Webinar Video: QSBS 1202: A Powerful Tax Benefit You’ve Probably Never Heard Of
In this educational webinar, Damon Elder, publisher of The DI Wire, Justin Reich, president and chief executive officer of Seedbrite Ventures, Brad Updike, partner with Mick Law, and Matt Chancey, a private wealth advisor and tax strategist with CoastalOne, discuss Internal Revenue Code section 1202, which provides for capital gains tax exclusion for investment in qualified small business stock.
“It’s an extremely powerful tool, one in which the IRS and the U.S. Treasury is encouraging investors to make investments into qualified small businesses,” said Reich.
The DI Wire recently published an article authored by Updike, Reich and David Cohen, Seedbrite’s general counsel, which details IRC 1202 and how investors can capitalize on its benefits.
Video Transcript
Damon Elder 00:10
Hello, and thank you for joining The DI Wire webinar. I’m Damon Elder, publisher of The DI Wire. I’m joined today by Justin Reich, president, and CEO of Seedbrite Ventures, Brad Updike, a partner with Mick Law and a member of the Board of Directors of ADISA. And Matt Chancey, a private wealth advisor and tax strategist with CoastalOne. Today we’ll be exploring a powerful tax benefit you’ve probably never heard of, Internal Revenue Code section 1202 and how it relates to investment in qualified small business stock. Now, I’ll have to admit, this is something I’d never heard of until about a month or so ago when The DI Wire published a byline article by Brad and Justin and its partners discussing this topic. So, I suspect most of our audiences probably never heard of it. So why don’t we dive right in. Justin, we’ll start with you. What is IRS section 1202 and what benefits does it provide?
Justin Reich 00:57
First, thanks for having us, I really appreciate it. It’s a very powerful benefit that the US government, the IRS is providing investors who invest in qualified small business early-stage companies. They’re encouraging investors to take risk to invest in early-stage company in exchange for that risk, not a deferral, not a deduction, but the IRS is allowing you to exclude a hundred percent of your capital gains taxes upon exit. So, it’s an extremely powerful tool, one in which the IRS and the US Treasury is encouraging investors to make investments into qualified small businesses.
Damon Elder 01:41
So, is this a relatively new section of the code? How long has it been around? You know, what’s the genesis there?
Justin Reich 01:48
Sure. It originated in 1993. And what I think is interesting and unique about this provision is that over time, most provisions associated with deferrals or deductions get attacked in a negative way over time. But this provisions actually improved. In 1993 the exclusion from taxation for capital gains was at 50%. And over time I think in 2009, it went from 50% to 75% exclusion. In 2015 it went to a hundred percent permanent exclusion of capital gains. So, it’s a very powerful tool. It seems like the government wants to continue to encourage the investment into qualified small business stocks, small companies because those companies hopefully will become large companies that will pay taxes and employ thousands of people. So, it’s a great benefit that continues to be improved. And the last thing I’ll mention is even as recent legislation that whether or not it passes, we’ll see are trying to lower the hold period requirements from five years to three years. And you’ll hear a lot today about the whole period requirements, but it just shows the interest in making this provision even more broadly accessible and more powerful as opposed to the opposite in terms of trying to cancel it or lower the benefit.
Damon Elder 03:14
Gotcha, gotcha. So, you referenced that this is part of the tax code that’s clearly designed to help capital flow into small startup businesses, and you reference qualified small business stock. So, you know I don’t know Brad, why don’t we point this one to you? You know, what exactly is qualified small business stock? What, you know, what is eligible to participate in this 1202 exemption?
Brad Updike 03:35
Excellent. There are three key attributes of qualified small business stock. First of all, it’s stock that’s issued by a C corporation whose business activities actually will qualify for the gain exclusion. Although S corporations can’t issue it, they can acquire it just like individual taxpayers and pass through entities such as partnerships and LLCs. Secondly, the issuing C Corp must have gross assets of less than 50 million dollars at the time the stock is issued. And then third, 80% of the target companies’ assets must be used in an active trader business. And there are actually two 80% tests that apply from a tax compliance perspective. There’s one 80% test that applies to asset utilization within the companies just active businesses in general. And then there’s also a second more stringent test, which looks at whether or not the 80% actually is of the assets are within qualified businesses.
Damon Elder 04:50
Yeah. Brad, you mentioned that it’s got to be within a business that has an active, that it’s an active trader business. You know, what qualifies as a quote unquote active trader business?
