or…how it cost me $1,000,000 to sell startup shares on the secondary market.
After joining 3 startups, I was lucky enough to help found a company that went from 0 to single digit billions in 4 years. My role during much of that time was running the engineering team. I do not know the percentage of the company that I owned originally but my current shares are about to 0.002% of the company or about $X,000,000. The million dollar question is: converted to cash, how much money do I have?
Why sell some shares?
Well, $X,000,000 is an unfathomable sum for me who never really imagined making 100k/year. I grew up in a relatively poor rural-ish part of the country to well educated parents. I attended public school with no tutors or after school stuff. Sundays were spent cutting coupons out of the paper and it took years after college to be comfortable ordering an appetizer at a restaurant (much less going to one). I feel extremely fortunate about how I was raised and the resources I had access to. However, my world growing up is very different from NYC in 2021.
I chose to sell a portion of my shares since the money would be transformative. I also think having 95%+ of my net-worth in one company is risky.
What happens when selling shares on the secondary market?
Selling shares on the secondary market is quite a process. End to end it took 16 weeks from contacting the secondary sales company to receiving funds.
After leaving the startup I helped found, I emailed my long time tax advisor that I was considering selling some shares of the company I had been working at for the past 4.5 years. I asked whether there were any tax implications that I needed to be aware of in selling shares on the secondary market. He said that since I had early exercised and done an 83(b) election, the shares would qualify for long term capital gains. Great!
On April 15th, I signed agreements to sell a portion of my shares totaling $2,000,000 of shares on the secondary market (Note: not the actual amount!). I believed this would keep a good amount of upside while, in the short term, help me live more flexibly and help my mom retire. (This was pre-tomato plants)
For transactions as small as mine (lol), the people facilitating the transaction take their max fee at 5% which in this case is $100,000. Here is how I calculated my anticipated take home:
2,000,000 - 100,000 Total after placment fee = $1,900,000 1,900,000 * 0.2 (federal long term capital gains) + 1,900,000 * 0.12 (NYC state + local) Total taxes = $608,000 1,900,000 - 608,000 Total take home = $1,292,000 (608,000 + 100,000) / 2,000,000 Taxes and fees as a percent of takehome: 35%
April 28th, Biden announces that his tax plan where capital gains over $1,000,000 would be taxed as income and the changes will be retroactive to April 28th, 2021. Unfortunately for me, the taxable event date for my sale is not when I signed the transfer agreement (April 15th) but when I receive the funds. This means that my transactions, despite being initiated without knowing about this potential policy change, will be subject to this new tax rate. With this new tax rate, my total taxes and fees are:
2,000,000 - 100,000 Total after placment fee = $1,900,000 1,000,000 * 0.2 (federal) + 900,000 * 0.4 (federal under biden plan) + 1,900,000 * 0.12 (state) Total taxes = $788,000 1,900,000 - 788,000 Total take home = $1,112,000 (788,000 + 100,000) / 2,000,000 Taxes and fees as a percent of takehome: 44%
This brings the take home on a sale of $2,000,000 in stock to $1,112,000. 44% of the total is taken by taxes and fees. However, there is nothing I can do and so things proceeded.
In mid July, about 14 weeks after the transfer agreements with the buyer were signed, the funds from the secondary sale land in my account. This transfer happens 4 years and 10 months from when the options were initially granted to me which I had early exercised with the 83(b) election. After the sale is complete, the company voids my prior stock grants and gives me a new grant with my remaining shares.
Minor note: The cost of my shares was $0.01 and so my calculations rounded down to a $0.00 basis for calculating capital gains. State taxes are also deductible on your federal taxes to a maximum of $10,000. Both of these changes would give a couple thousand dollars in savings.
Note 2: I am validating these calculations with multiple CPAs.
Around this time, a financial advisor from a large investment bank reaches out over LinkedIn about helping startup employees manage their new wealth. I respond for some reason and they say that my Cityblock shares may be eligible for a 'QSBS tax exemption'. Despite reading what I thought was virtually everything about taxes relating to startup shares and asking my tax advisor prior to the sale about potential tax implications, I had never heard of a 'qualified small business' tax exemption.
The QSBS exemption means that if you owned shares of a 'qualified small business' while the business had less than 50mm in assets and held those shares for 5 years, then up to $10,000,000 in profits are completely exempt from federal taxes. (**breathes**)
The whole idea that there are further tax exemptions beyond long term capital gains was/is crazy to me. I never thought the federal government would create a 100% tax exemption and so I never looked.
While the QSBS exemption is great for early stage employees/founders, it is particularly favorable to early stage startup investors. It also allows someone to roll funds into other investments before the 5 years and maintain tax exemption. For example, say you invest in an early stage startup and then sell those shares after 3 years. You can then invest your money in another early stage startup within 6 months and sell after 2 years (5 years total invested in a QSBS). These investments now avoid any federal taxes on profits up to $10,000,000…per year allowing you to stagger sales to further avoid taxes.
How does QSBS apply to my situation?
After doing a bit of research, I found that the startup appears to qualify as a 'qualified small business' and that about 1/2 my shares were vested while the company had less than 50mm in assets. However, given that I sold some of my shares, there are complications.
- If I sold 1/2 my shares, did I sell the first 1/2 of my shares (those would qualify for QSBS in the future) or the last 1/2? How would I know?
- Given that I now have a totally new stock grant with a new date, can any of my shares be considered held while the company had < 50mm in assets?
My current understanding is that one or both of those disqualify me. This means that none of the shares I currently own will be eligible for the QSBS exemption in the future.
A stacked game
So, I made one decision that cost me either $X00,000 (current tax rate) or $1,000,000+ (proposed capital gains changes) in taxes. Given that none of my shares qualify for QSBS in the future and that taxes on my shares are 35%-44% of $X,000,000, that cost equates to ~1/4-1/3rd of my personal wealth.
How does that feel? Well, I both am doing great and feeling shitty. It reminds me of playing a board game with someone who didn't explain all rules ahead of time. They say "boom I win; game over" unveiling some new rule they forgot to explain. Had I known about this hidden rule, I would have taken a different strategy, but the moves have been made.
With one move, I simultaneously hit two hidden rules - a retroactive tax change and an obscure tax exemption. Had I known either one of these things, I would have waited or sold fewer shares.
What is next?
I was pretty advantaged in this situation and lost a lot of money. I have worked at many startups and learned about the AMT exemption and the 83(b) election which few startup employees both know about and can afford. 83(b) requires paying to exercise for 4 years of options within 30 days of starting a new job. In most cases, this cost is 10s of thousands of dollars. Fewer still understand how the AMT exemption applies to exercising startup options (ask your CPA about that). By early exercising all my shares when their value was $0.01, I was able to 'hold' my shares as long as possible and get closer to the QSBS exemption.
Is all this fair? I don't know. Many people are much more wealthy by utilizing AMT, QSBS and their ROTH IRA in ways few understand. Complexity privileges those with knowledge and resources.
I do know that I have both more knowledge and more money than I did yesterday.