For any security to qualify under Section 1202 as Qualified Small Business Stock, the company must first be considered an eligible Qualified Small Business (QSB) meaning:
- It is a domestic C-Corp
- It has less than $50 million in gross assets (when the stock is issued)
- It is an active business in a qualified trade
- Learn more about about the additional requirements to be a Qualified Small Business
The securities themselves must also satisfy certain criteria including:
- They were acquired at original issuance
- They were acquired in exchange for money, other property (not including stock), or as compensation for services provided to such corporation
- They were held for a minimum of five years
For each security type however, when the 5-year holding period begins is determined based on nuances particular to each security type. Depending on the security type the holding period might begin on the purchase date, the exercised date, vesting date, etc.
What are “Convertible Notes”?
Convertible notes are a type of short-term debt security that accrues interest and eventually converts into equity— usually within the start-up’s funding round. An investor who loans money to a startup in its first round of funding can receive shares of preferred stock, rather than getting the loan paid back with interest. In short, the start-up will be labeled as a debtor and the investor will be labeled as a creditor, and the investor will be compensated by receiving shares in the company. Typically, the note would convert to the preferred stock at the closing of Series A financing, but depends on the terms of the note. There are good reasons on why the note would convert to preferred stock at the closing of Series A financing including:
- No base to determine valuation at the time of the investment
- Series A gives start-up’s more figures to calculate valuation of preferred stock
- Some Convertible Notes are created when the company is only a proposition
What are the Advantages of “Convertible Notes”?
A benefit to acquiring convertible notes is that the valuation of the issuing company is postponed until the Series A funding—as expressed previously—during which there is a lot more information to accurately value a startup. Since a convertible note is considered debt instead of equity, a formal valuation is unnecessary and the company mitigates the risks of dilution, tax problems, and option pricing.
A convertible note can be closed and issued in under two days which makes it one of the quickest and simplest types of securities to issue. Additionally, the cost of issuing a convertible note is favorable in comparison to other security types since only a 2-3 page promissory note is required and legal fees are “minimal.”
Another advantage—from the startups point of view—to the issuing company is that the convertible note does not give the investors the same level of control that other securities or funding options give. Preferred stock grants investors certain rights such as board seats and minority stockholder voting rights. Convertible noteholders do not benefit from these same types of incentives.
In addition to the speed at which a single investor can be issued a Convertible Note, this type of security can aid in the timeline of financing rounds by allowing companies to give different prices and caps to different investors.
Are Convertible Notes eligible for QSBS?
In order to be considered QSBS, shares must be originally issued stock purchased directly from the qualified company. Since a Convertible Note is not stock until it converts, it cannot be QSBS. Additionally, the required 5-year holding period for QSBS would not begin until after the note is converted which often can take around 2 years from issuance. Once converted, the startup has to comply with Section 1202 requirements for a 5 year holding period; once then, the investor is eligible for up to 100% tax exclusion on the capital gains received from the sale/exit of the converted stock.
Read more from Brett Calhoun about Convertible Notes and QSBS.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.