Brad Updike 05:01
Okay, there’s the active trader business requirement. It’s satisfied for purposes of code section 1202. If, first of all the issuer was a C corporation, both when the stock was issued and when it was sold. And then during substantially all of the taxpayers holding period the C Corp, the corporation has to be a C corporation. And then at least 80% by value of the corporation’s assets has to be used in the active conduct of trader businesses and not for investment purposes.
Justin Reich 05:39
One of the ways I, you know, I like to think about the active trader business and Brad, you can jump in if you think it’s the wrong characterization, but businesses that manufacturing distribution, software businesses, businesses that they’re only asset is the skill or reputation of the firm oftentimes are excluded. Think about law firms, think about CPA firms, think about engineering firms, those are firms that typically are specifically excluded from the active trader business definition. So, while I’m painting it with a broad brush, if you really want to think about it, manufacturing, software, distribution, retail, and wholesale businesses, those would fit other businesses like law and engineering and architectural firms where the only asset of the business, the skill and reputation of the underlying professionals usually do not qualify.
Brad Updike 06:37
Yeah, Justin you’re actually referring to that second 80% test that I was referring to, because at least 80% by value of the corporation’s assets also have to be used in the active conduct of one or more qualified businesses, that’s the second part. And then as Justin accurately pointed out those trades or businesses that qualified includes manufacturing, technology, research and development, software design development, then there’s a lot of other excluded categories. It does seem nichey, but there are a lot of companies out there, manufacturing companies and technology companies that are trying to get funded in a view of that. I believe that 1202 has a very large reach.
Damon Elder 07:22
So, there’s actually a defined list or exclusions. The types of business you can’t invest in and the types you can. So, there’s not a gray area there, is that right?
Brad Updike 07:31
No, it’s pretty crystal clear. There are certain, yeah, there are certain sectors that will qualify for the capital gains exclusion, and there are many that don’t.
Damon Elder 07:44
Okay, good, good. That’s unusual in the federal government to provide clarity. So that’s great. Why don’t we turn to Matt, because Matt, I know those of us who know you in the industry, you know, you’re known as a bit of a CPA whisperer, a lot of expertise there and tax benefits and whatnot. So, I want to kind of dive into a little bit more of the history of section 1202. Justin had reference that it’s been around now for, you know, 30 decades or three decades, sorry. And I understand that it’s been utilized over those years among venture capital firms. Why is this and does venture capital investment make sense you know, now from a retail investor perspective?
Matt Chancey 08:21
I think retail investors have always wanted access to, and I guess, well that depends on what your definition of a retail investor is, right. What level of net worth is considered a retail investor? There has to be a breakpoint, but you know, having access to private market investments are something that higher net worth investors are looking for access to. And I think historically there’s a lot of access to maybe lots of real estate programs, development programs, but when you see things that the underlying asset or economic driver is a business there aren’t as many opportunities. And if you think about things like the opportunity zone code that came around a few years ago, a lot of that was based on the concept very similar to this, of economic expansion and growth. Moving capital into a place where it could help economic expansion. A lot of that was fundamentally built on real estate, but there were some opportunities for qualified or for you know, QOZ businesses to get capital gains abatement as well and those were opportunities that were harder to find and harder to uncover.
I think in the 1202 space understanding how to access that pipeline and to be able to invest in small businesses before they go through that life cycle of you know, venture capital then ultimately private equity, maybe have an IPO event and go public and get substantial tax benefits along the way for doing that is a really interesting space for a private market investor. But I think one of the impediments has always been access. And to your point, you know talking about you know, how working with CPAs and other tax professionals, even work with a lot of tax attorneys around the country. They’re always looking for tools that have tax benefits because their wealthiest and their largest clients are asking for, you know, how do we get more tax juice of ultimately what we’re trying to accomplish here for our clients.
And these are just tools that should ultimately be considered. And 1202, albeit something new from an investment standpoint that’s becoming eligible now has a lot of bang for the buck. And there’s a lot of attorneys that have done this with their own individual clients helping them structure their underlying investments to qualify for 1202 with them being an active GP in their trade or business and trying to develop some type of disruptive software or underlying product. But being able to do it as a non-control LP and go along for the ride, I think is something that many of them are finding appealing because we can only have expertise in so many things of ourselves to be able to build a business in. So, to be able to piggyback on somebody else’s ideas a great opportunity.
