Steps to make a hybrid model work for your business
Last week we showed you how to retain employees, with methods beyond just a good compensation. This week’s topic ties into this, using what we’ve learned over the pandemic about remote vs. in-person work and what’s best for the business and employees.
In this blog, we will discuss questions to ask to make sure you choose the best model for your company.
Question 1: Can your employees be optimally productive?
While most employers found that their employees were just as productive at home, this varies by industry and employee. It’s important to note that each workplace has a different level of collaboration, and highly collaborative cultures are harder remote, though far from impossible.
Employees have different home environments and may be more productive going into the office or at least occaisionally going to a coworking space. Know each person in order to meet their needs, so they can be their best for the company.
If you do choose remote only, you will want to check in with your employees both as a team and individually, weekly. Calls and e-mails in between will help with keeping the motivation and urgency up, and collaboration and communication flowing smoothly.
Lastly, give your employees tools to collaborate (applications like Zoom, Miro, Google docs/Microsoft Word docs in OneDrive, etc.). This will enhance teamwork, potentially even more than the in-person atmosphere did.
Question 2: What’s the cost-effective choice?
For small businesses and startups, the overhead of paying rent for office space is simply not economical. If your competitor(s) is(are) a remote organization, they already have a huge advantage over you. You could use that money toward more compensation, benefits, events, and/or coworking space memberships and still have money saved. Remote work is certainly here to stay. A Standford study conducted in June of 2020 found that 42 percent of employed Americans were working from home full time (Bloom, 2020). This year, the American Opportunity Survey found that 58 % of workers have the opportunity to work from home at least one day a week and 35% of workers have the option to work from home five days a week (McKinsey, 2022). This is the new norm and employees, and clients may expect at least this type of hybrid of the two – remote AND in-person.
Question 3: Does everyone want a hybrid model?
Make sure you poll your employees about their wishes if your company is implementing a big change. During the pandemic, many workers did not like the forced nature of working from home. If they have a say, they are more likely to buy into the idea, even if they don’t get their ideal work situation. When it comes to a hybrid model, there are many different work schedules to consider: week by week (one week in the office, one week remote), synchronized schedule (people share office spaces and only a few people are in the office on a given day) and choice (employees can choose between the office or remote).
Question 4: Are there times when everyone can meet?
An advantage to fully remote work is that you can bring in talent from multiple states or countries. The disadvantage is that communication can be more challenging with different time zones. There are two things to consider here: 1) making sure that employees have the tools they need to work independently on their own time and 2) embracing asynchronous communication, which is that you cannot expect your employees to respond immediately. Do make it clear what the communication expectations are, though (e.g. emails are answered within 24 hours, calls within 4 hours, etc.).
Question 5: Do you have the IT, cybersecurity, and online community tools needed to be partially or fully remote?
Give your employees tools to collaborate (applications like Zoom, Miro, Google docs/Microsoft Word docs in OneDrive, etc.). This will enhance teamwork, potentially even more than the in-person atmosphere did.
Question 6: What do you need to be compliant?
You must pay taxes to the state in which the work is performed, so this gets tricky if you have employees in many different states. For certain corporations and LLCs, you may need to apply for foreign qualification to do business in the states your employees are in.A permit could be required for each employees’ home occupation, although this mostly applies to governmental agencies. “Tax nexus” may come up if you have a tax presence os are “doing business” in another state.
This could include sales, income or other tax types. Classify your workers as independent contractors (if they and their job duties qualify) to reduce payroll taxes and other labor costs. A couple other imperatives are workers’ compensation and unemployment insurance. Cybersecurity is also a good idea in order to prove you have kept data private and secure. Since everyone has their own phones and laptops, it is important that servers are online and secure (such as Google confidential emails, Microsoft 360 and DropBox). A password keeper such as LastPass is also important to share within the company yet keep passwords complex enough to be hacker-proof.
IPO stands for initial public offering. An IPO means that a privately held company offers its company shares for the first time to the public by listing the stock on the national exchange. This action allows companies to raise equity capital through new stock issuance.
Why Do Companies Goes Public?
There are many reasons a company wants to go public; one of the main motives is to raise huge capital during the company’s growth stage. Usually, during this stage, companies require fast funds to meet the demand of the growing business.
