Mark: One buzzword you hear in technology M&A is reverse vesting or re-vesting. That's a requirement imposed by a buyer to get retention value for the key employees that are part of the deal by requiring, even if you're a founder that has fully vested in your equity, to re-vest a portion of that tied to your continued employment with the buyer. It ranges anywhere from 25%, sometimes all the way up to 100% over a 2-4 year vesting time period.
But it's a negotiable term, one in which buyers want to get the retention value and something that also can raise certain tax implications. What are the tax implications of the re-vesting feature that we see commonly in deals these days?
Eric: Sure. So whenever you have a payment that is tied to the future performance of services, it raises a concern as to whether that payment should be treated as compensation for services. And that's generally bad news for sellers because compensation for services is generally subject to the highest tax rates, whereas deal consideration, proceeds for stock, is generally eligible for more favorable capital gains rates, as well as potentially 100% exclusion as qualified small business stock, or QSBS.
Fortunately, there is favorable tax authority that says, notwithstanding the fact that that consideration may be tied to future performance of services, as long as it's a value for value exchange, namely that the stock given up by the selling shareholder is equal in value to the buyer equity or other consideration that they receive in that transaction, that it will not be treated as compensation, even though it's subject to continued performance of services. However, it's critical to have the parties agree on the reporting of that, consistent with that treatment as deal consideration and not compensation for services.
Mark: So basically, in my experience, it's a requirement imposed by buyers, but not one that the sellers ought to be exposed to extraordinary tax risk because of the magnitude of the tax implication if it were recharacterized as compensation.
So it's important to know that the terms of the re-vesting is negotiable. There are acceleration rights that can be negotiated to the individual's benefit. And for sure, we need to make sure that the tax alignment between the parties is obtained so that we can mitigate that risk.