This is not a trick question. Would you rather have $5 million or $3.9 million?

By Sarnaa Archie

Venture Capitalists make their money in lots of ways. They put out a bucket anywhere the machine of your business might spin off a coin or two, today or in the future. Venture investments are risky bets that often fail. So, to lower their risks, VCs will put hooks in your intellectual property, your customer database, and some long-term option on your talent, and they’ll own your equity—some or a portion or all tiers of it (the preferred shares and certain classes of your common stock, too) because of the multitudinous ways that it might pay them back over time. These are the many ways they try to mitigate their risks about an uncertain future.

Finance, after all, is about the future. Incentives heavily influence the future.

All kinds of investors operate under different names and in various models: angels, banks, VCs, private equity, vulture capitalists, hedge funds, etc. But their goals are the same. They want a dollar invested today to be worth more than a dollar tomorrow and are willing to wait for it.

But there’s another often unmentioned financier who is not often thought of as one—the founder, the owner, the partner, the entrepreneur, who, like the bank and the venture capitalists, invests some capital, but usually in the form of a little cash and a whole lotta sweat, in the hopes of building something that will return time and money to them in the not-so-distant future.

Most of these investors and entrepreneurs, too, will get their money back through the sale of the entire business—either an asset sale (buyer preferred) or a stock sale (seller advantaged).

Corporations issue stock.

This is one of the reasons that VCs require startups to be corporations before they funnel any of their cash into your unprofitable coffers. But they also do so for legal and financial reasons too. First, Corporations keep their legal problems away from them and those who gave them their money to invest. (They limit investor/owner risk.) Second, a significant benefit is if your venture is even slightly more successful tomorrow than when they gave you the first dollar. Known mostly only to those inside the startup and VC world, there’s a massive discount in the tax code called qualified small business stock (QSBS) enshrined in Section 1202 of the web of laws known as the Internal Revenue Code.

When you acquire and then sell QSBS to the next person, whether in a private or public market transaction, you get a substantial discount (depending on when the stock was issued to you a 100% discount) on the tax you would otherwise have to pay on the sale—if there was a gain of any kind. It’s not a special kind of stock with a particular feature; it’s a stock issued by a company that “qualifies” according to the tax code rules.

In tax speak, the amount you’d have to pay on profits from stock sales is called a capital gain. This means that if you bought stock—even in your own company—for $100 and sold it five years later for $5,000,000, you’d usually have to pay the federal government from that $5 mil a tax of $1,049,979.

But if your stock is QSBS, you’d pay $0 in taxes. (Again, depending on when the stock was issued to you or when you bought it.)

I can lay out a complex spreadsheet model here replete with percentages and scenarios with annotated comments and differential equations (I can’t really), but the math here is simple, and the analysis can be summed up in the question posed in this post’s title: Would you rather have $5 million or $3.9 million dollars when you sell your business?

It’s undoubtedly a more complex and nuanced question than that since to even get there, and you’d have to build a business worth at least $5,000,000 and find a buyer who thinks that’s a good deal and capable of paying. That’s the hard part, but setting it up for this future is, in a way, the easy part. But you have to do so now instead of later because, as you might imagine, the government won’t give up its cheese that easily.

It’s pretty simple for your business to qualify.

Brace yourself for this run-on sentence:

Your business can’t be a hotel, a gas station, a doctor’s office, or a business that relies on the reputation or skill of the founder (like a law firm, a consultant like me, or an architect), must have less than 50 million dollars in assets at the time the stock is issued, be an American corporation (not a partnership, sole-proprietorship, or LLC, or foreign company), and for the discount to apply the stockholder must have received or bought the stock, when it qualified or from someone who got it when it qualified.

But there’s one more caveat.

To get the tax discount, the stock must be owned by the shareholder for at least five years. However, there is a way, not so much around this particular 5-year rule, but a way that completely follows it in less than five years. It’s kind of like magic. The tax code is our secret magic book. I suppose that would make me the magician. (I accept.)

Contact me if you think or would like to know how you can take advantage of this, even if you’re already ready to sell, nowhere near it, or recently sold your company and would like to see if you can get a refund on your sale.