Examining the Tax Advantage of Founders' Stock

• Author: Gregg D. Polsky - Brant J. Hellwig
• Position: Professor of Law, University of North Carolina at Chapel Hill School of Law - Professor of Law, University of South Carolina School of Law
• Pages: 1085-1145

1085

Examining the Tax Advantage of

Founders’ Stock

Gregg D. Polsky* & Brant J. Hellwig**

INTRODUCTION .................................................................................... 1087

I. FOUNDERS’ STOCK TRANSACTIONS ...................................................... 1090

A. THE “THIN COMMON” VALUATION STRATEGY ................................. 1090

1. The Thin Common Strategy as Normatively Acceptable

Ex Post Tax Planning? ......................................................... 1094

2. Is Current Under-Enforcement a Subsidy? ........................ 1095

B. ADJUSTABLE CONVERSION RATIOS AS HIDDEN BONUSES ................... 1095

C. “ACQHIRING” ................................................................................. 1097

D. THE ISSUANCE OF FOUNDERS’ STOCK GENERALLY ............................ 1099

II. DETERMINING WHETHER A TAX ADVANTAGE EXISTS .......................... 1100

A. THE UNILATERAL PERSPECTIVE ...................................................... 1100

B. A PREVIEW OF THE MULTILATERAL PERSPECTIVE ............................. 1103

C. COMPARING FOUNDERS’ STOCK TO CARRIED INTERESTS ................... 1104

III. DETERMINING THE GLOBAL TAX ADVANTAGE OR DISADVANTAGE ...... 1106

A. THE SUCCESSFUL CASES .................................................................. 1109

1. Home Run ............................................................................ 1109

2. Triple ..................................................................................... 1110

3. Double ................................................................................... 1110

4. Single ..................................................................................... 1111

5. Summary ............................................................................... 1112

B. THE UNSUCCESSFUL CASES ............................................................. 1113

1. False Start .............................................................................. 1113

2. Strikeout ................................................................................ 1114

C. SUMMARY ...................................................................................... 1115

* Willie Person Mangum Professor of Law, University of North Car olina at Chapel Hill

School of Law.

** Professor of Law, University of South Carolina School of Law.

The authors are grateful to Christopher Bruner, Joshua Fairfield, Martin J. McMahon,

Jr., David Walker, and Ethan Yale for their informative comments on earlier drafts of the article.

1086 IOWA LAW REVIEW [Vol. 97:1085

IV. ASSESSMENT OF DESCRIPTIVE RESULTS ................................................ 1116

A. IS THE NET TAX SAVINGS IN THE FALSE START SCENARIO A

NORMATIVE TAX ADVANTAGE? ....................................................... 1116

B. THE POTENTIAL FOR MARKET FAILURE ........................................... 1119

1. Questioning the Account .................................................... 1121

2. Even Assuming the Account Is True, Does It Justify a

Tax Response? ...................................................................... 1123

CONCLUSION ....................................................................................... 1124

APPENDIX ............................................................................................. 1125

2012] FOUNDERS’ STOCK 1087

INTRODUCTION

In their 2003 Harvard Law Review article, Ronald Gilson and David

Schizer argued that founders’ stock—the shares that founders of startup

companies receive—is tax-advantaged.1 They described how the standard

founders’ stock transaction enables executives to convert compensation

income otherwise taxed at ordinary income rates into stock appreciation

taxed at preferential rates for capital gains, thereby reducing their tax

burden by roughly sixty percent. Gilson and Schizer suggested that the tax

benefits associated with the issuance of founders’ stock served as a principal

justification for the leading transactional form of venture capital

investment.2

More recently, Victor Fleischer, already known for highlighting the

carried interest tax break benefitting managers of private equity,3

characterized the tax advantage of founders’ stock as a critical design flaw in

the tax system—one that supplies an additional new reason to consider

fundamental tax reform.4 The idea that founders’ stock is favorably taxed

extends beyond the legal academy. In a 2011 editorial, Nicholas Kristof of

the New York Times characterized founders’ stock as being “hugely

undertaxed.”5 The conventional wisdom, therefore, is that founders’ stock is

1. See Ronald J. Gilson & David M. Schizer, Understa nding Venture Capital Structure: A Tax

Explanation for Convertible Preferred Stock, 116 HARV. L. REV. 874, 910 (2003) (contending that

the founders’ stock tax advantage can be classified as a tax subsidy for high-tech startups).

2. See id. at 877 (describing the tax benefits associated with the issuance of convertible

preferred stock in exchange for venture capital funding as “likely of first-order importance”); see

also id. at 889 (characterizing the tax advantage enjoyed by executives of st artups as a “key

reason” for the pervasiveness of convertible preferred stock in venture cap ital contracting).

3. See Victor Fleischer, Two and Twenty: Taxing Part nership Profits in Private Equity Funds,

83 N.Y.U. L. REV. 1, 5–6 (2008). Fleischer’s article garnered attention from academics,

journalists, and policymakers. E.g., Karen Burke, The Sound and Fury of Carried Interest Reform, 1

COLUM. J. TAX L. 1, 2 (2010); Noël B. Cunningham & Mitchell L. Engler, T he Carried Interest

Controversy: Let’s Not Get Carried Away, 61 TAX L. REV. 121 (2008); Chris William Sanchirico, The

Tax Advantage to Paying Private Equity Fund Manage rs with Profit Shares: What Is It? Why Is It Bad?,

75 U. CHI. L. REV. 1071, 1074 (2008); Editorial, Taxing Private Equity, N.Y. TIMES (Apr. 2,

2007), http://www.nytimes.com/2007/04/02/opinion/02mon1.html; Allan Sloan, Busting a

Few Blackstone Tax Myths, FORTUNE MAG. (Sept. 17, 2007), http://money.cnn.com/2007/

09/14/news/companies/100351828.fortune/index.htm; see also DEP’T OF THE TREASURY,

GENERAL EXPLANATIONS OF THE ADMINISTRATION’S FISCAL YEAR 2012 REVENUE PROPOSALS 61–

62 (2012), available at http://www.treasury.gov/resource-center/tax-policy/Documents/

General-Explanations-FY2012.pdf.

4. See Victor Fleischer, Taxing Founders’ Stock, 59 UCLA L. REV. 60, 69–70 (2011).

Fleischer analogized the tax break afforded to founders’ stoc k to the carried interest loophole.

See Fleischer, supra note 3, at 2 n.2. For discussion of carried interests and how they compare to

founders’ stock, see infra Subpart II.C.

5. Nicholas D. Kristof, Op-Ed., Taxes and Bill ionaires, N.Y. TIMES (July 6, 2011),

http://www.nytimes.com/2011/07/07/opinion/07kristof.html.