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An Advisor’s Guide to Planning for Startup Founders

Help mitigate risk and set the stage for financial success both before and after a liquidity event.

Many startups are funded by venture capitalists and angel investors with the ultimate goal of being sold to a larger competitor or going public. So much time and effort is spent growing the business and preparing for a liquidity event at the business level that the founder’s personal planning often takes a back seat.

By planning for the personal side of a liquidity event, both before and after the transaction, a startup founder can help mitigate risks associated with the founder’s equity (particularly income tax, estate and gift tax and concentrated equity risk), and set the stage for personal financial success.

Anatomy of a Startup

Most startups begin life with a few founders, a business idea and a small pool of capital contributed by the founders, their families and friends. Knowing that they hope to seek venture capital funding as they grow, the business is typically formed as a C corporation, to be able to take advantage of the tax benefits of qualified small business stock as discussed below. The founders are issued restricted common stock (sometimes referred to as founders’ stock), some or all of which is subject to a vesting schedule. An options pool is also set aside for employees. After the company has some success, it’s able to attract funding from venture capitalists and angel investors (basically wealthy individuals and family offices). These investors receive preferred stock, which has preferential rights to the common stock. The preferred stock can be converted to common stock, thereby diluting the percentage ownership of the founders and employees. If the business continues to grow, additional rounds of venture funding may occur. At a certain point, the venture capitalists expect the business to be sold to a larger company or go public. An acquisition of the business is far more likely than an initial public offering. The time frame for the liquidity event typically ranges from five to 10 years following the initial venture funding. Assuming everything works out as planned, the liquidity event will result in a large payday for investors. 

Planning Prior to the Liquidity Event

Putting together the team. Startup founders are typically young and not wealthy. As such, they’ve rarely worked with outside professionals regarding their personal financial affairs. This will need to change as the business increases in value. Choosing a good CPA is the first step. Making sure tax returns are properly filed and tax elections timely made is extremely important. Next up is a trusts and estates attorney to make sure an estate plan is in place if the founder is hit by the proverbial bus. The attorney can also help draft documentation regarding gifts to family members and charities. Finally, a startup founder should retain a qualified wealth manager. The wealth manager can help with financial planning, including the model for making early tax elections in connection with equity holdings. For best results, these outside advisors would collaborate with each other regarding important decisions along the way, each bringing to bear his specific expertise.

Importance of financial planning. Financial plans, typically prepared by a qualified wealth manager, can be important foundational documents in the personal planning of startup founders’ anticipating a liquidity event. A good financial plan begins with the long-term financial goals of the startup founder. Once goals are established, the plan will determine cash flow needs going forward. These fall into three buckets. The first bucket relates to liquidity, which is basically the assets needed to maintain your client’s lifestyle. The second bucket deals with longevity; the assets needed to improve your client’s lifestyle. And the final bucket pertains to legacy, which are the resources your client would like to use to improve the lives of others—either through gifts/bequests to family and friends or philanthropic contributions. A good financial plan will also help the founder manage restricted stock and equity compensation, including understanding company transfer restrictions, tax elections and liquidity necessary to pay taxes on equity transactions. Finally, the financial plan can deal with single stock diversification strategies and inform a proper investment strategy based on the founder’s risk tolerance after the founder has become liquid.

Basic estate planning. Because many startup founders are young, it isn’t unusual for there to be no estate plan in place. Startup founders can have significant paper wealth, which could pass without a will in place to unintended individuals. In addition, if the startup founder dies, any amounts over $5.49 million in 2017 (if single) will be subject to a 40 percent federal estate tax (and an additional state estate tax in several states). Paying the tax may be difficult if the stock is illiquid. As such, the founder should consider term life insurance to provide liquidity for any estate taxes owed. In addition, if the founder is married, life insurance may be required to provide income replacement for the surviving spouse until the startup shares become liquid. Finally, a good estate plan includes documents providing for what happens should the founder become incapacitated, which include revocable living trusts, durable powers of attorney and appointment of healthcare agents and directives.

