Here’s how to create a tax-effective exit for your startup's shareholders

For founders, the day that someone comes to buy their startup can be bittersweet.

Whilst many startups and scaleups forge their own independent path by continuing to grow their market share, for others, a successful exit will be a huge validation of what the whole team has built over the years.

Given the hard work and financial investment that goes into building a startup, it will be critical to maximise the value for shareholders in an exit. Price negotiations will be underway with the buyer – this is what everyone knows and expects. But there is something else that is sometimes forgotten but will nonetheless have a major impact on shareholder value – TAX.

Since tax is applied as a percentage of the gain, it can quickly add up to a very large number. So it is critical that sufficient time and attention is applied to the tax planning. It is not an exaggeration to say that no exit can be truly successful if shareholders lose a bigger-than-necessary chunk of their wealth to the Tax Office.

(Note: the below does not constitute tax advice as it does not consider the individual circumstances of any taxpayer)

Early Stage Innovation Company (ESIC) Tax Incentive

This is a powerful tax incentive because capital gains from years 1 to 10 of ownership for qualifying shares are completely tax free for eligible shareholders. Where available, this is a true game-changer.

Given the amount of taxes at stake and the relative complexity of ESIC rules, we suggest startups and their investors devote the necessary time and attention to optimise ESIC eligibility and maintain all required documentation. And the time to do this is now – not at the time of exit when it is usually too late to make a difference.

See further details here for tips on ESIC.

An Oldie but a Goodie – 50% Capital Gains tax discount

The 50% Capital Gains Tax discount is a key consideration in an exit for a simple reason – it can cut the tax bill by half.

To qualify for this discount, the shares must have been held for at least 12 months prior to the exit. Other requirements exist, but today we will focus on the issues that come up most often.

William Buck’s Jack Qi

The exit must be made “at the right level by the right seller”. This is because only Australian resident individuals and trusts (including investment funds) can be eligible for the 50% CGT discount.

One of the most common questions that come up early in sale negotiations is whether the acquirer will be buying the shares of the startup or the startup’s assets.

This matters because of key legal, commercial and tax differences between the two options.

In a share sale, the sellers will be the startup’s shareholders. This contrasts with the other scenario where the startup company itself sells its business assets – customer contracts, code, IP, supplier contracts and goodwill – to the buyer.

This would then make the company the taxpayer.

Since companies are not eligible for the 50% CGT discount, the combined amount of extra tax eventually payable by the company and its shareholders becomes a major disincentive for undertaking an exit in this manner.

There is a natural tension between what the seller wants and what the buyer wants.

Commercially speaking, the buyer will sometimes prefer to acquire only the assets of the startup instead of the startup company in order to avoid the historical risks associated with the company or because there are non-core assets that the buyer doesn’t want.

Generally, the buyer and the seller are able to come to an agreement once the size of the tax disparity between the two approaches become apparent and the seller is able to get comfort from indemnities and warranties given by the seller.

Other Tax Concessions

Besides the ESIC tax incentive and 50% general CGT discount, there are a number of other tax concessions that could materially reduce the tax payable by shareholders in an exit.

Scrip for scrip tax rollover

Where the buyer is a company and that company provides shares in itself as some or all of the purchase consideration for acquiring the startup, the key tax concession is the “scrip for scrip” (i.e. shares for shares) tax rollover. If eligible, this can be utilised to defer some or all of the capital gain made by shareholders.

The eligibility requirements are complex, and it will be critical that the Share Purchase Agreement is drafted in a particular way from the very start. This means the tax advisor must be involved early in the negotiation process.

Look-through earnout rights

Often, the sale consideration will be in the form of an “earnout”, whereby the startup’s shareholders will receive consideration in the future that is dependent on some future outcome, such as the financial performance of the startup.

The deal should ideally be structured such that the earnout satisfies the tax law definition of a “look-through earnout right” because this would allow the shareholders to be taxed on this contingent consideration in a future income year when it is actually received.

This concessional treatment contrasts with the “default” tax treatment whereby a value is attributed to the earnout and included in the shareholder’s tax return in the year of sale, potentially well before any value is received.

Small business CGT concession

Whilst this is a great concession for small businesses in “traditional” industries with just a few shareholders at most, shareholders of startups and scaleups often have a hard time qualifying for this concession due to its $2 million business turnover test and $6 million net asset value test. Nonetheless, at least consider this concession and cross it off the list of things on your radar.

Become ‘exit-ready’ today

There are clear benefits to shareholders when a startup is “exit-ready”. Fundamentally, this is about making itself an attractive target for a buyer, who will usually closely examine the startup with the help of a team of lawyers and accountants to find any “skeletons in the closet” from a tax, commercial and legal standpoint.

This is a standard part of the due diligence process. It is highly likely that any past tax issues will be exposed during this phase of the negotiations and become a drag on the deal or result in adjustments that ultimately reduce shareholder proceeds.

There is rarely a quick fix to these historical tax problems. Therefore, with the startups and scaleups we work with, to maximise the shareholder value we treat the exit as a years-long process whereby best-practice is adopted by looking at the following tax issues in advance:

Spinning out non-core businesses or assets in a tax-effective manner (thereby increasing the likelihood of the buyer taking the startup company instead of just its assets);
Designing employee share schemes that facilitate – rather than hinder – an exit (see tips here);
Minimising employee Vs contractor risk;
Reviewing compliance with payroll tax (e.g. has ESOP been included in payroll tax returns?);
Understanding overseas digital tax and sales tax obligations (see details here); and
Ensuring compliance with the R&D tax incentive, especially keeping the documentation required by ATO (see details here).

The common thread is the need to start the tax planning process years before the actual exit. This will make a real difference to how smoothly the transaction plays out and ultimately whether founders and shareholders receive what the startup is really worth.