By going public, companies have one thing in mind, which is to raise funds constantly. The expansion of a business is limitless compared to being privately held. Besides that, it also strengthens the business brands and credibility.
The Pros and Cons of IPO
Some of the key pros are:
The ability to raise equity capital
Strengthening the brand and credibility of the company
Possible increase in the company valuation by taking advantage of the share trades by the public
Creating visibility and publicity
And an exit opportunity.
Every IPO brings a set of risks such as:
Market pressure on the share price
Potential loss of control in the business growth and ownership
The need to expose lengthy financial information to the public
The cost involved to go public.
Process and Compliance of IPO
For a private company to go public, it takes six months to a year to complete. It is a lengthy process that is required by the SEC.
To find a suitable investment bank: The purpose of the bank is to provide sound advice and other services like underwriting. Typically, an investment bank is chosen based on
Quality of services,
Expertise in a specific industry favorable to the company
Type of distribution the bank does.
To perform due diligence and filings: The bank’s role as the underwriter is to act as a broker between the company and the public. Usually, the underwriting comes with a selected commitment level by the bank.
The best commitment will be the ‘firm commitment’ whereby the bank buys the whole shares from the company and sells them to the public.
The other type of commitment will be the ‘best efforts’ where the bank doesn’t guarantee the fund amount raised for the company but merely sell the stocks on behalf of the company. ‘All or none’ commitment requires the whole stock issuance to be sold, or the agreement will be canceled.
The bank will share the risk of an IPO with other banks through a ‘syndicate of underwriters. Whereby the bank will ally with different banks to sell the IPO.
The bank will then draft the engagement letter, letter of intent, underwriting agreement, registration, and red herring document.
Pricing: The bank will submit the paperwork for SEC approval. Once approved, the bank and the company will discuss the pricing of the stock. A few factors must be considered when fixing the price, including the current economic condition and the company’s goal.
Stabilization: Under this step, the bank will have to provide analyst recommendations followed by after-market stabilization. Then to create a market for the stocks issued.
Market Competition Transition: Under this final step of the IPO process, the market competition will start after 25 days of the cooling period as per the SEC’s guidelines. This means the public will transition from relying on mandates and prospectus for the stock’s information to market forces after the cooling-off period.
The required form to be completed for an IPO is the SEC’s S-1 form, which can be found on the SEC website. (https://www.sec.gov/files/forms-1.pdf). SEC will determine if a company is eligible to go public by verifying the information on the form.
Is IPO a good Exit Strategy?
IPO is a good exit strategy if the IPOs are successful. Many startups prefer IPO, which can quickly raise huge equity capital for the necessary business expansion. Once the stock reaches the secondary market (generally after the cooling-off period whereby the public can sell their shares), the market forces begin to impact the value of the stock.
When there is high trading activity on the stocks, there is a possible increase in the price per share. This strengthens the value of the company and increases the public interest.
There are three approaches under the IPO exit strategy:
Flipping: This happens when investors start liquidating or selling their shares after acquiring them. Usually, the share price is higher when it reaches the secondary market, leading to further inflated prices when the shares are in demand. The market makers, underwriters, and even the company do not encourage this approach.
Long term investment: Under this tactic, investors who acquired shares at the lowest price would benefit from high profit if and when the shares are held longer, taking advantage of the rising share price in the long run. This is a typical scenario in large-cap growth stocks.
Observation of the lock-in period: Usually, there will be a lock-in period for shares held by private investors. According to the SEC, private investors cannot liquidate their holdings entirely during the lock-in period (usually between three months to two years). This is to mitigate any sharp fall in the value of the stock, thus controlling the share price by moving down sharply.
How can Startup Tandem help?
IPO is the quickest and most efficient way to fund a company’s growing needs and effectively grow the business’s size. Even though the process of going public can range from six months to a year and requires adherence to complex regulations, it is worth it as the possibilities for expansion are prominent and endless. Companies who wish to use IPO as an exit strategy, especially startups, could benefit from the market forces on the valuation of the business in the long run.
Startup Tandem has licensed advisors to help you during the process. If this is an exit strategy you have been thinking of, we can help you during your assessment to determine if indeed this is the best option for your business during this economic time. Learn more on how to choose the best exit strategy here.
