How to Valuate the Start-Up Enterprise

As with most transactions involving buyers and sellers, the valuation of a potential investment in a business is often a matter of perspective. The founder views the business equity as full of promise of future returns. The investor, holding cash and, therefore, access to alternatives as to where to deploy that liquidity, apprehends that same equity as opportunity cost, because his or her election to invest in a given enterprise ends access to alternatives. This opportunity cost looms larger for investors, and larger in proportion to their experience.

Reconciling this tension in valuation perspectives, especially with early stage ventures, between founders and investors is often left to a sort of ersatz market clearing mechanism of road shows and elevator pitches, leaving it to the experienced investors to apply their experienced, if subjective, valuation metrics to an otherwise unknown company. Less confident investors then step in behind the seasoned players to acquire an apparently lower risk, and lower value, portion of the equity.

Investors and their advisors should work with the information they have to evaluate their risk tolerance. Negotiations between the investor and the founder all too often focus on subjective hopes and dreams for the marketplace and overlooks objective calculation of the magnitude of the equity share that a startup investor should seek in exchange for a cash infusion. That is, the metric of equity share should be deployed as part of the discussions between the parties, as a goal, and not merely as an incident, of valuation. These calculations are drawn from the Venture Capital Method of valuation. Here, I briefly review this method.

Simply put, an investor that wants to obtain a desired return is obliged to follow a mathematical map to achieving that return. This calculation is accomplished using the functions of present value, future value, and percentage ownership. Let’s consider an investor who wants to deploy $1 million today in order to participate in a start-up’s anticipated $40 million exit value in five years.

The present value of the proposed $40 million exit va​lue is calculated by discounting $40 million at the rate of 40% per year for five years. The equation for this is:

So, to accomplish the desired return on the initial investment, an investor should obtain an equity interest calculated as the initial investment divided by the present value of the exit value, or:

In other words, the investor should negotiate for about a 13.5% equity interest in order to achieve the desired return. A common way of referring to the present value of the exit value is the postmoney value of the business. We can think of it as the present value of the potential of the business if the investment is made. The term premoney value is the postmoney value less the investment, or $7,437,377 – $1,000,000 = $6,437,377.

Observe that the target rate in our calculations should be distinguished from an expected rate of return. The target rate rests on the presumption that the business grows as planned.

Next, consider what happens to our equity expectation when we raise the exit value of the enterprise to $60M.

The higher exit value raises the present value of the exit figure and reduces the equity percentage the founder will be expected to part with in return for an early stage investment. This relationship calls for both investors and founders to be aware of the incentive to under or over-estimate the likely growth of the company.

To be sure, the valuation of a startup involves as much art as it does science. Additional methods of valuation including, but not limited to, the Berkus Method, Scorecard Valuation Method, and the Risk Factor Summation Method might be productively used in addition to the Venture Capital Method to provide a broad set of metrics for understanding the potential of a new enterprise. The proper use of these tools is necessary for the success of any venture.

These notes are intended to provide a review of general principles only and are not legal or tax advice. The reader is encouraged to discuss his or her particular circumstances with a qualified professional before taking any action.

Cryptocurrency Tax Consequences

A recent decision by the Internal Revenue Service (IRS) to clamp down on cryptocurrency back taxes has understandably concerned many investors and thrown a host of complicated legal questions into sharp relief. In an effort to collect capital gains taxes on cryptocurrency trades, the IRS recently sent out a series of letters to about 10,000 investors warning them that failure to account for capital gains accrued in cryptocurrency markets could invite an audit or the imposition of even harsher penalties.1 The IRS has reportedly sent out three types of letters – one gently reminding investors to update their tax returns, another warning about the costs of tax evasion, and a third threatening an audit if a response is not received – “depending on the severity of the [tax] issue.”1

The IRS’ legal authority to send such letters and threaten enforcement action is rooted in the designation of cryptocurrencies as taxable property, rather than as currencies. In explaining this classification, the key consideration employed by the agency is that while cryptocurrencies can “be used to pay for goods or services” just like regular currencies, they can also be “held for investment,” a status that makes cryptocurrency subject to capital gains taxes.2 Cryptocurrency’s status as taxable property has a host of ramifications for tax preparation, the most important of which will be summarized below.

