Thread by @MichaelMartocci

I’ve made what will likely become a roughly $75 Million mistake related to QSBS

It’s a painful lesson and 100% avoidable if I educated myself earlier

So this is me sharing a bit of what I wish I knew so you can avoid making the same mistake 👇👇

First off, what is QSBS?

It stands for qualified small business stock - I’m not going to go into every little detail, but basically it’s part of a program that incentivizes the creation of certain types of startup business in the US

The main qualifications for QSBS are that the business must:

1. Be a c corp
2. Be under a certain size (less than $50m in assets)
3. Be in one of the qualified types of businesses (no investment companies etc)

If the corp meets these reqs, the shares they issue are QSBS

The reason this matters, is that cap gains on eligible QSBS stock is tax free up to a certain threshold as long as you hold it for at least 5 years since it was issued (incenting innovation in 🇺🇸)

There are some ways around the 5 yr mark but not important here

Now onto the threshold, it’s the greater of $10mil or 10x the cost basis for the QSBS

For various reasons (including that founders stock basically has $0 real cost) it’s rare to be eligible for more than $10m tax free

That said, pocketing an extra $2m at exit is great

So, how is it posisble to make a $75m mistake?

Well, there’s this one interesting “loophole” that when timed right, can change the max tax free gain from $10m/person to up to $500m

The way to do it…change from an LLC to C-corp right before your co is worth $50m FMV

There’s a few things to unpack there

1) why does switching from LLC to c-corp matter? Because you are basically trading that resource for stock in the new c-corp

Say you own 50% of a LLC worth $40m and convert, your cost basis is $20mil x 10x = $200m potential tax free shield

2) why does $50m FMV matter and how is it measured? Back to the beginning qualifications, if the corp has over $50m in assets its ineligible - the LLC basically is the core asset

And the way Fair Market Value is derived is through a 409a valuation

409a’s are well known at this point and can be done by @cartainc or similar

Depending on the nature and stage of your company, they will derive what they believe to be the fair market value of the biz cia various methods, such as marking to public co multiples + a discount

So back to @swaguphq and me

We’ve recently been going through a LLC > C-Corp transformation for various reasons one of which is/was QSBS

Only problem, our 409a is considerably higher than the $50m threshold

Given this, not only is the $10m cap out, so is 10x basis

Looking back, we should have started this process earlier and been doing 409a’s along the way…that way as we approached the $50m threshold, we would have made the conversion and locked in a close to $500m tax free shield

But I was naive…

To be honest, I had only heard about QSBS maybe 12 months ago…up to that point we were so myopically focused on providing value to customers, which has allowed us to build the business we have today

But it’s not all bad, ther’re legal ways to deal with this situation favorably

So I guess my point, besides trying to help someone reading this maximize QSBS’s impact for their team, is to surround yourself with really smart people who have been through this over and over

For example @karimatiyeh has helped me in areas that are not widely known

To close out, QSBS is a hot topic these days that’s being discussed in politics, this info could possibly become out dated in the near future - do your own research and find great attorneys (the best ones are incredibly valuable)

Good luck 🚀

Note : much of this is an oversimplification…talk to a lawyer

Final final point - this does not just impact me, this impacts every shareholder that got in early 😔