Last week we showed you how the most important step in avoiding expensive turnover is to hire the right person, including but not limited to values, personality, soft skills, diversity, and inclusion. The next step is to keep these employees with
In this blog, we will discuss steps to make sure you retain employees as you continue to grow your business.
Step 1: Compensation and Benefits
Dan Price, CEO of Gravity, (a credit-card-payment-processing company in Seattle), decided in 2015 to pay his employees a MINIMUM of $70,000 per employee. He justified this with social science research linking sufficient levels of income to greater well-being, combined with findings that benefits of happiness carried over from the personal to the professional sphere. Additionally, Seattle has a pretty high cost of living. He even cut his salary from $1.1 million to $70,000 a year (Ryans, A., Pahwa, A., Tao, L., Summers, T., Oh, W.-Y., and Chang, Y., 2015).
Gravity cut retention in half. But from this case, we learned that money is not everything. Money did not drive some people at Gravity, and they even disliked the pay increase because it felt like a handout, not based on their performance. So, while it’s competitive to pay your employees well, an important consideration is to include an element of “pay for performance” in their compensation packages.
A Harvard Business Review study conducted in 2017 provided 2,000 American employees, ages 18 to 81, a list of 17 benefits and asked them to weigh them when deciding between a high-paying job and a lower-paying job with more perks (Jones, K. 2017). The top benefits that would tip the ladder were better health, dental, and vision insurance, followed by flexibility and improved work-life balance. The last two highest scoring benefits were more vacation time and work-from-home options.
Step 2: Culture
Last week we talked about how hiring the right person, who is aligned with your company’s culture and values, is the most important thing you can do as an employer to avoid attrition. But how do you keep them aligned? It might sound like a turn-off, but performance reviews are the answer.
Performance reviews need to be:
1) your employees evaluate their work performance and
2) include culture and values alignment in this process to reengage and refocus their energies.
Creating a culture of recognition will also keep employees on board. People want their colleagues to catch them “doing good.” Consider creating a “kudos” system – where employees can recognize each other publicly on an app like slack or even systematically through email. Verbal praise also helps employees feel appreciated.
Step 3: Training and Development
This is the most ongoing step and should never end for your employees if you want them to stay. Training and development not only give them the skills and knowledge they need for the job but also help them feel appreciated and invested in. Just like you want your employees to believe in the company, they want you to believe in them.
There’s no need to reinvent the wheel. We look to companies with a proven track record, even when working with your small business. For example, as of 2019, Southwest had a 96% retention rate, 44 consecutive years of profitability, and no layoffs in its history.
They have various training programs that start early with college internships and a Technology Direct College Hire program. Southwest Airlines University provides virtual and in-person training to not only increase skills for the job and to foster personal growth and development. “Days in the field” provides on-the-job training aimed at the future in which they can experience other departments they may want to grow into. Lastly, “leadership development” assists with individual development as well as that of the company. Instead of hiring from outside for management and c-suite positions, employees are simply promoted from within after completing this rigorous training. This is retention at its finest.
How Can Startup Tandem HR Help?
If you follow these simple steps, you can retain your employees for years to come. Although it may take some time and money to implement culture and training programs up front, the cost is minimal compared to turnover and/or implementing these programs down the road.
How to choose the best exit strategy for your business?
Every entrepreneur has one target in mind when starting their business, to grow and to be profitable in the long run. Many entrepreneurs start a business to multiply its and other stakeholders’ investment. It has been more common lately to see a company go thru an IPO or acquisition as an exit strategy. This blog will discuss how to choose the best exit strategy for your business.
As discussed in our blog, starting a successful business in an inflated economy, you have the opportunity to create innovative products or services to solve a problem that arises during hardship times. As an entrepreneur, you have the power to influence and change the current ecosystem by building a great startup. So why think about an exit?
Reasons why an exit strategy is needed
Many factors can contribute to an exit:
The business has been running at a loss for a while now
Legal reasons such as massive lawsuits
The demise of the owner (usually sole proprietorship)
Merger & Acquisition looks appealing
IPO to multiply investors’ money
What makes an exit a bad strategy?
