Treat your startup equity as if it’s worth nothing. This insight is not wrong; you don’t want to buy a pied a terre in Brooklyn or plan for early retirement based on the latest valuation of your seed-stage company. Your shares, after all, are hard to monetize relative to liquid assets like public stocks, and the valuation could change significantly from round to round.
But it’s not exactly right, either; there are multiple ways to monetize startup equity and, even better, options to do so tax free. In this article, we’ll explore several such strategies, including exchange funds, loans, and charitable remainder trusts. We’ll discuss the benefits and risks of each strategy, as well as who might be best suited to use them.
Let’s first start with the basics.
How do these strategies work?
An exchange fund is a type of investment vehicle that allows investors to diversify their assets, such as startup equity, without triggering capital gains taxes. In exchange for trading in shares, investors receive shares in a pooled exchange fund, which invests in other assets, such as valuable late-stage private companies, publicly traded securities and real estate. You can learn more about exchange funds here.
The benefits of using an exchange fund to monetize startup equity include:
- Tax free exchange of illiquid assets: When an investor exchanges startup equity for shares in an exchange fund, there is no taxable event and, as a result, no capital gain taxes.
- Diversification: Investors can diversify their private equities in the exchange fund, which invests in a variety of assets.
- (Potential) Liquidity: In some cases, you may be able to receive a loan on your interest. Because of the relative diversification of the fund as compared to a single company’s stock, this loan may have a lower interest rate than any loans that may be available to take directly against your equity.
The risks of using an exchange fund include:
- Loss of control: Investors lose control over their startup equity when they exchange it to the exchange fund.
- Management fees: Exchange funds typically charge high annual (and potentially upfront) management fees, which can reduce the investor’s return on investment.
- Illiquidity of the exchange fund: The exchange fund may be illiquid, which means that it may be difficult to sell the shares quickly or easily.
Another way to monetize startup equity tax free is to take out a loan against your shares. In most cases people will do this via an unsecured loan so they aren’t personally liable beyond their equity in case their equity loses its value, an unfortunately very real risk for any startup equity owner. You can learn more here.
The benefits of taking out a loan against startup equity include:
- Tax-free proceeds: The proceeds from the loan are not taxable, as capital gains or otherwise.
- Quick access to cash: Investors can quickly access cash by taking out a loan against startup equity.
- Retain ownership: Investors retain control of their startup equity when taking out such a loan. This means the owner retains voting rights and, importantly, keeps ownership of the shares themselves, offering potential upside if the share price increases faster than the loan interest rate.
The risks of taking out a loan against startup equity include:
- High interest rates: Startup equity loans can have high interest rates due to the equity volatility, which can make them expensive to repay.
- Default risk: If the investor defaults on the loan, the lender could foreclose on the startup equity.
- Limits upside: If the investor takes out a loan against their startup equity, they may have to promise the lender a share of the proceeds if the share price goes up. This is a tradeoff that many are willing to make for access to liquidity now.
Charitable Remainder Trusts
With a Charitable Remainder Trust (CRT), a shareholder may gift equity to the trust, sell it and reinvest it tax free, and then receive a stream of income from the trust for a specified period of time. After the trust’s term ends, the remaining assets are donated to a charity of the owner’s choice. You can learn more here and estimate the ROI.
The benefits of using a CRT to monetize startup equity include:
- Tax-free growth: Investors can sell, avoid paying capital gains taxes on the appreciation to date and reinvest their equity tax free.
- Diversification: Investors can diversify their private equities tax free in the CRT after selling their asset and invest in assets ranging from publics stocks, real estate, crypto, collectibles to other startups.
- Potential for charitable deduction: Investors are be eligible for a charitable deduction for a portion of the value of the assets donated to the trust, typically the charitable deduction is 10% of the assets put into the CRT
The risks of using a CRT to monetize startup equity include:
- Loss of liquidity: You can’t pull all the assets from the trust at once; as the owner may only withdraw a set percentage of trust assets every year.
- Investment Limitations: You can invest in public and private market investments, crypto, real estate etc. but can’t invest in things you or your family personally benefit from like your own startup and you can’t take on debt inside the trust which can limit real estate investments.
Who are these strategies for?
While, these strategies may be a good option for investors who are looking to access cash from their startup equity without triggering capital gains taxes the best way to monetize startup equity tax free will vary depending on your priorities and the options available for your equity.
- Exchange funds may be a good option for investors who want to diversify their concentrated startup equity.
- Loans may be a good option for investors who need quick access to cash and either can’t sell their equity or want to retain control of their startup equity.
- CRTs may be a good option for investors who want to sell their equity in a tax advantaged way to create more long term wealth.
There are two key decision points for these solutions: (1) Does the strategy apply to you? In other words, are you allowed and able to take advantage of it? and (2) does the strategy serve your purpose, whether it is diversifying your portfolio, short-term liquidity, or otherwise?
Let’s take a closer look.
Does the strategy apply to you?
Before we address the applicability of each strategy, it’s worth noting one qualification that applies across the board: All of the options we’ll discuss are available only to shareholders — that is, individuals who have already exercised their options, converted their restricted units, or otherwise taken possession of actual shares.
With respect to the individual strategies:
- Charitable Remainder Trusts: Available to anyone who owns their shares, though the strategy will offer positive returns only if the shares have appreciated significantly.
- Exchange Funds: Available only to shareholders in a limited list of unicorn companies available here.
- Loans: Same. Available only to shareholders in a limited list of unicorn companies available here.
Does the strategy serve your goals?
We’ll focus on the three most common goals in this context: Achieving liquidity, diversifying holdings, and monetizing without selling.
- Charitable Remainder Trusts: Allow you to achieve liquidity (to a certain extent) and diversify holdings. Require that the owner sell at least some shares outright.
- Exchange Funds: Allow you to diversify, offering exposure to a wider portfolio of companies (often including other late-stage private companies, as well as public ones). Do not require that you sell your shares, but also does not create immediate liquidity (though you can take a loan against your exchange fund equity).
- Loans: Allows you to monetize equity without selling it.
In conclusion, while startup equity may be challenging to monetize compared to liquid assets, there are several strategies available to do so tax-free. Exchange funds, loans, and charitable remainder trusts offer different approaches to unlocking the value of startup equity. Each strategy comes with its own benefits and risks, and the best option for monetizing startup equity tax-free will depend on individual priorities and circumstances.
Exchange funds provide a tax-free exchange of illiquid assets, diversification opportunities, and potential liquidity through loans. However, investors should consider the loss of control and management fees associated with these funds. Loans against startup equity offer quick access to cash, retention of ownership, and tax-free proceeds. Yet, high interest rates and default risks should be carefully evaluated. Charitable remainder trusts enable tax-free growth, potential charitable deductions, and long-term wealth creation. However, limited liquidity and investment restrictions should be taken into account.
Ultimately, understanding the available options and evaluating their applicability and alignment with goals will empower startup equity holders to make informed decisions on monetization, potentially maximizing the value of their equity in a tax-efficient manner.