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KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 1 1.Newco simple start-up (a)E's proposal.

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Presentation on theme: "KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 1 1.Newco simple start-up (a)E's proposal."— Presentation transcript:

1 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 1 1.Newco simple start-up (a)E's proposal

2 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 2 Newco $5m Entrepreneur ("E") VCs and/or angels Experience and future services $5m cash

3 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 3 Simple start-up E's proposal — corp w/ all c/s E seeks 60% carried interest ("CI") in both capital and future profits Amt invested in Newco Newco stock received VC $5m 40 c/s E E's experience and future services 60 c/s

4 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 4 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

5 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 5 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

6 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 6 Tax at front end (no cash to pay tax) OI rather than LTCG E's IT at front end = $3m x 35% fed + ~ 5% state.............. =$1.2m 15% (or 14%) LTCG rate 35% OI rate vs

7 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 7 Problem #2: Premature Newco liquidation while $5m still on hand Cash available............. $5m VC's c/s %................ 40% VC's liquidation proceeds....$2m

8 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 8 Problem #3: Favorable Newco sale after 1 yr at 2x investment Sales proceeds............. $10m VC's c/s %................ 40% VC's sales proceeds.........$4m

9 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 9 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

10 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 10 1.Newco simple start-up (b)VC's proposal

11 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 11 Non-convertible subord deb and/or pfd stock....$4,650,000 $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............. VC's proposal Qualitative differentiation— corp w/ cheap c/s VCE

12 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 12 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)

13 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 13 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................0

14 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 14 1.Newco simple start-up (c)Vesting

15 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 15 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

16 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 16 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

17 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 17 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

18 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 18 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

19 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 19 Tax at vesting not sale (no cash to pay tax) OI rather than LTCG E's IT at vesting = $29.85m x 35% fed + ~ 5% state........... =$12m 15% (or 14%) LTCG rate 35% OI rate vs

20 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 20 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

21 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 21 1.Newco simple start-up (d)Use of executive options

22 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 22 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

23 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 23 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

24 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 24 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

25 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 25 2.ISO tax aspects No OI at grant or at exercise LTCG at stock sale = proceeds less cost Excellent tax result 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 {

26 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 26 2.Newco complex start-up

27 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 27 Newco complex start-up Newco corp, p'ship, or LLC E E's 10 relatives E's 10 golf buddies E's 10 neighbors ("F&F") 5 VCs and/or angels 10 Newco salespersons 10 Newco machinists 10 Newco secretaries ("SPs")

28 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 28 SEC regis'n Newco must register w/ SEC issuance of securities subord debs pfd stock c/s

29 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 29 SEC regis'n causes: (1)substan'l delay (2)substan'l expense (3)public dissemination of Newco's game plan

30 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 30 2 exemptions from SEC (and gen'ly state) regis'n: 1st exemption: Private placement to ltd # of wealthy/sophisticated investors Reg D safe harbor

31 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 31 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 non-AI, if offering >$5m

32 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 32 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

33 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 33 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

34 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 34 3.Newco choice of entity

35 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 35 Newco start-up—choice of entity Experience and future services Cash Newco E VCs and/or angels Choice of Newco entity C corp S corp Ltd p'ship LLC { Consider tax ramif'ns (1) each yr and (2) on exit

36 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 36 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

37 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 37 (b)On Newco's ultimate sale, delivering asset SUB to BuyerCo = double tax to sellers $100m Asset sale Asset SUB $100m Asset TB $5m S/Hs Newco C corp BuyerCo Liquidating distribution

38 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 38 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 entity- level income taxed to equity owner Non-control equity owner should seek mandatory IT distrib'ns

39 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 39 (b)On Newco ultimate sale, can deliver asset SUB to BuyerCo w/ only 1 level of tax on sellers $100m Asset sale BuyerCo Asset SUB $100m Newco flow-thru Equity owners Asset TB $5m Liquidating distribution

40 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 40 (c)Loss pass through Subject to tax limitations (e.g. §469 passive activity loss rules)

41 KIRKLAND & ELLIS LLP NWU Entrepreneurship Conf — ©2006 Jack S. Levin 41 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


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