As private companies seek to stay private longer, many try to offer interim liquidity opportunities to their employees. These opportunities include secondary sales, where employees sell their common shares to investors, often at a price in excess of the then-prevailing fair market value determined based on a 409A appraisal.
This higher price is often in reference to the most recent preferred price, and often negotiated as part of a preferred stock financing. Sometimes, a discount to the preferred price is applied. However, often selling employees demand more than the appraised 409A price because they will lose upside in the shares to be sold.
The challenge regarding secondary sales is that this premium above the 409A appraised price may constitute compensation—and therefore will not be eligible for capital gains. Careful structuring of the secondary can help mitigate this risk. In particular, tax law would focus on the following factors to determine if the premium is compensatory—(1) the identity of the seller, (2) the identity of the buyer, and (3) the role of the company.
If the buyer is viewed as compensating employees on behalf of the employer at a premium, the employer would be liable for any tax withholding on the premium. Furthermore, a third party buyer could also be liable for tax withholding if the investor exercises control over the source of funds for the premium if the employer does not appropriately withhold.
Identity of the Seller
The risk that the premium is compensatory is higher with the following factors:
- If the sellers are entirely or mostly current employees;
- If the sellers are selected by the company among a group of employees—and skew toward higher performers, or key employees; or
- If the sellers are employees with the longest tenure at the company.
In contrast, the inclusion of former employees or investors as a significant portion of the selling parties reduces the risk of compensation, as long as they are selling on the same terms (and at the same price) as the current employees.
Identity of the Buyer
The risk that the premium is compensatory is higher with the following factors:
- If the buyer is a significant investor (often over 5-10 percent of the ownership);
- If the buyer has significant influence over company decisions, most significantly as a member of the board;
- If the buyer receives special information rights or disclosures from the company as part of the transaction; or
- If the buyer is a fund associated with, or controlled, by management.
If the buyer is the company, the premium will be compensatory, since it will be viewed as wages under tax law.
In contrast, a case for capital gain treatment can be made where the buyer will be a new stockholder, is buying shares at a premium to gain more rights (e.g., to become a major investor under financing documents), or where the buyer has little or no influence over management. Special attention is also paid to whether there is documentary evidence that the buyer sought to acquire more shares beyond what the company was willing to sell (e.g., mentions in term sheets or financing documents of an appetite for more shares beyond what is initially authorized in the preferred round financing itself).
Role of the Company
The risk that the premium is compensatory is higher with the following factors:
- If the company negotiated a premium price of the secondary transaction on behalf of employees;
- If the company selected specific employees to be eligible to sell (e.g., with longest tenure or highest performers);
- If the company provided disclosures to employees and/or the buyers about the company’s financial performance or business conditions and risks; or
- If the company later converts—or commits to convert—the common shares the buyer acquired into preferred shares, especially without further payment by the investor for this right.
Other Considerations
Another tension in the tax treatment of a premium paid on employee shares arises in connection with an employer obtaining a Section 409A valuation for purposes of setting the exercise price for future stock option grants.
Appraisers often look to secondary transactions to inform the value they assign to the common shares. The appraised value should not be impacted if the premium is deemed compensatory. However, if it is deemed capital gains, an appraiser may give some weight to the price as one of many indicators of value.
We encourage companies to work with their appraiser and audit firm throughout the entire secondary sale—including at the planning stages—to confirm how the premium will be reported and to study the impact of the secondary on future 409A appraisals.