be rendered; the promoters, if different from the founders, are obtaining stock for their organizational efforts. The omnipresent danger is that the IRS will successfully assert the position that all or a portion of the stock issued to the founders has been, for tax purposes, issued for services and a current tax is payable. Since that position reflects the economic reality, it is dangerous.
There are, however, three principal weapons on the side of the taxpayer. First, as indicated, §351 of the Code provides for nonrecognition of gain or loss upon the exchange of property for shares if the shareholders contributing cash or property are in "control" (meaning ownership of 80 percent of the stock) of the corporation after the transaction. The trick, within the bounds of reasonableness and good faith, is to argue that the founder's contribution is not "services," but intangible property, that is, a secret process or other proprietary information, because secret processes can be "property" under the Code. The second, the "passage-of-time" approach, is described below.
Thirdly, if the consideration paid by the founder cannot in good conscience be labeled "property," and the investors all come in together, then the inquiry turns to the value of the stock being issued. Assume the founder pays, as he always can, some small amount of cash. Is that cash sufficient to equal the "value" of the stock received so that no gain is recognizable? At first blush, if the founder pays $10 per share and the investors contemporaneously pay $100 per share, it looks as if the founder has made a bargain purchase and an element of taxable compensation has changed hands. However, the compensatory element may disappear if the investors receive preferred stock. The Internal Revenue Service has never challenged successfully the view that the issuance of shares with a liquidation preference, ordinarily labeled "preferred stock" can "eat up" value in an amount equal to the preference, thereby reducing the common stock (the "cheap stock") to marginal value. Put another way, if the liquidation preference of the preferred stock is equal to the cash contributions of the parties contributing cash capital, then a balance-sheet test immediately after organization suggests that the common stock is " worth" only the nominal consideration the founders have paid, thereby excluding any element that can be attributed to past or future services. See the following, a hypothetical balance sheet.
Balance Sheet
|
Assets |
Liabilities |
||
|
Cash |
$10,000 |
|
-0- |
|
|
Shareholders' Equity |
$10,000 |
|
|
Common Stock (1,000 shares) outstanding, 10¢ par |
$100 |
||
|
Total Assets |
$10,000 |
Total Liabilities |
$10,100 |
An uncritical examination of the balance sheet might suggest that 10¢ a share paid by the common would compare equitably, that is, no bargain purchase, with the $10 paid by the preferred, since the preferred appears superior to the common on the balance sheet in the full amount of the cash paid. Certainly, if the issuer were liquidated immediately after it was formed, that is, on the date the taxable event, if any, occurred, the common shareholders would get back just what they put in, $100. Of course, since no one intends to liquidate the corporation either right away, or, for that matter, ever (and, indeed, if it is liquidated, it is unlikely that either the common or the preferred will get anything), the liquidation value test is dependent on a contrary-to-fact convention, but nonetheless a convention that has stood the test of time in view of what appears to be the silent acquiescence of the Internal Revenue Service.
The power of the preferred to "eat up" value for tax purposes is enhanced to the extent the preferred shareholder owns additional superior rights, that is, senior as to dividends (of which there are usually none), special voting rights, registration rights, and the like. These rights are often significant to the cash investors in the early going and are helpful on the tax issue; from the founder's point of view, the fact that they fade away upon the exit date, the IPO, for example, means he can be relatively indifferent. It could, of course, be argued that one must weight the common's value upwards because all the "upside" belongs to the common; however, making the preferred convertible, albeit at a price of $10 per share, means that the preferred has a chance to share in the "upside" as well. In short, ordinarily the cash investors take convertible preferred shares (a choice which, parenthetically, excludes an election of S Corporation status), and the founder, common.
The principal caveat has to do with excess. In the example quoted, the cash investor's payment per share is 100 times the amount of the founder's payment. Many practitioners are uncomfortable with a spread that great. Others tend to take the more aggressive view. The belt-and-suspenders technique is to combine the "eat-'em-all-up" preferred approach with the "passage-of-time," or "Bruce Berckman's," approach discussed immediately below.
As indicated, it can be important to contributing shareholders other than the founder that the "eat-'em-all-up" approach works. To be sure, the biggest risk is to the taxpayer held to have received stock for services. However, any shareholder contributing appreciated property may be required to pay tax if the taxpayer deemed to have contributed services gets more than 20 percent of the resultant stock, since, as stated, §351 only works if the contributors of cash and property, not services, get 80 percent or more of the stock.