Venture Financing and Tax Laws: What You Need to Know

Your business may need venture capital funds at different stages of its formation and growth. Whether you are just getting your startup off the ground or expanding to a new product or service, you may require more cash than your company has on hand.

You must understand how venture financing and tax laws work to raise funds correctly. Let’s give an overview of business funding options and accompanying tax liabilities in the U.S.

What Is Venture Financing?

Many companies must boost their cash flow to kickstart, pay for ongoing needs, or fund major expenditures. Broadly speaking, businesses have two financing options: debt financing and equity financing. Either pathway has its pros and cons, and most ventures eventually use some combination of both.

With debt financing, your business takes out a loan, which it needs to repay later. Equity financing works by selling ownership shares in the company. The latter is a popular financing method among startups and large corporations with publicly traded stock. Equity financing involves many regulations at the federal and state levels.

Types of Venture Financing

Let’s get deeper into the characteristics of various venture financing types: equity financing, debt financing with its variations, crowdfunding, and corporate venture capital.

Equity Financing

Definition and Characteristics

In equity financing, your business raises venture capital by selling some of its shares.

Equity financing offers many advantages for startups and entrepreneurs. Most importantly, it involves no repayment: if your venture falls through, you don’t stay in debt to your investors.

Startups in the U.S. have a high failure rate. About 50% of all startup ventures won’t survive their first five years⁽¹⁾. If banks and other established lenders refuse to lend you money because they consider your company too high risk, equity financing can be a viable funding pathway.

A company may sell different types of equity for financing, such as:

• Common stock: Corporate ownership shares that essentially make investors part of the company’s management, letting them participate in major decisions like establishing corporate policies.
• Stock warrants: Options that grant an investor the right to buy corporate stock at a predefined price point within a certain timeframe. The investor only becomes a stock owner when they exercise their right to purchase.
• Convertible preferred shares: Securities that investors may choose to convert into common stock using a fixed conversion rate, usually once the company’s stock crosses a certain market price.

Advantages and Disadvantages

Equity financing can:

• Provide your business with funding when traditional lenders ignore you
• Reduce risks since you and your company won’t incur debt
• Make your venture more attractive to potential buyers
• Get you valuable guidance from investors with relevant connections and experience

On the other hand, equity financing:

• Means you relinquish some control over your company when selling shares
• Involves consulting major shareholders when making important decisions
• Transfers part of your business profits to stock investors
• May cost more than a loan in the long run

Debt Financing

Definition and Characteristics

Debt financing for business ventures works like personal debt: You source a loan and must pay it back with interest. The main advantage of debt financing is that it doesn’t require you to relinquish a portion of your company ownership. The lender won’t become a stockholder or impact your business operations.

Despite their obvious risks, loans are a common financing option for startups and emerging businesses. Almost 35% of entrepreneurs use a traditional loan to fund their venture⁽²⁾.

Advantages and Disadvantages

Financing your venture through a loan allows you to:

• Maintain full control of your business
• Avoid disagreements and misunderstandings with shareholders when making business decisions
• Reap benefits when you pay taxes, since business loan interest is a deductible expense your company can list on its tax return

However, debt financing may:

• Restrict your company’s cash flow
• Limit your options of taking on additional credit
• Bump up your debt-to-equity ratio, which makes potential investors and lenders view your company as higher risk

Convertible Debt Financing

Definition and Characteristics

Convertible debt is a funding option that is essentially a loan you repay with company stock rather than money.

This is how it works: An angel investor or venture capitalist provides seed funds that you use to build your business. Down the road, the investor can convert this seed investment into company stock at a reduced price compared to other investors.

Advantages and Disadvantages

Convertible debt financing is:

• Usually faster and simpler to source than direct equity financing
• More accessible than a traditional loan for new businesses
• A flexible financing choice with options like a discount or a value cap for an investor’s future stock purchase

On the other hand, convertible debt financing can:

• Remain as outstanding debt if your venture’s equity fails to grow
• Dilute equity when investors exercise their stock-buying options

Crowdfunding

Definition and Characteristics

Crowdfunding is a method of venture financing that involves using a designated platform, like Crowdfunder or Indiegogo, to raise small amounts of cash from many private investors. These investors usually aim to promote the emerging venture’s vision and goals.

Crowdfunding is an increasingly popular option for sourcing cash for startups: Currently, crowdfunding platforms generate over $17 billion in North America each year, and we may expect to see the crowdfunding market reach the $300 billion mark by 2030⁽³⁾.

Advantages and Disadvantages

Business crowdfunding offers some major advantages. It:

• Provides a low-risk way to source funds for your venture
• Helps you build a community of like-minded individuals around your business model
• Allows you to hold on to company equity

Nonetheless, crowdfunding involves:

• A high failure rate
• Challenges in reaching your target audience
• Subjection to the strict rules and high fees of crowdfunding platforms
• A possible risk to your reputation if malicious individuals target your campaign

Corporate Venture Capital

Definition and Characteristics

Venture capitalists (VCs) are companies or individuals with substantial resources that they invest in potentially profitable ventures. VCs aim for businesses with a competitive edge and high growth prospects.

Typically, VCs fund businesses in the early stages and sell their equity shares for a profit during the IPO (initial public offering). Venture capitalists usually request a significant ownership portion in return for their investment. They also frequently demand to take part in crucial business and operational decisions.

Advantages and Disadvantages

Corporate venture capital can:

• Help you raise high capital amounts in a short time
• Mitigate risks and reduce your personal liability
• Provide additional benefits, like connections, leadership, and industry experience on the part of the VC

However, this venture financing method also means:

• You give up a substantial portion of your company’s equity
• You submit to significant involvement of the VC in business management
• Your venture competes for attention with many other businesses pitching their models to the same venture capitalists

What Are the Tax Implications of Each Type of Venture Financing?