After the Liquidity Event

Restrictions on transfer, hedging or pledging public securities. Just when your client thinks he’s seen the other end of a successful liquidity event and is ready to diversify his concentrated stock position, corporate lock-up agreements and certain securities law requirements say: “not so fast.” Public stock received in an IPO or an acquisition is typically subject to a lock-up period (imposed by the underwriters in the case of an IPO and the acquiring public company in the case of an acquisition) of up to 180 days before the stock is permitted to be sold. In addition, most companies have restrictions on insider trading, hedging and pledging shares by executives. Founders may want to consider a pre-established trading plan that will comply with SEC Rule 10b5-1 to avoid violating corporate policies or securities laws. Finally, SEC Rule 144 provides a safe harbor from registration of certain securities so that an employee may sell securities in a public market place. The rules differ depending on whether the employee is considered a control person or a non-control person.

Concentrated equity planning. Assuming transfers, hedging and pledging of public stocks is permissible, there are a variety of concentrated stock strategies (in addition to outright sale) that can help with the risk of a concentrated stock position. The most common strategies are equity collars, prepaid variable forward contracts, charitable remainder trusts and exchange traded funds.

Charitable planning. Charitable planning after a liquidity event can be a tax-efficient way to be philanthropic while offsetting some of the taxes in the year of the liquidity event. Unlike pre-liquidity charitable planning, post-liquidity charitable planning is fairly straightforward. In the liquidity event, the founder could receive cash, public stock or a combination of cash and public stock. While cash gifts are deductible up to 50 percent of the adjusted gross income in the year of the gift (with a 5-year carryforward), they’re not as tax efficient as gifting public stock (deductible up to 30 percent of AGI with a 5-year carryforward). When gifting the stock to a public charity or private foundations (deductible at fair market value for public stock), any income tax on the built-in capital gains on the stock disappears. All charitable vehicles are available post-sale, including outright gifts to public charities (including donor advised fund), gifts to private foundations, and gifts to charitable remainder and lead trusts.

Investment/financial planning. Once the liquidity event has occurred, the founder, working with his investment advisor, should update the financial plan with the actual dollar amounts (taking into consideration taxes that may be owed on the liquidity event). Once the financial plan is updated, the founder will be able to determine which of the three buckets the net worth should be divided into. Again, the liquidity bucket contains the portion of the net worth necessary to maintain lifestyle. The longevity bucket is made up of the assets needed to improve lifestyle. Any remaining assets go into the legacy bucket, which includes assets to help improve the lives of family and friends and to support philanthropic endeavors. Once the buckets are in place, the wealth advisor can put together a proper investment strategy for each bucket. The financial plan should be updated annually to reflect markets, changes in circumstances and any necessity to move assets among the buckets.

Qualified small business stock. Post-liquidity, there are some attractive income tax savings and deferral opportunities if the stock is considered qualified small business stock. QSBS is stock in a small, domestic C corporation that operates an active business. To qualify, the corporation must use at least 80 percent of its asset value in the active conduct of one or more qualified trades or businesses (certain industries are excluded) and the gross assets of the corporation, as of the date the stock was originally issued, can’t exceed $50 million.

On the sale of QSBS, the seller may exclude between 50 percent and 100 percent of the gain (depending on when acquired), up to the greater of (1) $10 million or (2) 10 times the basis in the QSBS. To qualify, the QSBS must be held for at least five years prior to the sale, and the shareholders must have acquired the stock at its original issue, in exchange for money or property, or as compensation for services rendered.

In addition, on the sale of QSBS (held more than six months), the seller may elect to defer realized gain by reinvesting the sale proceeds into a new QSBS investment within 60 days of the sale. The seller’s basis in the replacement stock is reduced by the amount of the gain deferred. This ensures that gain continues to exist, but is merely deferred.

As they say, “failing to plan is planning to fail.” Just remember how many rich startup founders of the dotcom boom in the late 1990s lost everything in the dotcom bust of the early 2000s.


This is an adapted version of the authors' original article in the December 2017 issue of Trusts & Estates.

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