Damon Elder 10:51
So, you know, you referenced the opportunity zone programs and obviously I think the two most popular tax exclusion programs in the retail space certainly are, you know, 1031 DST programs and obviously in the last several years opportunity zone programs. So, DSTs, I don’t believe come with a hold period, opportunity zones clear to get the full benefit you have to hold that investment for some time. Is there a hold period when it comes to qualified small business stock and the 1202 exemption.
Matt Chancey 11:19
Well, there is, I mean, because we, you have to have, I mean, based on the code we’ve got to, they’ve got to be able to hold the qualified small business stock for at least five years to be able to get that. And look, everybody would like to be, every investor in the history of the world would like to be liquid as soon as they possibly can and not have restrictions on whole period. So, it’s just a function of outweighing to see if the if the restrictiveness of having to hold something for five years is outweighed by the tax benefits associated with getting that. And I think that’s kind of the balance you have to look for in any of these programs. Is the juice worth the squeeze? And so, for the right investor to be able to gain those tax benefits, five-year hold in the grand scheme of thing is not necessarily that long a time, specifically if you could do it in a diversified offering.
Brad Updike 12:03
One thing to point out, I mean being able to satisfy the five-year whole thing period is good and well, but you have to really also pay attention to the exit at the end of the five years because there’s certain transactions that could totally blow your exemption. One being if you have like an asset sale at the end of the five years as opposed to a stock sale because if the company’s just divesting of its assets and then distributing the proceeds that won’t qualify as a sale of the stock. And yeah, you’ve kind of blown the exemption. The exit transaction is critically important.
Justin Reich 12:38
Two things I was going to try to add both to Matt and Brad, what you’re saying is, you know, people have been looking for access to private markets, early-stage companies, credit investors for forever. They’ve been investing in them, but they haven’t found a specific style that allows them to have a diversified approach and access to 1202. Certainly, that’s something that exists now. But the other piece of it that I think is powerful is the five-year hold period, while it sounds like a long time, that’s really what it takes to invest in small businesses and allow them to grow. It’s not like buying a piece of real estate that is mature enough to sell in year two or year three or year four. So, while the whole period appears, you know, long and some might consider it long, that’s really what it takes to invest in early-stage companies and get that company to the next level. I think certain research shows that the average venture investment is held for five years. That that’s what it takes in my opinion.
Matt Chancey 13:44
And I would, and I would caveat that and even say this, I don’t think five years is really that long for a private market investor from another perspective. Any private and market investor that’s ever invested in private real estate. If there’s the development, the zoning and entitlement, the permitting, the underground infrastructure, assembling the sticks and bricks, building the asset, getting a certificate of occupancy, refinancing that stabilizing it and selling that asset, that process doesn’t take, you know, five years is kind of in the ballpark of accomplishing that as well. So, you’re talking about the same value accretion period timeframe that it takes to do the fundamental things that it does to get an economic lift. And if you can do that and accomplish it, you get substantial tax benefits. So, it’s definitely something worth considering.
Brad Updike 14:30
Yeah, I think the five-year holy period, I mean it’s pretty straightforward. The biggest issue though I think the provision that makes it hard sometimes to satisfy that period is the fact that the company has 80% of their assets by value have to be supporting a qualified trader business during substantially all of that five-year holding period. And sometimes that’s hard for some of these companies to do because they style drift, they go into certain areas, certain economic acceptors that may not qualify as a qualified trader business.
Justin Reich 15:04
Yeah, I think going into these assets, knowing exactly what the requirements are and making sure that you have the alignment between the venture manager, the underlying portfolio companies, the structure of this, you know, Brad, you mentioned they have to sell stock at the end of the day to get the full access to the benefit. Everybody’s going into these companies with that underlying expectation and that knowledge. I mean, venture capitalists have been using 1202 for a long time. Now they may not be using it exclusively cause possibly they’re investing in companies that are greater than 50 million gross asset test value. So, they’re, they may not be eligible in everything that they do, but when they know that a company is eligible, they absolutely are ensuring that the alignment is there to achieve the benefit. Cause the benefit, it’s like making an extra 30% plus on your transaction. It’s a huge benefit.