A lousy exit usually involves poor strategy adaption. When a business owner decides to halt the business, choosing the right exit strategy is vital. Poor strategy management may cause financial losses and even steer the business brand away from its values. Business owners can choose the suitable method based on the business needs; every element of the strategy implementation is essential for a smooth exit process and optimizing business outcomes.
Most common exit strategies
There are a few exit strategies that we will discuss here. The most common ones are:
Transferring the business to another family member or a neutral person
Merger and Acquisition
Selling the company to a partner or an interested investor
IPO (Initial Public Offering)
Exit Strategy 1: Transfer the business to a family member
Why choose this exit strategy?
As a business owner if you decide to retire, one of the most common ways to exit the business is by transferring to a family member. Business owners like this exit strategy as they are able to keep the business with family and pass it on from generation to generations to come.
Factors to consider when exiting this way.
It is prevalent to inherit a business from a family member. Usually, this type of business is more mature and established in the economy. The transferee should evaluate some factors before beginning the transfer. First of all, the soundness of the acquiring party. It is crucial to ensure the new owner has the mental and financial ability to take over the business and sustain its values and profitability. It can often become a challenge for both parties to have the same business practices mindset. Both parties should try to reach a common ground where the transfer can be done smoothly while ensuring the legal aspect of the transfer has been taken care of.
Exit strategy 2: Mergers & Acquisitions (M&A)
Why choose this exit strategy?
This M&A strategy is most common among startups and business owners. It can be a preferred strategy as the owner can set their terms, continue to hold control, and influence the price of the acquisition.
Factors to consider when exiting this way.
There are two outcomes from this type of transaction: either businesses merge and maintain equal interestand holdings, or the acquiring party becomes the major stakeholder of the merged entities. When the latter happens, the appointed CEO will be from the acquiring side, and significant changes can be made to the structure and processes of the other company. This strategy requires internal and external expertise to complete each transaction area and weigh the outcome of such activity. Some of the crucial part that will decide whether to continue with the strategy is the projected profitability, the size of the debt, and any ongoing legal issues that might fail the purpose of the M&A transaction. More on this topic soon!
Exit strategy 3: Business Liquidation
Why choose this exit strategy?
Business owners are ready to liquidate their business and move to the next venture. This may sound very appealing to a business owner if the passion for the business is lost. If the entrepreneur does not have any family members or partners to sell the business to, then liquidating the business is the preferred stategy to exit.
Factors to consider with this exit strategy.
It may sound simple and easy, but it is critical to inspect and ensure you create a proper checklist for each business area. Liquidating a business translates to permanently shutting down the business, so it is essential to ensure the business values and brands stay positive in the market and that such a decision will be profitable. Business owners often seek external services to help analyze and compile the necessary data to adapt the exit strategy successfully.
Exit Strategy 4: Bankruptcy Filing
Why choose this exit strategy?
Almost all business owner tries to avoid this type of exit. Filing for bankruptcy often relates to the inability to sustain the business profitably while the level of unpaid debt is snowballing. To avoid being sued or the possibility of losing not only business but personal assets, many owners’ resorts to this avenue. It takes a thorough process to qualify for the filing.
Factors to consider with this exit strategy.
Business owners should weigh the outcome and the consequences so that it will appear beneficial for choosing this exit strategy. We recommend seeking professional services to advise and assist in consolidating the business for filing purposes.
Exit Strategy 5: Selling the business to a partner or investor.
Why choose this exit strategy?
The exit strategy above is pervasive, especially among startups and small businesses. For example, many small entrepreneurs create business pages on social media such as Facebook to market their products and services. In time, the pages might have gathered a large number of followers, which might pique others’ interest in buying over the page with the acquired followers. It is easy for an interested investor to market their business with an established page with more significant followers by just changing the page’s name and other details while maintaining visitors’ traffic.
Factors to consider with this exit strategy.
Suppose business owners wish to sell their business, especially the ones with established brands. In that case, they should carefully review the circumstances and potential loss of future profit by analyzing the company’s value at the time of the sale.
Sometimes, it will include a royalty income in the sale agreement. There are many angles to be looked into before effecting any deal to achieve the best outcome.
Exit Strategy 6: Initial Public Offering (IPO)
Why choose this exit strategy?
An Initial Public Offering (IPO) is also a desirable exit strategy for entrepreneurs and investors. This exit strategy can substantially multiply the investment of private investors and business owners, making it very desirable.
