Once an investor and an entrepreneur have decided that they want to integrate a structured liquidity mechanism into their deal, they need to decide whether to implement it in the form of debt or equity. There are a number of factors to consider, including tax implications, potential regulatory restrictions and economic considerations – such as whether uncapped upside or stronger downside protection is desired. The table below summarizes some of the main differences between the two forms based on U.S. law. But, first, here are some rules of thumb based on what we’ve seen:
|Preserve option for sale / IPO upside||No||Yes|
|Downside protection||Creditors are paid first in downside scenario and loan amount can be secured by collateral||Liquidation preference possible, but debt is paid first. Generally, no dividend or redemption payments will be allowed if the company is insolvent (see below under Board of Director approval)|
|Annual payment amounts limited by usury laws||Yes||No|
|Board of director approval||Generally, required once to approve the loan agreement.||Required for each payment. The board will need to ensure that state law governing the amount of distributions to shareholders permits each dividend and redemption payment. Generally, payments will be allowed unless the company is insolvent.|
|Company tax implications||Interest payments are tax deductible, but IRS reporting is complicated||No tax deduction for dividend and redemption payments|
|Investor tax implications (gains)||Interest taxed at ordinary income rate (up to 43.4% federal)||Qualified dividends taxed at special rate (up to 23.8% federal)
Capital gains taxed at maximum rate of 23.8%, but could be as low as 0% effective rate in certain situations
|Investor tax implications (losses)||$3,000 per year deductible against all income, remainder only against qualified investment income||$3,000 per year deductible against all income, remainder only against qualified investment income, but amount of losses deductible against all income could be as high as $100,000 in certain situations|
|Transaction cost/complexity||Generally lower up front cost, but complicated IRS reporting||Generally higher up front cost, but usually simpler IRS reporting|
When equity is preferred
- Early-stage company on conventional financing track, and the company’s stakeholders would prefer, or are at least open to, an IPO or Sale. Here, a redemption provision is used as a hedge against an IPO or Sale not occurring, rather than as the primary means of achieving liquidity.
- Investors are willing to defer most if not all of repayment and return on investment for 8 or more years post investment. Investors may agree to defer payments because they believe it is important to reinvest profits to accelerate growth. If investors defer repayment, they will also benefit from the lowest available federal tax rates on gains, and, in some cases, they may not be required to pay federal tax at all.
- The parties want to avoid the complications and unusual tax treatment associated with variable payments for debt instruments.
When debt is preferred
- For PRI investments. Although a growing number of foundations will consider equity PRI investments, debt continues to be the predominate form of investment.
- For some investors, investments into a limited liability company or other entity with “flow through” tax treatment. Tax-exempt entities will often avoid direct equity investments in these entities because of concerns related to unrelated business taxable income. Foreign investors will typically avoid direct equity investments in LLCs because these investments would likely subject them to US federal and state taxation. Other investors may want to avoid direct equity investments in LLCs because these investments may require them to file tax returns in all of the states in which the LLC operates.
- When the parties desire a shorter investment period (less than 8 years) and seek regular payments that commence relatively quickly after investment.