Matt Chancey 16:03
Yeah, absolutely agreed. And I would piggyback on that and say, you know, there’s an ecosystem of investors that are, I would say active GP like starting these type companies that are going to attorneys all day every day in the course and scope of what they’re doing and creating QSBS because they’re entrepreneurial in nature to want to take advantage of that. That’s always been happening in the marketplace, but very few people have ever had access to piggyback along with that. It’s happening and so nobody is going to an attorney hiring a law firm to structure their underlying company to qualify specifically for these benefits and then not going to make, you know, a stock sale on the back end of it and let somebody, you know. The average business sale in an M&A transaction might show up in there and there might be some negotiation between asset and stock sale, but not in this space. They, they’re absolutely going to be looking at a stock sale.
Damon Elder 16:59
Well, I’m glad you brought that up Matt, because I did want to kind of dive into that a little bit longer. Cause Brad, Brad had mentioned, you know, there’s ways to blow the exemption on the exit and during the process I guess during the actual holding period. So why don’t we dive into that a little bit more, you know. What protections are put in place for, you know, investors who are going into one of these programs to make sure that the companies are going to be managed in such a way that the five-year that the exemptions aren’t blown during that five-year hold period or upon exit. Justin, why we go with you?
Justin Reich 17:31
Well, you know, to me the biggest protection is alignment. Every single person involved in the transaction from the underlying initial founder all the way through the VC partner and a fund like Seedbrite, are all investing in these assets knowing that certain boxes need to be checked, certain items need to be done correctly in order to achieve the tax benefit. And everybody in the chain of those events wants to achieve them. There’s, to me it’s pretty simple and the good news, you talk about the IRS code being clear in this case, which it isn’t always in other cases. It’s very clear what everyone needs to do. And I think that that helps ensure that the alignment matches with the ultimate outcome, which is to, to sell stock and achieve that full benefit.
Brad Updike 18:17
Yeah, the alignment of interest, I think that keeps everybody honest cause when you’ve got like the allocation managers and the principles of these PE firms when they have their co the money invested alongside the retail investors, I mean that’s, that’s yeah, going to be good economic motivation.
Justin Reich 18:35
Everyone gets access, the venture managers, the investor LPs, everyone gets access to it. So, nobody wants to blow that exemption.
Matt Chancey 18:43
Sure, sure. And I would, and look, and I would agree, I’ll play devil’s advocate on this one just a little bit to kind of be fair and balanced cause this conversation came up a lot with investors and their tax professionals around opportunity zones. Like, hey, what happens with the 10 years? Well, if somebody came and wanted to buy one of your assets prior to 10 years, like they would have to make one heck of an offer and way overpay for that asset, for somebody to want to potentially blow the tax benefits on that underlying business and not get that gain exclusion. I don’t think that’ll necessarily happen, but that is at the end of the day we’re talking about net net, is what’s the benefit to somebody. So, if somebody really wanted to come in and grossly overpay for something, I think any reasonable manager would have to look at that and say, my job is to manage to a standard of highest and invest for my investors and is taking this, you know, cash offer or whatever that would be today, that stock sale today at an exponentially higher price. If that’s what maximizes value for investors, then I think it would have to be considered.
Justin Reich 19:41
Yeah, that’s a good point.
Brad Updike 19:42
I guess also 1045 should also think about that. Because even if maybe a decision is made by the fund manager to maybe liquidate some of the qualified small business stock holdings, the investor does potentially have an avenue through 1045 to be able to continue that deferral of that gain by rolling that gain into another qualified small business stock, which will be the subject of another article that we’re going to do here in the near future.
Justin Reich 20:09
Yeah, I’ll add one more thing to that, Brad. It’s not just rolling that gain into one other QSBS eligible company. It could be into a QSBS eligible fund that is in 15 or 20 companies. So, it’s interesting to be able to take maybe your gain, let’s say an event like Matt describes happens where after three years somebody’s willing to way overpay for an asset and you have a large capital gain. You don’t just have to put that into one other company to defer that gain and get the exclusion. You can roll that into as many QSBS eligible companies as you want.
