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How the Democratic Party’s Proposed Capital Gains Tax Changes Affect Founders

Summary
  • The Democratic party's proposed tax changes for capital gains treatment
  • How the changes could negatively affect founders hoping to sell all or part of their business in 2-3 years

Founders of middle market internet and software companies with moderate growth (10-30%) could be dramatically affected by proposed changes in the tax code by the Democratic Party and presidential candidate Joe Biden to the tune of millions of dollars.

If put in place, the proposed hike in capital gains rates would significantly reduce the take-home amount founders receive upon the sale of shares in their business. As such, founders should evaluate timing a potential acquisition or capital raise in the event that Biden is elected president and the Democratic Party gains control of Congress.

The Proposed Tax Changes for Capital Gains

Historically, federal and many state tax bureaus have instituted a lower tax rate on income from the sale of capital assets. Instead of taxing income from capital assets at the ordinary income rates, these entities created different or related brackets and rates.

Under the Tax Cuts and Jobs Act put into place in 2017, the tax rates on long-term capital gains (for capital assets owned > 1 year) were set at 0%, 15%, and 20% at the following levels of taxable income (or adjusted gross income):

Tax Brackets for Long-Term Capital Gains

Taxable Income Rate
0 - 78,750 0%
78,751 - 434,550 15%
> 434,550 20%

As part of his bid for presidency, Democratic candidate Joe Biden has proposed changing the special treatment on income from the sale of capital assets. Biden proposes that for individuals with taxable income greater than $1M in a year, their capital gains would be taxed as ordinary income under standard income brackets—up to 37% under current tax code and up to 39.5% as proposed by Joe Biden.

Because the net positive sale of business stock is considered a capital gain, founders need to consider how these changes could affect what they take home post-transaction on a full sale or capital raise.

Higher Tax Rates Could Offset Earnings from Growth

For companies with moderate growth (10-30%), the higher tax rates could result in founders taking home less money post-transaction despite revenue growth.

For example, consider a SaaS company with $10M in annual recurring revenue (ARR) at the end of 2020 growing at 20% YoY. (For simplicity, assume the founder owns 100% of the company and there is no state tax.) In a full-sale transaction and at the given growth rate, the company could reasonably sell at a 5x multiple—$50M. At the current long-term capital gains tax rate (assuming the founder has owned the company stock >1 year), the proceeds to the founder would be:

Taxes & Proceeds Under the Current Tax Code

Enterprise Value $50M
Capital Gains Taxes (20%) ($10M)
After Tax Proceeds $40M

Now consider what would happen if this same founder waited until after the tax change (potentially the end of 2021 or beginning of 2022). While revenue would have grown 20% (another $2M in revenue and additional $10M in enterprise value at a 5x ARR multiple), unfortunately the math doesn’t play out in the founder’s favor due to the increased tax rate:

Taxes & Proceeds Under the Proposed Tax Code

Enterprise Value $60M
Income Taxes* ($23.6M)
After Tax Proceeds $36.3M
After Tax Proceeds (NPV)† $33.7M

* Assumes the founder is filing singly. Tax brackets and rates are based on 2020 tax code, with the exception of the highest bracket, which is set to Biden’s proposed rate.

The net present value of the proceeds, discounted at an 8% investment rate.

The present value of proceeds to the founder in the second scenario is $33.7M, meaning the founder in the second scenario effectively took home $6.3M less after putting another year of talent and risk into the business and growing the business 20%.

In other words, the increase in incremental enterprise value was more than offset by the increase in taxes.

The Effect of the Democratic Paryty's Proposed Tax Changes

Also note that any other income the founder would have in that same year would be taxed at the top rate of 39.5%.

While the math will play out differently depending on a company’s growth rate and revenue, the dramatic increase in taxes paid (in this case, from $10M to $23.6M) could have a significant effect on proceeds to founders.

How likely is the tax code to change under a Biden presidency?

In order for the tax code to change, two conditions must be met:

  1. Candidate Joe Biden is elected president.
  2. The Democratic party gains a majority in congress.

If both the above conditions were met, then the Democratic party would have unified control over the legislative and executive branches, and thus would have the power to enact Biden’s proposed tax codes.

We’re not political analysts, so we can’t tell you how probable it is that the above two conditions happen together. We can as investment bankers, however, speak from our own area and say that:

  1. Running a full sale or capital raise transaction can take up to 6 months, so if you wait for surefire signs of a tax change to appear, you may be too late.
  2. In general, founders are better off taking some money off the table when they’re growing by running a private equity capital raise, then swinging for the fences with a new capital partner and larger financial resources.

How Founders Should Prepare for a Potential Tax Change

To prepare your company to sell in the event you want to transact before these changes take place, then over the next 6 months, you as a founder should:

  1. Speak to an investment bank to determine if your revenue and growth rate put you in a position where a sale in the next year makes the most sense.
  2. Speak to a personal wealth/tax professional about your tax & estate situation so you can capitalize on tax-advantaged vehicles like charitable trusts and gifting of stock.
  3. Begin cleaning up your business data and investing in business intelligence to streamline information gathering for an eventual sale/capital raise.

Founders who take these necessary steps will be on the right path to conduct a timely transaction in the event that all signs point to tax hikes. To take the first step, speak to a qualified, unconflicted investment bank.

Modified on Oct 20, 2020