Before any investor can assess their cryptocurrency-related tax liability, they need to tabulate their “taxable events.” Taxable events, according to, encompass the following: “trading cryptocurrency to fiat currency” or to another form of cryptocurrency, “using cryptocurrency for goods and services,” and “earning cryptocurrency as income.”3 (Importantly, these provisions apply to cryptocurrency “miners,” the individuals who are paid in cryptocurrency to maintain blockchain networks).3 Whenever any of these taxable events occur, cryptocurrency investors need to log the “fair market value” of the cryptocurrency (plus any fees associated with the cryptocurrency purchase, sale, or trade) and determine if they incurred any gains or losses in the transaction.3 The tax rate on each transaction is determined by the length of time for which the investment was held. That is, cryptocurrencies purchased, held, and sold within a year are subject to the short-term capital gains tax (equivalent to regular income tax rates).4 Because U.S. tax law seeks to incentivize long-term investing, assets purchased and held for more than a year are subject to the long-term capital gains tax, which is considerably lower than the short-term rate.4

Although these rules may seem complex and burdensome, there are many ways to minimize your cryptocurrency tax liability. First and foremost, investors can actually claim deductions on their cryptocurrency losses – just as capital losses are deductible for more conventional assets.3 Moreover, as Accounting Today notes, investors can avoid capital gains taxes by gifting or donating cryptocurrency.5 Because the long-term capital gains rate is lower than the short-term rate (as discussed above), investors can lower their tax bill by making long-term investments.5 Finally, investors can reduce their tax liability by immediately converting cryptocurrency that has appreciated in value into a fiat currency like U.S. dollars, rather than using it to purchase another form of cryptocurrency.5 This is because both the conversion to U.S. dollars and the act of purchasing another cryptocurrency with capital gains are both taxable events.5

Despite the uncertainty and mystique surrounding cryptocurrency, these novel investment opportunities are governed by laws and regulations familiar to any experienced investor. Common sense, sound legal advice, and diligence will prevent your cryptocurrency tax bill from growing exorbitant.



Pastore & Dailey Advises Clients on the Complexities of Family Offices

Recently Pastore & Dailey advised clients on complex questions regarding family offices and the compensation of non-family member “key employees” of such offices. Pastore & Dailey referenced the Investment Advisers Act of 1940, Dodd-Frank, and other securities act provisions to help the clients maneuver the complex structure of a family office and how to properly compensate non-family member employees pursuant to these provisions so as to not lose the family office exemption.

The New Partnership Audit Rules: Two Ways Out

The new changes imposed by the Bipartisan Budget Act of 2015 established new rules for how partnerships will be audited and how they are assessed liability for federal taxes due after an examination. These new rules require that every entity that could be treated as a partnership to examine, and when needed, revise its governing documents to be able to comply with the rules. This article delves further into the new BBA rules and how partnerships may opt-out to avoid the full effects of the new consolidated partnership audit rules and push-out the adjustments to income, gain, loss, deduction, or credit to each partner of the partnership for the reviewed year by following a prescribed process. For those considering purchasing or selling partnership interests should be aware of the current responsibilities implemented by these new rules and review their partnership agreements.

Dan M. Smolnik Presents at Annual Meeting of the Connecticut Bar Association

Pastore & Dailey is proud to announce that Dan M. Smolnik, Special Counsel at Pastore & Dailey, has been asked to present his views on recent developments in Tax Law at the June 12, 2017 Annual Meeting of the Connecticut Bar Association. Mr. Smolnik will be addressing two new developments:

  1. The new rules on self-employment tax affecting tiered partnerships; and
  2. The new rules regarding disguised sales and how these rules now affect a much broader array of transactions than before.

In particular, he expects the new disguised sales rules will affect virtually all partnerships going forward. Mr. Smolnik has practiced in the areas of tax, business transactions, and tax-exempt organizations for almost 30 years and has helped numerous organizations thrive while meeting their responsibilities and opportunities with tax and business law. He has extensive experience representing insurance companies, banks, and international corporations in tax, regulations and organizational law issues.

