Updated. Originally posted November 3, 2022.
Over the past six years, a particular method for providing founder liquidity has gained significant popularity: an investor purchases common stock from founders during a preferred financing at the preferred price. The investor then exchanges those same common shares with the company for the latest class of preferred shares—the shares the investor wanted all along.
I first encountered this “secondary purchase plus exchange” structure near the end of 2019.[1] Since then, I’ve seen 50+ such transactions, often with AmLaw 100 firms approving the structure.
However, sentiment about the structure’s viability has shifted. Accounting firms have begun scrutinizing it, and a few years ago, I heard that DLA Piper requires reporting and withholding on the difference between the post-investment 409A valuation of the common stock and the purchase price—treating that spread as compensation.
Below, I outline the principal tax and legal risks associated with this structure, assuming the company is a C corporation and the founder is an employee.[2]
Potential Compensation
Risk #1: Characterization of Excess Value as Compensation
Suppose the post-Series A 409A valuation prices the common stock at $0.40 per share, while the Series A preferred sells at $1.20 per share. The IRS could argue that $0.80 of the $1.20 paid to founders per share represents compensation rather than purchase price. Treasury Regulation §1.83-6(d) provides that if a shareholder transfers property to an employee in consideration of services, the transaction is treated as a capital contribution by the shareholder followed by a bonus from the company to the employee. The company would therefore have a withholding obligation and report the amount on the founder’s W-2.
From 2019 through mid-2022, nearly all such transactions were structured on the assumption that the full purchase price reflected consideration for stock, not compensation. Practitioners justified this position by demonstrating that:
- The founders were already receiving reasonable compensation,
- The investor’s intent was purely investment-related, and
- All common holders had the opportunity to sell at the same price.
Recently, however, accounting firms appear less persuaded by these arguments, increasingly requiring that the spread between the 409A common valuation and the investor’s purchase price be treated as compensation.
Qualified Small Business Stock (QSBS)
Risk #2: Possible Recharacterization as a Redemption
The IRS could also recharacterize the transaction as the investor purchasing preferred shares directly from the company, followed by the company redeeming the founder’s common shares. Such a recharacterization could trigger a “significant redemption” and jeopardize QSBS eligibility.
QSBS treatment under Section 1202 allows for up to a 100% exclusion on gains from qualified small business stock held for more than five years.[3] To preserve QSBS status, companies must avoid “significant redemptions”—generally, repurchases exceeding certain thresholds within a two-year window (one year before and after the testing date).
Two K&L Gates tax partners have argued that the IRS would be hard-pressed to recharacterize these transactions as redemptions, since doing so would invent a purposeless step, contrary to established case law. They further note that Section 1202’s legislative history focuses on preventing abuse of the original issuance requirement, not on transactions like these.
I’m less certain. While the investor’s cash never flows through the company’s accounts, economically, the company issues preferred stock, and the founder receives payment equivalent to the preferred price for common stock that the company effectively cancels. The IRS could reason that routing the cash directly to the founder doesn’t change the transaction’s substance: the investor paid the company for preferred stock, and the company used that cash to redeem common. This recharacterization closely resembles the logic of Treas. Reg. §1.83-6(d). That said, Treas. Reg. §1.1202-2(c) explicitly distances the redemption rules from §1.83-6(d), which may limit such overlap.
Corporate Waste
Risk #3: Shareholder Claims for Corporate Waste
There is also litigation risk. In 2015, a Digital Ocean shareholder sued the company[4], alleging waste after it repurchased founder common at the preferred price and later issued options at a lower 409A value. The shareholder claimed that either the company overpaid for the stock or underpriced the options, violating the equity plan and Section 409A. The parallels are evident: in the “purchase plus exchange” structure, the company issues preferred stock in exchange for investor-held common—without receiving meaningful consideration—raising similar fiduciary and valuation concerns.
A Lower-Risk Variation
A more defensible variant exists. Suppose investors intend to purchase $2 million of founder common stock at the preferred price. Instead, they purchase for $1.8 million and pay the remaining $200,000 to the company for the right to exchange their common for preferred shares. The company can then, if desired, pay the $200,000 to the founders as a taxable bonus. This approach may reduce both the risk of recharacterization as a redemption and the risk of treating part of the purchase price as compensation.
This variation remains rare—perhaps three in ten deals—but with growing accounting scrutiny, it could see increased interest.
About the Author
Mike Baker advises clients on the tax implications of secondary sales and related structures. He has decades of experience in tax, employee benefits, and executive compensation law. For more information, contact mike@mbakertaxlaw.com.
[1] A prior version of this structure that has been used for years (though it was more common some years ago) is FF stock which is common stock issued to a founder that has a right built into it from the outset allowing it to convert into preferred stock, so a founder can sell it to investors at a future financing round. I think that FF stock does a better job of avoiding the risks described in this article. The fact that FF stock has fallen out of popularity, in my opinion, is simply that to be most effective it needs to be put in place at formation, which is a a time when founders may not yet have involved counsel and in any event are likely cash strapped and wanting to avoid any extra complication.
[2] These same considerations will apply if the founder is an independent contractor of the company, except that the company isn’t at risk of having a withholding obligation and any compensatory amount would be reported on a Form 1099-MISC instead of on a W-2.
[3] Higher rates apply to stock issued prior to September 28, 2010. Also, for the favorable QSBS rates to apply, in addition to avoiding significant redemptions, the company must run an active business during substantially all of the stockholder’s holding period.
[4] The shareholder also sued Digital Ocean’s outside counsel and the valuation firm.