Accelerators + Tax Flashcards
Should we apply to an accelerator?
In general, accelerators or incubators can be a valuable first step for founding teams. Most programs provide a small amount of money, a cohort of peers, and educational programming, which can be helpful benefits as the founders finalize their team, product, and business model. For founders without large investor networks (which is most founders), the accelerators/incubators also usually organize a demo day or pitch event and provide brand-name credibility when the founders pitch the VC investment community.
These programs are often a helpful bridge between “idea stage” and product launch and/or $500,000 - $2,000,000 raised. For founders who are repeat entrepreneurs, or who have already raised significant funding or have significant revenue, typically accelerators/incubators make less sense.
The best-known accelerator is YCombinator. For Stanford-affiliated founders, StartX is also an excellent option (noting that StartX provides no investment and takes no equity, which is a slightly different model). Other well-known programs include 500 Startups, TechStars, Plug N Play, and Pear VC.
StartX
StartX is a non-profit organization associated with Stanford University. StartX does not offer investment, and does not take equity, positioning itself as a “founder community” rather than a traditional accelerator. StartX has supported 700 founding teams since 2011 and thier companies have a combined valuation of more than $26B. Each accepted company to StartX raises $11M+ on average and 92% of its companies are still growing or have been acquired. Acceptance into StartX also provides access to 1600+ founders in the StartX community.
The typical applicants StartX accepts are serial entrepreneurs, industry experts, well-funded/growth-stage startups, and they will also consider “especially high-potential first-time founders” on a case-by-case basis. One particularly unique aspect of StartX is that acceptance into its community requires at least one founder to be Stanford affiliated. A Stanford-affiliated founder is someone who was/is a Stanford undergraduate student, graduate student, faculty member, post-doctoral scholar, academic staff member, or a fellow in a recognized Stanford fellowship program. The Stanford founder must also hold a significant equity stake in the company.
StartX adds value to founders through its community-driven experiential learning and collective intelligence program designed to support founders for life, not just the life of their companies. The three most important attributes of the StartX program are:
Community: The philosophy that 1000+ of the world’s top founders can achieve more together than they could individually.
Education: 1-on-1 mentorship and on-demand training from 300+ top serial entrepreneurs and domain experts.
Resources: drop-in office space, legal advice, recruiting, PR & BD resources, and more (to include what it values as $1.2M+ in free resources).
StartX has three application cycles per year that occur in the Spring (January-February), Summer (May-June), and Fall (September-October). Applications are reviewed and accepted on a rolling basis and can be submitted here.
StartX also offers a 6-month Student-in-Residence (SIR) Scholarship that follows the same application cycle mentioned above. To be eligible, applicants must be an actively enrolled Stanford student/PhD in good standing, hold a significant equity stake in the company, and must apply with the full team of founders. However, only the active students will be considered for the scholarship. The scholarship includes: access to 1000+ investors, $1M+ in free resources and discounts, 6 months of free, dedicated office space, pre-negotiated packages with top law firms, customized education and coaching from the StartX network, and a conversion pathway into StartX full-time. Applications can be submitted here.
Successful StartX companies include: Patreon, Lime, Life 360, Kodiak, Marco Polo, and Bolt.
YCombinator
YCombinator is considered to be the premier and most prestigious accelerator. Since 2005, YCombinator has invested in over 3,500 companies with a combined valuation of nearly $1 trillion. These companies include Airbnb, Stripe, Instacart, Reddit, Coinbase, and DoorDash.
Each year, YCombinator takes two founder cohorts — a winter cohort (January through March) and a summer cohort (June through August) — referred to as “batches.” Batches typically consist of around 400 companies, although the most recent data suggests they may be shrinking, as the Summer 2022 cohort consisted of 250 companies. Each program lasts 3 months, though many resources are available when the program concludes, including office hours and alumni gatherings.
YCombinator invests $500,000 in every company on standard terms, made via two separate SAFEs. $125,000 of that sum is invested in a post-money SAFE with a valuation cap of approximately $1,800,000 (equivalent to 7% of the company), while the remaining $375,000 is invested in an uncapped SAFE with a Most Favored Nation provision. This means that this SAFE will acquire the terms and valuation cap of the next capital raised (e.g., if the company raises money from third-party investors on SAFEs with a valuation cap of $10,000,000, this previously uncapped SAFE will become a $375,000 SAFE with a valuation cap of $10,000,000).
Eleven weeks into the program, YCombinator organizes Demo Day, where founders present their startups to investors and press.
To be considered a founder, YCombinator requires applicants to have at least 10% equity in the startup. Teams are invited to interview on a rolling basis. Applications can be submitted here.
Can a founder use a living trust to shelter a portion of common stock gains from tax?