More information: Two New Tax Rules That Affects Partnerships, LLCs and Other Pass-through Entities (pdf) by Dan M. Smolnik

Preserving Loan Treatment of S Corporation Payments from Shareholders

The sense of control and informality of operations experienced by shareholders of S corporations is a robust bridge for entrepreneurs, providing them an accessible connection between their personal and work lives, without the constraints of a board of directors, awkward motions and resolutions, and the pesky documentation requirements attorneys seem to impose on entrepreneurs in some other forms of business.

Among the most prevalent and cherished characteristics of S corporations is the perception  by their owners that the income tax transparency of the S corporation translates into the interchangeability of the corporation with the shareholders for all tax purposes.

On August 24, 2016, the Tax Court filed a Memorandum decision providing a good review of the standards for characterization of transfers between shareholders and close corporations as either loans or capital contributions. Tax attorneys see, all too often, shareholders, partners and other principals receive large and unexpected tax bills, with penalties and interest added, resulting from incomplete or inaccurate application of the rules associated with capital contributions and loans to businesses they control. Virtually without exception, the taxpayer is caught by surprise.

In Scott Singer Installations, Inc., T.C. Memo 2016-161 (August 24, 2016), the sole shareholder and sole officer of an S corporation loaned over $1 million to his corporation over about a 5 year period. During the same period, the company paid the shareholder’s personal expenses by paying his creditors directly.

All of the cash advances by the shareholder were reported as shareholder loans on the corporation’s books of account and on the Form 1120S. There were, however, no promissory notes executed and no interest charged.  (A discussion of the correct way to calculate and document interest charges under the tax rules is beyond the scope of this article.)

The IRS audited the books and records of the corporation and concluded that the payment by the corporation of its shareholder’s expenses was taxable income to the shareholder, and, further, subject to employment withholding taxes. The IRS further concluded the advances made by the shareholder were contributions to capital. While such treatment would have the effect, among other things, of increasing the shareholder’s basis in the corporation, it would also generally render the repayments of the advances as return of capital, rather than debt repayment, and the interest portion would not be recognized for tax purposes.

With regard to the advances, the Tax Court weighed the factors associated in law to determine of there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention was consistent with the economic reality of creating a debtor-creditor relationship. The court found the fact that the corporation consistently carried the advances as outstanding loans on its ledger. It further found that the consistency of the corporation’s payments expense payments for its shareholder, even when the corporation was losing money, supported the conclusion that such payments were debt service and not ordinary income.

The Tax Court’s discussion calls to mind the nonexclusive 13 part test typically used in evaluating the nature of transfers to closely held corporations:

  1. The names given to the documents that would be evidence of the purported loans;
  2. The presence or absence of a fixed maturity date;
  3. The likely source of repayment;
  4. The right to enforce payments;
  5. Participation in management as a result of the advances;
  6. Subordination of the purported loans to the loans of the corporation’s creditors;
  7. The intent of the parties;
  8. The capitalization of the corporation;
  9. The ability of the corporation to obtain financing from outside sources;
  10. Thinness of capital structure in relation to debt;
  11. Use to which the funds were put;
  12. The failure of the corporation to repay; and
  13. The risk involved in making the transfers. (Calumet Indus., Inc., (1990) 95 TC 25795 TC 257)

These tests are, of course, factual, and weighted differently in each case. Hence, it is incumbent on shareholders of S corporations to assure, through clear, written and contemporaneous documentation, consistently prepared and maintained, that the elements of the creditor-debtor relationship are demonstrated in cases where the shareholder is lending money to the corporation.

This article is not intended as legal or tax advice and is a discussion of general principles only. The reader should consult with a qualified professional concerning his or her specific circumstances before taking any action.

Smolnik Appointed New Chair of Subcommittee by CT General Assembly

Dan Smolnik, Of Counsel with Pastore & Dailey LLC, has just been appointed by the Connecticut General Assembly to the Commission on Connecticut’s Leadership in Corporation & Business Law.  He will be chairing the subcommittee on tax law and policy.