Various types of venture financing have different tax implications. For example:

• Equity financing may subject you to capital gains tax if you receive venture capital in exchange for company shares.
• Debt financing may involve personal income tax when you make interest payments.
• Individual investor financing by family or friends could trigger a gift tax, depending on the amount you receive.

A tax professional can help you understand how tax laws work for each financing option your business may use.

How Do Tax Laws Impact the Choice of Financing in Venture Financing?

The interplay between venture financing and tax laws is an important consideration when you choose a financing option for your business.

For example, venture capital funds are typically limited partnerships that place tax liabilities on the fund’s limited and general partners rather than the fund itself. Taxable transactions include management fees, investment dividends, and capital gains from sales. Knowing how taxes may influence your bottom line will allow you to make an informed decision when you choose a funding method.

The Importance of Tax Planning in Venture Financing

Make sure you include tax planning in your venture’s business model. Effective tax planning can help your company:

• Choose the optimal business entity structure (e.g., decide whether and when to incorporate your business)
• Maintain a positive cash flow and maximize profitability
• Take advantage of various available tax benefits for startups (like research and development tax credit)
• Ensure compliance with state and federal tax regulations
• Avoid stressful tax audits, costly penalties, and time-consuming litigation
• Shield your reputation and attract more investors

Your company’s tax strategy may have a major long-term impact on your business. A competent tax advisor can help you use tax laws to maximum advantage for your venture.

Common Tax Planning Mistakes to Avoid

As a startup or new venture founder, you should avoid the following common tax mistakes:

• Failing to take state taxes into account
• Mixing business and personal expenses
• Not keeping a proper track record of deductible expenses
• Neglecting tax regulations or filing taxes late
• Failure to comply with tax regulations in different countries if your business operates or plans to operate abroad

Venture financing and tax laws can be complicated, and making mistakes is easy without professional tax support. Trying to do it all yourself may lead to confusion, especially as your business grows. Investing in a smart tax planning strategy now can save you a lot of money and trouble down the road.

What Are Some Strategies for Minimizing Tax Liabilities?

You could potentially reduce the tax burden for your startup by:

• Establishing your venture as a C-corp. C-corporations can tap into various tax benefits and keep your personal and business assets separate.
• Using the QSBS (qualified small business stock) deduction. This tax exemption may generate major savings on capital gains tax for your business. Eligible businesses are active C-corps operating in eligible industries with assets below $50 million.
• Listing all your deductible expenses, including home office costs, employee education, and travel expenses.

Tax Implications of Cross-Border Venture Financing

If your startup is U.S.-based, but some of your investors are non-U.S. citizens who live abroad, this could have distinct tax consequences for your business. The tax implications may depend on the country your investors come from and whether this country has a tax treaty with the U.S.

Foreign investors must usually file a W-8 form to confirm their non-citizen status and benefit from reduced taxation.

What Are Some Tax and Entity Structure Strategies for Attracting Institutional Investment?

Probably the best tax strategy to attract institutional investment would be organizing your company as a standard C-corp. A C-corp structure not only offers the tax benefits (of separating an entrepreneurs personal taxes from the entity; unlike a partnership which is pass through)  but also makes your business more appealing to institutional investors. Many venture capital funds and other investment organizations receive endowments or funds from sources that require investing only in C-corp entities. This is primarily due to certain tax implications and the protection of the investor’s non-profit status.

When considering where to incorporate your C-corp, popular jurisdictions that offer various advantages include Delaware, Wyoming, Florida, and Texas. Each state has its unique benefits, such as Delaware’s well-established corporate legal system, Wyoming’s low business costs and strong privacy protections, Florida’s favorable tax environment, and Texas’s pro-business climate. Choosing one of these jurisdictions can enhance your company’s appeal to institutional investors and improve your chances of securing funding.

By organizing your company as a C-corp, you remove the need for a blocker organization, which is an intermediary entity that prevents tax liabilities from passing through to the endowment or fund. Blocker organizations can complicate the investment process and may deter some investors. By being a C-corp, you streamline the investment process, making your business more attractive to institutional investors and improving your chances of securing funding.

Are There Some Recent Developments in Venture Financing and Tax Laws?

Entrepreneurs often must adapt to current regulations in venture funding and taxation. For example, tech founders in the U.S. currently struggle with changes in tax provisions for Research and Development costs⁽⁴⁾.

While until 2022, companies could deduct their full research and development expenses in the same year of incurring these expenses, the new regulations require spreading tax deductions over five years. This creates a major cash flow barrier to investing in innovation-based ventures, and, so far, it’s unclear whether lobbying will change relevant laws anytime soon.

This example illustrates the important role a thorough, flexible financing and tax roadmap can play for your business.

Why You Need Professional Help With Business Financing and Taxation

Professionals like financial advisors, fund managers, and an experienced startup lawyer can help guide your company in the right direction from the earliest stages of your venture.

For instance, a corporate and venture capital lawyer can:

• Help make sure you comply with laws and regulations that involve securities
• Draft, review, and amend venture capital agreements
• Identify possible liabilities and help you avoid them
• Advise you on tax regulations relevant to your venture
• Provide valuable insight throughout the startup and venture capital raising stages

Montague Law: End-to-End Legal Counseling for Businesses in All Stages of Growth

Are you working on a financing plan for your business? Contact us at Montague Law for reliable legal guidance on venture financing and tax laws. Follow our blog for game-changing corporate law news and updates.

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