A living trust (aka revocable living trust or revocable trust) is a legal document that establishes a trust for any assets you want to transfer into it. Its main purpose is to oversee the transfer of your assets after you die. When you set up a living trust, you are the grantor of the trust and the person you designate to distribute the assets in the trust after you die is called the successor trustee. You retain control over the assets even after you transfer ownership rights or title of the assets in the trust so you can amend or revoke the trust at any time. Typically, there are no tax consequences for taking assets back from a revocable trust. Revocable trusts become irrevocable when the grantor is unable to manage his or her own financial affairs or dies.
A living trust can be a good tax optimization tool when used to hold Qualified Small Business Stock (QSBS). Any entity can hold QSBS except for C Corporation, including individuals and trusts. Therefore, a founder can use a living trust as a second holder of QSBS and get an additional $10,000,000 of exclusion on capital gains.
The goal of tax optimization with regard to equity usually centers on the long-term capital gains (LTCG) rate and Qualified Small Business Stock (QSBS).
The goal of tax optimization with regard to equity usually centers on the long-term capital gains (LTCG) rate and Qualified Small Business Stock (QSBS).
Strategy #1: Early Exercise Stock Options and File Section 83(b) Tax Election
Sometimes stock options allow the grantee to exercise the options before they actually vest. In this case, the grantee would own common stock of the company, and this common stock would vest over time on the same schedule as the options. This allows employees to gain ownership early, start the one-year clock on LTCG, and potentially also benefit from the QSBS exclusion. Sometimes the grantee does not have enough money to exercise; in this case they may consider partial exercise.
The goal of tax optimization with regard to equity usually centers on the long-term capital gains (LTCG) rate and Qualified Small Business Stock (QSBS).
Strategy #1: Early Exercise Stock Options and File Section 83(b) Tax Election
Sometimes stock options allow the grantee to exercise the options before they actually vest. In this case, the grantee would own common stock of the company, and this common stock would vest over time on the same schedule as the options. This allows employees to gain ownership early, start the one-year clock on LTCG, and potentially also benefit from the QSBS exclusion. Sometimes the grantee does not have enough money to exercise; in this case they may consider partial exercise.
If you do exercise early and receive common stock vesting over time, remember to file your Section 83(b) tax election.
The decision to early exercise stock options can be complicated and fact-dependent, and we recommend consulting an experienced financial and/or tax advisor.
Strategy #2: Full or Partial Exercise One Year Prior to Sale
The goal of tax optimization with regard to equity usually centers on the long-term capital gains (LTCG) rate and Qualified Small Business Stock (QSBS).
In an M&A context, if your startup is acquired for cash then your stock will be automatically purchased by the acquirer. Exercising your options at least one year prior to the transaction will allow you to benefit from LTCG.
In an initial public offering (IPO) context, there will be strict rules governing the exercise and sale of options, such as the standard 180-day “lock-up” period post-IPO which precludes employees from selling their stock. (This mechanism plays an important role in creating price stability after the IPO.) An employee who wants to benefit from LTCG may decide that they plan to sell half of their equity after the IPO & lock-up period, and hold the rest as stock options for now. In that case, they might exercise their options six months prior to the IPO, wait for the IPO, wait for the 6-month lockup period, and then sell common stock subject to LTCG.
Of course, exercising options and holding for a period of time carries risk, namely the possibility that the company will fail and the stock will be worthless, resulting in the loss of the money used for exercise. Given the potential risk, fact-specific nature of each company, and option holder’s financial strategy, we recommend seeking the counsel of an experienced tax advisor prior to exercise and sale of stock options.
How are stock options taxed?
Stock options are taxed differently depending on whether they are nonstatutory/non-qualified stock options (NSOs) or statutory stock options granted under an employee stock purchase plan or an incentive stock option plan (ISOs).
In general:
NSOs: Grant of the option is not taxed. At exercise, report the fair market value of the stock at the time of exercise minus any amount paid to exercise as W2 income. At sale, report the capital gain or loss, which is the difference between the exercise price (basis) and receipt from sale. If sale is more than a year following exercise, the long-term capital gains tax rate applies, otherwise the short-term capital gains tax rate applies, which is equivalent to ordinary income tax.
Stock options are taxed differently depending on whether they are nonstatutory/non-qualified stock options (NSOs) or statutory stock options granted under an employee stock purchase plan or an incentive stock option plan (ISOs).
In general:
NSOs: Grant of the option is not taxed. At exercise, report the fair market value of the stock at the time of exercise minus any amount paid to exercise as W2 income. At sale, report the capital gain or loss, which is the difference between the exercise price (basis) and receipt from sale. If sale is more than a year following exercise, the long-term capital gains tax rate applies, otherwise the short-term capital gains tax rate applies, which is equivalent to ordinary income tax.
