One of the hot issues that are recently emerging out of financing transactions in the high-tech industry is the sale of stock by founders of a company, as part of an investment round in the company ("Secondary Sale"). In short, most of the early stage high-tech companies are initially bootstrapped i.e., financed by their founders, and sometimes also by friends & family, and angle investors. Because companies lack significant finance sources in their early stages, the founders usually withdraw minimal salaries from the company as compensation for their services. The first time when founders meet with significant finance sources is upon a later financing round. Thus, in many events, upon an investment event the founders insist on getting (or the investors propose to allocate) some amounts from the investment, to make a Secondary Sale and to allow some liquidity for the founders. In some later financing stages, investors offer to purchase common stock in addition to the preferred stock in which they are investing, either because they want to own a larger percentage of the company or the investors may do this because some of the founders have expressed a desire for liquidity.
As in most investment rounds, investors get preferred stock for their investment (while founders hold common stock) they expect to receive the same through the Secondary Sale. One way of achieving such outcome, is by the conversion of founders' common stock into preferred stock, prior to the sale, and in the frame of the investment transactions.
The issues arise because in many cases, the value of preferred stock exceeds the value of the common stock (due to liquidation preference, participation rights, or other benefits, which are only attached to preferred stock), and as a result, the founders get an additional benefit from the company upon the conversion of the common stocks to preferred stocks. For example, let's assume that the fair market value of a common stock is $10 per stock and the fair market value of the preferred stock is $13. That means the founder gets a benefit of $3, from the company, for each stock that is being converted. This create two main tax exposures:
If such sellers also serve as employees or service providers of the company, such conversion may deem this additional benefit as a consideration for the sellers' employment or services to the company, and therefore, the excess value of the preferred stocks may be taxed as ordinary income rather than...