Matt Chancey 20:45
True. Sure, and that’s, and that’s an interesting talking point because when communicating with CPAs and attorneys that understand what QSBS is, they typically are thinking about this from a concentrated position to a concentrated position because they’re working with QSBS type entrepreneurs. So, if somebody were to have a liquidity event and get that gain exemption, they would be thinking, well, where do I roll that money over into, through 1045 and get that exemption? Well, they’re not thinking about it, about going into a diversified solution, which would mitigate the risk on the backside. So that kind of, that’s a little bit of an educational piece that we’re having to work through to go, you know, there might be a diversified offering, how do we understand how to access that and still get the tax benefits? So that’s been a little bit of the communication that we’re working through and hopefully this educational tool will help solve some of that as well.
Damon Elder 21:37
I think the point is though, it sounds like there’s flexibility within the code to make sure that investors do have some ability to maneuver around some of the things that could accrue during the holding period. Well let’s go back, Brad, I want to go back to you. You referenced that one of the requirements is that the qualified small business stock be issued by a C Corp, you know, why is that, and is there any provision for an S Corp to, to issue QSBS?
Brad Updike 22:02
The qualified small business stock? I believe what you’re asking, are you asking, I guess your question, can an S Corp like convert to a C Corp and then get the benefit? Is that where you’re going?
Damon Elder 22:14
Possibly, yeah, I mean why is it excluded? Why is it limited just to C Corp?
Brad Updike 22:21
You know, I don’t know that this is kind of speculation, but I did do some internet research a couple days ago. I do know that, although C Corp account for maybe the smallest number of entities in the United States, they do also account for a significant majority of the sales revenues, employee count, and net profits of all US businesses. So, I think it’s a matter of like economic impact. You know, when they looked at this provision, they did want to provide relief for corporations you know, during the great recession. That’s why they ultimately made this a permanent part of the tax code. But in doing so, I believe the C Corp, I mean, that’s where a lot of the economic value, a lot of our GDP lies. So, I think it’s a matter of like economic impact. That’s why C Corp are, are the bene factors of this.
Justin Reich 23:19
Yeah, I’ll speculate a little further on that, Brad, because C Corp was interesting is it’s one of, you know, it’s the entity that doesn’t have pass through associated requirements, right? So, LLCs other partnerships, there’s pass through taxes and people are passing through the income associated with those companies and they’re getting tax distributions. C Corp, the money stays in the company, which is really part of what these early-stage companies need to do to grow. So, I think doing it through a C Corp, a C Corp apparatus and structure actually makes, makes sense. All the money stays in the company to grow these businesses. There is double taxation, which is why you sell stock and not assets when the company exits because you do not pay double taxation on the sale of stock.
Brad Updike 24:15
I think that’s, yeah, the C Corp, I mean also that’s where product value is. I mean that’s where all of the, like the publicly traded companies are. They’re all C corporations.
Justin Reich 24:26
They’re all C-corp. That’s exactly right.
Brad Updike 24:27
So, I would venture to say of all of the equity value among all entities across the US let’s LLCs partnerships, S Corp, C Corp, I meant 90% of that value’s got to be C Corp related, I would think.
Justin Reich 24:42
Yeah, and I think the 2017 tax cut from 35, I think to 21% for C Corp’s also kind of increased the number of people thinking about starting a business using a C Corp as opposed to an LLC. Because the double taxation isn’t nearly as much as what it used to be pre-2017.
Matt Chancey 25:02
Sure. And I would just agree that back on and say you know, the government is trying to incentivize people to build something big to swing for the fences to go for it. Right? And to create something that’s really going to make leave its mark on society. And I and I think that’s, this is how they incentivize that do tax benefits.
Damon Elder 25:19
Gotcha, gotcha. Okay. So, let’s go back into the benefits then. Are there, you know, let’s say you’ve gone through the hold period, you’ve realized again on the investment. Are there limitations on the amount of gain that can be excluded? The cap gains?
Brad Updike 25:32
Yes, there is a cap. It’s the greater of 10 million or 10 times the taxpayer’s basis in the stock. So that means, I guess by way of example, you have an investor that’s holding qualified small business stock. They have a basis of 1 million in that they’ve held it for more than five years. And let’s say they sell it for 25 million, they get to exclude 10 of the 25-million-dollar gain.
Justin Reich 26:01
Right? And the other thing I’ll add to that is that’s per QSBS stock. So, if someone were in a diversified pool and there were 15 companies and all 15 companies had, I mean, unlikely in a venture scenario, but there certainly will be a number of companies that have exits if those companies have exits, it’s not just one investment amount, it’s per qualified small business stock that is owned by the underlying fund.