ISOs: Grant of the option is not taxed. Exercise of the option is not taxed. At sale, report the capital gain or loss, which is the difference between the exercise price (basis) and receipt from sale. If sale is more than a year following exercise, the long-term capital gains tax rate applies, otherwise the short-term capital gains (ordinary income) tax rate applies.
The taxation of exercise and sale of stock options can be complicated, and vary depending on other factors. Prior to exercise and sale of stock options, we recommend seeking the counsel of an experienced tax advisor.
How is common stock (e.g., stock granted to founders) taxed?
Common stock is taxed upon sale at the applicable capital gains rate. If the stock is held for at least one year prior to sale, it is taxed at the long-term capital gains rate. The federal long-term capital gains rate is 0%, 15%, or 20% depending on taxable income and filing status. If the stock is held less than a year, it is taxed at the short-term capital gains rate, which is equivalent to ordinary income tax rate.
If the stock is Qualified Small Business Stock (QSBS) and is held for at least five years prior to sale, not only will it be taxed at the long-term capital gains rate but also the first $10,000,000 of gains will be excluded from federal and state capital gains unless the taxpayer is a resident of Alabama, California, Mississippi, New Jersey, Pennsylvania, and Puerto Rico.
Additionally, some taxpayers will be subject to the 3.8% Net Investment Income tax, which is imposed on your net investment income or the amount by which your modified adjusted gross income is above a certain threshold.
Common stock is taxed upon sale at the applicable capital gains rate. If the stock is held for at least one year prior to sale, it is taxed at the long-term capital gains rate. The federal long-term capital gains rate is 0%, 15%, or 20% depending on taxable income and filing status. If the stock is held less than a year, it is taxed at the short-term capital gains rate, which is equivalent to ordinary income tax rate.
If the stock is Qualified Small Business Stock (QSBS) and is held for at least five years prior to sale, not only will it be taxed at the long-term capital gains rate but also the first $10,000,000 of gains will be excluded from federal and state capital gains unless the taxpayer is a resident of Alabama, California, Mississippi, New Jersey, Pennsylvania, and Puerto Rico.
Additionally, some taxpayers will be subject to the 3.8% Net Investment Income tax, which is imposed on your net investment income or the amount by which your modified adjusted gross income is above a certain threshold.
Most startup founders and early key employees who receive common stock will therefore benefit from the long-term capital gains rate (>1 year) and the QSBS exclusion (> 5 years) when stock is sold in a secondary sale, via M&A, or after initial public offering (IPO).
Prior to a sale of common stock we recommend seeking the counsel of experienced tax advisors.
Does Qualified Small Business Stock (QSBS) apply to LLCs?
No. Only U.S. C Corporations can qualify as qualified small businesses and issue qualified small business stock. However, an LLC can be converted to a C corporation to become QSBS eligible in certain circumstances.
What is Qualified Small Business Stock (QSBS) and how does it benefit me?
Qualified Small Business Stock (QSBS) refers to shares of a qualified small business (QSB) under the definition of the Internal Revenue Code (IRC). Most early stage technology startups qualify, because they are within the definition of active C Corporation with gross assets of ≤ $50 million at all times before and immediately after the equity was issued, and which is not on the IRS list of excluded businesses (e.g., law, engineering, accounting, finance, etc.). QSBS refers to shares acquired in the original instance, not options, warrants, or convertible instruments prior to exercise/conversion, and not shares purchased on the secondary market. This means common stock issued to founders and other key early employees (before the creation of a stock option plan) and also preferred stock issued to investors in the early rounds of financing.
If you hold QSBS-eligible stock for ≥ 5 years, you can qualify for the QSBS tax exclusion. This means that, upon sale of that stock, the first $10,000,000 of capital gains is excluded from federal and state taxation (note: state tax still applies for residents of Alabama, California, Mississippi, New Jersey, Pennsylvania, and Puerto Rico). This exclusion can save QSBS holders millions of dollars in taxes.
What are some popular services to help us automate & professionalize our payroll and tax operations?
How much is our City/County Tax?
Example: City and County of San Francisco
In San Francisco, you are required to file a return in the tax year if (1) you were engaged in business in San Francisco, (2) you were not otherwise exempt, and (3) you had more than $2,090,000 in combined taxable San Francisco gross receipts. Gross receipts are the total amounts received/accrued by a person or business from any source including but not limited to amounts derived from sales, services, dealings in property, interest, rent, royalties, licensing fees, other fees, and commissions and distributed amounts from other business entities. Gross Receipts Tax rates vary depending on the business’s gross receipts and business activities, but generally range from 0.10% to 0.80%. Because most technology startups do not achieve $2,090,000 in gross receipts for several years, this is usually not applicable.
