This is part 2 of a high-level discussion of funding, dilution, terms, and their effect. Part 1 is here. This brief update adds two very simple concepts: legal/banking/etc Fees and Capital Gains Taxes.
Capital gains tax rates — the tax rates that apply to one’s gains on “capital assets” such as stocks, mutual funds, bonds, real estate, etc. — are determined by the type of investment asset and the holding period. The type of investment applies to an entrepreneur’s gains on the equity they own in their company. In short, there are two types of Capital Gains (CG) Taxes: short-term CG and long-term CG. The disti nction is very simple: if you hold your asset (equity, in this case) for longer than 12 months, then you would qualify for long-term CG; selling your equity prior to the 12-month holding time means that any gains would be subject to short-term CG.
NOTE: Your capital gains will also be subject to state income taxes. Most states do not have separate capital gains tax rates and will tax your capital gains as ordinary income. The good news here is that seven states impose no income tax: TEXAS, Alaska, Florida, Nevada, South Dakota, Washington, and Wyoming. About.com has a reasonable, broader discussion of Capital Gains Taxes.
Why are CG taxes an important part of this discussion? One, it affects your take-home amount of cash. Two, because in general, short-term CG looks like ordinary income (see below) and long-term CG, in general, is set at a fixed 15% for now — which can mean, depending on your bracket, giving up less than HALF of what you would other wise give up to taxes under the short-term schedule. To be clear: if your annual salary was $85k, you would pay 28% tax rate under short-term CG and 15% under long-term CG; if your gains were $200k, you’d pocket $144k if you paid short-term CG and $177k if you paid long-term CG. The difference goes up as your income/bracket go up.
It’s also important because the option plan that your company adopts can materially affect how likely you will have short-term versus long-term CG. Option plans that allow for purchasing of options ahead of/during the vesting period have the (significant) advantage of starting the capital gains “clock” ticking as early as possible. Option plans that only allow for purchase after vesting delay the start of the “long-term” period and therefore make short-term tax rates on your gains much more likely. More detail on this topic is available but the short summary of this point is: option plans that allow for option purchase ahead of vesting represent a BIG employee benefit and little downside to the company.
If you’re single, the following tax bracket applies to you. This isn’t a post on current tax code, so please do your research on current rates and rules as appropriate.
- 10% on income between $0 and $8,350
- 15% on the income between $8,350 and $33,950; plus $835
- 25% on the income between $33,950 and $82,250; plus $4,675
- 28% on the income between $82,250 and $171,550; plus $16,750
- 33% on the income between $171,550 and $372,950; plus $41,754
- 35% on the income over $372,950; plus $108,216
Legal / other fees
It’s an almost guaranteed that you’ll use a law firm during any sort of liquidation. The fees here range greatly depending on the size of the deal, state of the business and the complexity of the transaction. For the sake of this spreadsheet and discussion, we’re going to use 1.5% and I believe that’s a reasonable estimate because I can imagine it being higher but not much lower in any typical transaction.
Typically in a liquidation, the way money will be distributed is in this order: pay legal/other fees, accommodate preferences, distribute monies, and then individuals pay taxes. As our spread sheet gets more complicated, we’ll make sure we use this sequence to make it easier to follow along with the cash distribution.