None Oct. 19, 2016

Will Founders Shares in Startups be Double Taxed? Strait Solution to Reverse Vesting

One popular and important mechanism in the relationship between a startup and its founders is the reverse vesting. The mechanism enables the company to repurchase from a founder's shares, when he and the company separate earlier than expected. In the last several years, the concern that the tax to be imposed on such shares shall be doubled increased. Recently, the Israeli Tax Authority (the "ITA") eliminated such concern.

What is the reverse Vesting Mechanism?

The founders of startup are usually considered as one of its important assets.  Therefore and due to the legal and practical difficulty to ensure that the founder keep serving the company lead to the need for the reverse vesting mechanism. Such mechanism subjects the founder's shares in the startup to the company's right to repurchase the shares, in case of early separation therebetween. The mechanism is designed to encourage the founder to stay active in the startup and create fair allocations of the shares in the company, considering the contribution of each founder to the company.

Naturally, the mechanism is most common in founders' agreements, which are usually entered into at the beginning of the startup's venture and relate to the rights and obligations of the founder regarding the startup. Further, in many cases the insertion of the mechanism is required by a later stage investor that wishes to mitigate the risk resulting from an early separation from a founder.

The reverse vesting mechanism defined the terms during which the company may repurchase from the founder shares. For example: until the expiration of one year – 75%; thereafter and until the expiration of two years – 50%; and thereafter and until the expiration of three years – 25%. The date on which shares are no longer subject to the company's repurchase rights is called "vesting date". This vesting is considered "reverse" in relation to the regular vesting of securities granted as incentive, under which the securities vests and only then it is possible to issue shares thereunder. Of course, the reverse vesting mechanism provides for a prohibition by the founder to transfer unvested shares.

In addition, the mechanism defines the circumstances in which the company may repurchase founder shares. The trivial situation is termination of the engagement of the founder with the company. However, in many agreements certain circumstances of such termination, for example when the company terminates the founder for no breach of his basic duties towards it or when the founder terminates the engagement for extreme causes, such as material change in the place of work, are excluded, such that in case of such excluded circumstances, the repurchase rights shall not apply.

The mechanism shall also determine the repurchase price, which shall usually be close zero.

The Tax Concern

In the last several years, as the Israeli Hitech world progressed, the arrangements between the company and founders became more sophisticated and use of reverse vesting increased. Simultaneously, the concern that revenues from founder shares subject to reverse vesting shall be taxed as income (as oppose to capital gains), arguing that the mechanism connects the founder shares with his shares. The practical implication of taxation is doubling tax on founder shares. From the Just Altuvia's judgment, it seemed that this is indeed the direction to be taken.

The result was mainly uncertainty regarding the taxation of founder shares upon exist and attempts to partially resolve the confusion through complex mechanisms. The aforesaid lead, inert alia, to significant cumbersomeness on the negotiation of founding and investment transaction. In the long run, the reverse vesting and substitute mechanisms may have disappeared, allegedly a result that serves the founders (on the non-tax side). However, it seems that in parallel to such developments, investors would quantify the risk and invest in lower company evaluations (or, in extreme cases – not invest), which could constitute a grave impairment of the Hitech industry generally, and of startup founders in particular.

The Updated Solution

On August the ITA published a professional circular, in which the ITA discloses its opinion that in general founder shares subject to reverse vesting mechanisms shall not cause revenues therefrom to be taxed as income. For such result to apply, the mechanism imposed on the founders shares should meet the following conditions:

  1. The mechanism is established around the company's foundation or as part of a material investment therein.

  1. In case that the mechanism is activated, the company only (or its shareholders) shall purchase the shares for no consideration or at their par value.

  1. The shares are ordinary shares, equal in rights to the other ordinary shares of the same class and provide for voting rights, dividends and participation in the company's assets upon liquidation.

Allegedly, the common reverse vesting mechanisms meet the aforesaid conditions, but each case has to be examined separately, relating to the details of such conditions.

The direction that the ITA took in this case arises from considering the benefit to and from the Hitech industry in the long term. Hence, the ITA removed the cloud hovering above the reverse vesting mechanism during recent years and enabled the various Hitech industry players use an efficient tool for the fair allocation of risk thererbetween.

 

What do you think of the direction the ITA took? Will you implement reverse vesting in your startup?