Example: Palo Alto
In Palo Alto, Business Tax is imposed per square foot occupied by the business, and exemptions apply for certain business types. The monthly Business Tax rate is $0.075/square foot for non-exempt businesses with a $500,000 annual tax cap adjusted by the Consumer Price Index, a measure of the average change in consumer prices over time based on a representative “basket” of goods and services. There will also be a 2.5% flat increase annually for both the month rate and tax cap beginning in fiscal year 2026-2027. Exemptions include an exemption for the first 10,000 square feet occupied by small business as well as seasonal businesses operating fewer than 90 days per year. Because most startups fall within this exemption for several years, this is usually not applicable.
How much is New York (Foreign) Corporation Tax?
Delaware corporations that are registered to do business in New York must also pay applicable New York business taxes. Most corporations will calculate their New York corporation tax using the Fixed Dollar Minimum schedule based on gross receipts. For most early-stage startups, tax due will be $25.
For a corporation with New York State receipts of:
Tax
Not more than $100,000
$25
More than $100,000 but not over $250,000
$75
More than $250,000 but not over $500,000
$175
More than $500,000 but not over $1,000,000
$500
How much is California (Foreign Corporation) Franchise Tax?
Delaware corporations that are registered to do business in California must also pay California Franchise Tax. California Franchise Tax is the greater of $800 or the applicable tax rate percentage of net income. Because net income for startups is usually zero (or negative), most startups incorporated in California or registered as a foreign corporation in California will pay the $800 minimum, at least for the first few years. For corporations with material net income in a given tax year, we recommend that you consult an experienced tax advisor to assist with accurate and timely payment.
For C Corporations, franchise tax is due on the 15th day of the 4th month after the entity’s tax year ends. Usually this is April 15.
How much is Delaware annual Franchise Tax? (Or: Why is the initial estimate of my Delaware annual Franchise Tax bill so high?)
Delaware non-stock and non-profit companies. Exempted by the State of Delaware and not required to pay the standard annual Delaware Franchise Tax, although they must file and pay the annual report fee of $25 each year.
Delaware LLCs or Delaware LPs. $300 flat annual franchise tax. Due by June 1 each year.
Delaware Corporations. There are two calculations for annual franchise tax. The Authorized Shares method and the Assumed Par Value Capital method. Delaware allows you to use the lower of the two calculations. Due by March 1 each year.
For a Delaware corporation with 10,000,000 authorized shares and little in the way of assets (like an early-stage startup), using the Authorized Shares method, the estimated franchise tax is approximately $85,000.
Delaware non-stock and non-profit companies. Exempted by the State of Delaware and not required to pay the standard annual Delaware Franchise Tax, although they must file and pay the annual report fee of $25 each year.
Delaware LLCs or Delaware LPs. $300 flat annual franchise tax. Due by June 1 each year.
Delaware Corporations. There are two calculations for annual franchise tax. The Authorized Shares method and the Assumed Par Value Capital method. Delaware allows you to use the lower of the two calculations. Due by March 1 each year.
For a Delaware corporation with 10,000,000 authorized shares and little in the way of assets (like an early-stage startup), using the Authorized Shares method, the estimated franchise tax is approximately $85,000.
For a Delaware corporation with 10,000,000 authorized shares and little in the way of assets (like an early-stage startup), using the Assumed Par Value Capital method, the estimated franchise tax is approximately $450. For obvious reasons, all early-stage startups use the Assumed Par Value Capital calculation.
How do we calculate Federal Corporate Income Tax?
The United States has a flat 21% corporation tax on the taxable income of corporations at the entity level. Then, any distributions made to equity holders (e.g., via dividend) are taxed again at the personal income tax level. The two-step taxation is called “double taxation,” as compared with “pass-through taxation” of S-corporations, partnerships, and LLCs that elect to be S-corporations or partnerships, which do not pay income tax at the entity level, and instead any taxable income is “passed through” to the equity holders (who pay personal income tax on these amounts). This may seem like a large tax advantage for LLCs, S-Corps, and partnerships, but recall that most venture-backed startups will show losses for the first few years (and therefore not owe federal corporate income tax), and also, most will not ever distribute profits to the equity holders prior to exit, so double taxation is a moot point.
To calculate your company’s Federal Corporate Income Tax, first evaluate the corporation’s taxable income (Taxable Income = Adjusted Gross Income – All Applicable Deductions). Next, multiply the corporation tax percentage (currently 21%) by the taxable income to determine the corporation’s tax liability (Corporate Tax = Taxable Income x 0.21). If the company has been operating at a loss, the company will also be able to carry forward net operating losses to future tax years.
Your company may also be eligible for an R&D tax credit. Federal research and development (R&D) tax credit results in a dollar for dollar reduction in your company’s tax liability for some domestic expenses. Qualifying expenditures are relevant to most tech startups, and include the design development or improvement of products, processes, techniques, formulas or software. R&D tax credits are outlined under Section 41 of the Internal Revenue Code.
We recommend consulting with experienced tax advisors regarding optimal tax strategy.