Factors to consider with this exit strategy
Many factors can affect an IPO, such as market conditions can influence how profitable this exit strategy can be. Other reasons companies go for IPO include brand strength, liquidity, company success, and improved market valuation. We will write more on this strategy next week.
How can Startup Tandem help you?
As a business owner, you should partner up with a team that can help you choose the best exit strategy for your business and support you in the process that comes with it. All of these exit strategies need finance advisory and legal support.
The advisory team at Startup Tandem is available to help you prepare your company to achieve the desired exit. Startup Tandem advisory can help you value your company by using the discounted cash flow or LBO model and provide advice on any transaction to achieve the best exit possible for you and your investors.
Startup Tandem has developed a network of businesses and individuals that come together to help startups and small businesses. Reach out if you need referrals or if you need to discuss any of these exit strategies more in depth.
Avoid expensive employee turnover by improving your hiring practice
As a small business owner, you may not have a human resource department to guide you through the best recruitment, hiring, and retention practices. The process of recruiting for the same position comes with a significant cost attached to it. This blog will discuss steps to improve your hiring practices as a business owner. Avoid expensive employee turnover by improving your hiring process thru these steps below.
Human Capital is the Greatest Asset.
It does not matter what industry you are doing business in, retaining human capital is the most valuable asset in an organization. Employees are either interacting with customers directly or indirectly when creating products. Therefore, hiring the best candidate is the first step to avoiding the expensive costs that come with employee turnover.
Employee turnover can get expensive
During the replacement process of an employee, a business loses time and a tremendous amount of money. The Society for Human Resource Management (SHRM) reported that “on average, it costs a company six to nine months of an employee’s salary to replace [them]. Let’s consider an employee making $60,000 annually; replacement fees come to $30,000 – $45,000 in recruiting and training costs.”
You may have many reasons to let go of an employee or for them to quit. Still, hiring the right person aligned with your company’s culture and values is the most important thing you can do as an employer to avoid attrition.
Hire and build a diverse team
You should aim to attract a diverse talent of individuals. Companies that have diverse teams are proven to be more successful at making better decisions as everyone has different problem-solving skills and resources. If you build a diverse team, you will also be able to connect with different types of customers. Diversity is the way to go when building a successful organization!
Step 1: Culture, Culture, Culture (and Values)
Of course, you want to make your culture attractive to recruit the best of the best. But you also need to hire people who will be a great cultural fit for the company. Determine the motivation for each prospective employee and see if it aligns with the company’s values (E.g., Here at ABC company, we want people who want to grow and learn).
Step 2: Hire for personality, train for skill
The most successful companies understand that you can’t change personality (a soft or “power” skill). They are forgiving about not having “hard” skills because they realize most people can quickly learn these skills with the proper training. Southwest Airlines coined the term “hire for personality, train for skill” and has done just that for years (Baker, 2014). Trader Joe’s is known to hire for “personality, specifically extroversion” (Ager & Roberto, 2014). Both these companies see that retaining employees with a great culture and training is cheaper in the long run than hiring people who later leave or get terminated. Attracting the “right” people is paramount.
Step 3: Cross your T’s and Dot your I’s
Do good work at both the attracting and deciding phases. Do not skip any of these steps just because you like a candidate.
Ask questions about competencies/knowledge, skills, and abilities (KSAs) needed to succeed in the specific position.
Ask questions about a prospective employee’s personality, vision, mission, values, and culture.
Ask, “Why this specific company?” This question will immediately let you know if they’ve done their research.
Ask, “why remote/hybrid/in office?
Ask, “Why this specific industry?”
Ask both behavioral and situational questions. “Behavioral… focuses on a candidate’s past experiences, behaviors, knowledge, skills, and abilities by asking the candidate to provide specific examples of when they have demonstrated certain behaviors or skills to predict future behavior and performance. Situational questions give the interviewee a hypothetical scenario and focus on a candidate’s past experiences, behaviors, knowledge, skills, and abilities by asking the candidate to provide specific examples of how the candidate would respond given the situation described.” (SHRM, 2022).
Ask for completion of a valid personality test such as the Caliper.
Ask for consent to a background check (criminal, civil, degree confirmation, license confirmation, etc.)