One popular and important mechanism in the relationship between a startup and its founders is the reverse vesting. The mechanism enables the company to repurchase from a founder's shares, when he and the company separate earlier than expected. In the last several years, the concern that the tax to be imposed on such shares shall be doubled increased. Recently, the Israeli Tax Authority (the "ITA") eliminated such concern.

What is the reverse Vesting Mechanism?

The founders of startup are usually considered as one of its important assets.  Therefore and due to the legal and practical difficulty to ensure that the founder keep serving the company lead to the need for the reverse vesting mechanism. Such mechanism subjects the founder's shares in the startup to the company's right to repurchase the shares, in case of early separation therebetween. The mechanism is designed to encourage the founder to stay active in the startup and create fair allocations of the shares in the company, considering the contribution of each founder to the company.

Naturally, the mechanism is most common in founders' agreements, which are usually entered into at the beginning of the startup's venture and relate to the rights and obligations of the founder regarding the startup. Further, in many cases the insertion of the mechanism is required by a later stage investor that wishes to mitigate the risk resulting from an early separation from a founder.

The reverse vesting mechanism defined the terms during which the company may repurchase from the founder shares. For example: until the expiration of one year – 75%; thereafter and until the expiration of two years – 50%; and thereafter and until the expiration of three years – 25%. The date on which shares are no longer subject to the company's repurchase rights is called "vesting date". This vesting is considered "reverse" in relation to the regular vesting of securities granted as incentive, under which the securities vests and only then it is possible to issue shares thereunder. Of course, the reverse vesting mechanism provides for a prohibition by the founder to transfer unvested shares.

In addition, the mechanism defines the circumstances in which the company may repurchase founder shares. The trivial situation is termination of the engagement of the founder with the company. However, in many agreements certain circumstances of such termination, for example when the company terminates the founder for no breach of his basic duties towards it or when the founder terminates the engagement for extreme causes, such as material change in the place of work, are excluded, such that in case of such excluded circumstances, the repurchase rights shall not apply.

The mechanism shall also determine the repurchase price, which shall usually be close zero.

The Tax Concern

In the last several years, as the Israeli Hitech world progressed, the arrangements between the company and founders became more sophisticated and use of reverse vesting increased. Simultaneously, the concern that revenues from founder shares subject to reverse vesting shall be taxed as income (as oppose to capital gains), arguing that the mechanism connects the founder shares with his shares. The practical implication of taxation is doubling tax on founder shares. From the Just Altuvia's judgment, it seemed that this is indeed the direction to be taken.

The result was mainly uncertainty regarding the taxation of founder shares upon exist and attempts to partially resolve the confusion through complex mechanisms. The aforesaid lead, inert alia, to significant cumbersomeness on the negotiation of founding and investment transaction. In the long run, the reverse vesting and substitute mechanisms may have disappeared, allegedly a result that serves the founders (on the non-tax side). However, it seems that in parallel to such developments, investors would quantify the risk and invest in lower company evaluations (or, in extreme cases – not invest), which could constitute a grave impairment of the Hitech industry generally, and of startup founders in particular.

The Updated Solution

On August the ITA published a professional circular, in which the ITA discloses its opinion that in general founder shares subject to reverse vesting mechanisms shall not cause revenues therefrom to be taxed as income. For such result to apply, the mechanism imposed on the founders shares should meet the following conditions:

The mechanism is established around the company's foundation or as part of a material investment therein.

In case that the mechanism is activated, the company only (or its shareholders) shall purchase the shares for no consideration or at their par value.

The shares are ordinary shares, equal in rights to the other ordinary shares of the same class and provide for voting rights, dividends and participation in the company's assets upon liquidation.

Allegedly, the common reverse vesting mechanisms meet the aforesaid conditions, but each case has to be examined separately, relating to the details of such conditions.

The direction that the ITA took in this case arises from considering the benefit to and from the Hitech industry in the long term. Hence, the ITA removed the cloud hovering above the reverse vesting mechanism during recent years and enabled the various Hitech industry players use an efficient tool for the fair allocation of risk thererbetween.

What do you think of the direction the ITA took? Will you implement reverse vesting in your startup?

The article was written by Ronen Monosevich,founding Partner at Monosevich & Co., Law Offices & Chairman of the Israel Bar Association Hitech Committee. 

For more information you are welcome to contact Ronen Monosevich at ronen@monosevich.com, 0544808969


 


 

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