Ask for three professional references and call all of them even if they provide a letter of recommendation. Some people will tell you things verbally they would never write in a letter.
Offer a limited window to sign an offer letter and employee agreements but offer support and be available/approachable for questions and negotiations. This creates a sense of urgency and lets you snag that desirable candidate.
Step 4: Create a hiring matrix
This technique has come very usefully for the Startup Tandem team. This matrix should have the following factors:
Decision criteria can be such as ‘professionalism, skillset’ in certain area etc.
Weight assigned to each criterion ex: 25%,50%
Rating per criteria ex: 5,4,3
multiply weight and rating to get the score per criteria
Comments per interviewer
Be sure to file a new hire report in your state. This determines if the new employee owes money to the government (e.g. child support). If they do owe money, the court or government agencies will mail you information on how much to deduct from their paychecks so your employee can pay back their debt. In California, for example, if the employee will be paid over $600, the form needs to be filed within 20 days via Form W-4 (form will vary by state) or you will face late penalties.
As they change, follow all state and federal anti-discrimination laws every time you hire an employee. For example, “California law protects individuals from illegal discrimination by employers based on the following: Race, color. Ancestry, national origin. Religion, creed.” CA Civil Rights Dept. Report all employees’ data annually to the Equal Employment Opportunity Commission (EEOC). This is not something you do upon hire, but rather by the annual deadline. You will find the reporting dates on our Startup Tandem HR Compliance Calendar. The last one was May 17, 2022, but they often get extended.
What to do next?
As a founder, CEO, and owner of your own company, you should allocate time to developing a correct hiring process that is aligned with the values of your company. developing these processes will avoid expensive turnover. There are compliance policies that you should keep in mind when hiring, which can become challenging to navigate. A partner like Startup Tandem can help you set up such processes and build a budget for retaining valuable human capital.
If you follow these simple steps, you can hire the right person who will strengthen your culture for years to come. Although it may take more time and energy than your current hiring process, this is an opportunity to cut those tremendous turnover costs. Ideally, you will lose very few employees over the years.
Startup Tandem CFO can help you create a budget that includes expenses such as software to run a background check, personality, conflict management, and leadership tests. Your budget should also include training and retaining human capital. Following hiring the best people for your company comes retaining your employees. We should also help you track your actual versus your forecasted expenses in the budget to stay on top of your cash flow.
Now that we discussed how to avoid expensive employee turnover by improving your hiring process, you can learn how employees like to feel appreciated by their boss. Everyone has a different way of feeling appreciated by their boss. Our blog Unique Ways to Optimize Retention, Engagement, Productivity – Startup Tandem, will give you some insight on how to increase retention. More on this topic soon! Sign up for our newsletter to receive blogs directly to your email.
Ager, D. & Roberto, M. (2014). Trader Joe’s. HBS No. 9-714-419. Boston, MA: Harvard Business School Publishing.
Baker, W. (2014). Southwest Airlines’ Nonstop Culture: Flying High With Transparency and Empowerment. HBS No. W94C04. Boston, MA: Harvard Business School Publishing.
What to do with the new tax reform as a business owner?
Biden’s new proposed tax reform to increase tax on carried interest can negatively affect institutional investors and small businesses. This will affect small business owners, startups, and projects, in this blog we will discuss what to do as a small business owner. Before diving into this topic, we should understand how private equity works.
What is Private Equity?
Private equity is essential in helping private businesses obtain funding. These firms manage funds to help private companies such as startups expand their working capital, scale operations, make acquisitions, or fund new projects.
In most cases, it is a common and preferred avenue to raise capital or for a business expansion compared to obtaining money thru debt.
The funds they manage can come from Limited Partners, a combination of high-net-worth individuals and institutional organizations.
Private equity firms can manage many types of funding; the most commonly used for startups is Venture Capital.
Venture capital is a fund used for a new business or a matter of expansion. Not all Venture Capital is made equal. Venture capital firms with millions of assets under management will only cut a check for a startup if this raises a series B or higher. These startups are in the growth or maturity stage of their business cycle.
Usually, these investors intend to cash out their investments during an initial public offering or an IPO.
How does Private Equity help startups?
Private equity is different from traditional financial instruments. These companies will provide capital to startups in exchange for the company’s stock. Unlike other financial institutions, obtaining money does not come with high interest and poor repayment plans. Therefore, they make the preferred choice to expand the cash runway for a startup.
In some cases, Venture Capital firms or individual investors will offer their knowledge and expertise to help scale the business. This level of involvement is not usual in traditional financial institutions.
How will the proposed tax reform affect private equity?
The main issue discussed in the tax reform on private equity is the carried interest allocations. In 2018 the allocation increased from 1 year to 3 years, which means investors can only claim capital gain with a favorable tax rate on the carried interest of an investment after three years of holding period. Recently, the government has been looking at extending the allocation to 5 years with a higher tax rate. This issue will impact individual and institutional investors as they won’t be able to take advantage of the much more favorable tax rate on capital gains than the income tax rate.
What does this mean to business owners and investors?
The new tax reform on private equity will directly impact new business and business expansion activities that rely heavily on private funding. Investors might shy away from private equity investment or be looking into liquidating their current holdings to escape the possibility of the allocation extension.
Acquiring debt will be the next option, but the recent increase in the interest rates might make it difficult for a business. Especially if a business is an early-stage startup with no strong credit profile, history, or cash runway.
Merger and acquisition activities might also be affected due to higher interest that needs to be paid to transfer or acquire the other entity.
Funding startups and small business has been one of the biggest use of funds. This new tax reform will affect investors on how they invest and small business in obtaining available funds needed to navigate the economy rising prices in logistics and raw materials to name a few.
What is a possible solution?
There are ways to minimize the Fed tax rate on carried interest allocation so that investors might still consider investing. One way is for new businesses to apply and qualify as small business stock (QSBS) under Section 1202.
This step will allow individual and institutional investors to exclude 100% of their capital gain from the sale or exchange of QSBS if held for more than five years. You can acquire more information thru the Securities of Exchange Commission (SEC) website.
How to qualify as a QSBC
To qualify for as a small business stock (QSBC) there are a few items to check of the list:
The small business needs to meet and pass the ” qualified trade or business” test. Meaning only small businesses that offer services and products that do not rely on an employee’s skillset to earn revenue. Retail, wholesale, manufacturing, and technology companies meet this test. Firms like professional services in finance, accounting, engineering, hospitality, farming and mining do not pass this test.
The business has to be a domestic C- Corporation
The accumulated assets for the small business are less than $50 Million.
How to claim the tax benefit on a QSBC
For an investor to be able to avoid the tax on carried interest, this must:
The investor needs to be a natural person, meaning not a company
The investor must hold the stock for five years or more
The stock is sold thru private placement like private equity
This stock should be purchased with cash or assets or exchanged for service
How can Investors still benefit from investing in private equity despite the new tax reform?
Investors can waive the carried interest allocation when there is subsequent appreciation in the holding investment. To be able to do this, comes down to the profit-to-cost ratio, whereby waiving the allocation will not impact the total return of the investment. Institutional investors may narrow their investment into operating partnership businesses or private companies so their income will be less affected by this event.
How are you affected as a consumer?
Consumers have no direct impact from this event; however, due to inflated interest rates and inflation, the spending power might be adversely affected, thus lowering the demand for goods and services. This reform will impact businesses’ sustainment and growth as demand is not meeting the supply. The increase has been seen in the Consumer-Packaged Goods industry, particularly companies whose products are in the cyclical sector.
What can you do to mitigate the risk of losing investors?
At this time, it is vital to seek professional advice and services to maneuver the process in the right and profitable direction for those who are starting a business or planning for an expansion. You can adapt many strategic moves for smooth sailing for business owners and investors.
Time and acquiring the right information are essential elements for a smart business movement.
How can Startup Tandem help?
If Biden passes this new tax reform, funds will be limited to support the growth and initiatives that small businesses take to help the economy, and environment. Venture capital firms greatly fund the innovative startups with surge, angel investors and other PE firms. Without the support of these funds, the United States startup ecosystem will decline. If you have a startup, it is imperative as a startup owner to act fast.
Startup Tandem provides fractional CFO services for startups and small business owners. This service helps small business owners prepare smarter to proactively create forecasting, manage cash, budgets, and financial analysis of their current business financial health and assess to meet growth plans.