Brad Updike 26:32
That’s one of the I guess benefits, real benefits of being able to invest in a private equity fund that specializes in 1202 eligible entities because you’re getting access to 20 different, you know, investments instead of like one direct, one-off investment.
Damon Elder 26:50
And then Brad, does the benefit transfer to heirs upon the death of the investor, the death of stockholder?
Brad Updike 26:56
It does. It does, they could, it transfers if there’s a gift during the stockholder’s life. Also, the stockholder’s death the probate heirs, they get the benefit of having qualified small business stock and then also retains its character if a partnership that holds this stock, distributes it to a partner. So it’s really a good asset to hold for estate planning purposes because not only do you get the possible capital gains exclusion if you meet the holding period requirements, but also there are some valuation discounts that will most likely apply to your equity position cause you’ve got minority discounts, marketability discounts that’ll probably factor into the gift or the estate tax valuation of that stock.
Damon Elder 27:46
Alright, great. So why don’t we really dive into it? You know, our audience is really retail investors and their advisors for the most part. So, you know, how does a retail investor, you know, invest in QSBS, take advantage of IRC 1202? Justin, why don’t we start with you, because obviously I think Seedbrite was formed to help retail investors participate.
Justin Reich 28:09
Well certainly you know, our view, and that’s why we’ve created what we think is I think maybe the first specific 1202 oriented fund where every company that we invest in is expected to be 1202. You know, we think there are a lot of investors that are trying to access, Matt mentioned earlier, it’s about access. They haven’t had access to a venture-oriented product before because many venture products have high minimums, have long commitment periods. So, trying to design a product that we think fits with the accredited investor that fits with advisors who are working with high-net-worth investors. That’s what we’ve been focused on. But certainly, I’m expecting there to be others. This will be a booming space over time, and I’d let somebody like Matt talk more about how he sees the appropriateness for his clients. But we do see that there’s going to be substantial demand for a, for this asset class in general over time.
Matt Chancey 29:15
Sure.
Brad Updike 29:16
I mean, local networks, friends, and family like investment clubs that you might find on the internet. Those might be all other, you know, avenues where you can get access to qualified small business stock. But to be honest, yeah, you’re really relying on trust and the vetting is, pretty difficult for a lot of these retail investors. They just don’t have the vetting and due diligence resources that a fund manager.
Matt Chancey 29:43
They don’t even, for the most part, I can tell you from experience, most of them don’t know what due diligence is and aren’t seeing any of it from a sponsor level or a deal structure standpoint. They’re just passing it around between other people that they know. Maybe it’s friends, maybe it’s family, maybe it’s another high-net-worth guy that they share deals with back and forth. Just literally a couple of weeks ago, I was having lunch with a couple of guys both worth over a hundred million dollars that were in individual deals that would’ve qualified. And I said, well, hey, you know, is this structured as a 1202 for QSBS benefits? And they’re like, what are you talking about? They didn’t even know what I was talking about, that it was a benefit when I explained it to them, they were really upset that they’re like, how are we not getting such a thing? But it was just because it wasn’t institutionally manufactured to squeeze all the juice out of the benefit. It was just something that was passed around between a couple of buddies. They thought the underlying business opportunity was worthy of making a capital investment, but they certainly weren’t, they were doing it in a concentrated position and not getting the tax benefits instead of looking at it from an institutionally structured third party vetted and due diligence, diversified offering that got all the tax benefits on a side-by-side comparison. It didn’t really look as appealing to what they were doing, but they felt like they had intimate knowledge of what they were investing in on the other side. And that was ultimately the appeal. And like Brad said, a trusted relationship from an existing network.
Brad Updike 31:09
Fund avenue, I mean, it’s clearly the way to go. Cause if you think about it, like out of 20 of these opportunities, one out of twenty probably going to make it. If you look at national averages, that’s why you really need diversification. You need to be in several of these opportunities because yeah, if you’re just going one off and you’re relying on trust your friends and family to be nice, I mean, yeah, you’re probably going to be very disappointed.
Justin Reich 31:38
And, and I think, you know, Brad’s referencing, you know, is it one out of twenty? Is it three out of ten? I think it depends what type of what type of partnerships you have in the venture capital world. People who invest directly with VC managers, VC managers aren’t just providing capital. They have resources, they have relationships. So being able to invest alongside a real VC manager who’s identifying companies from incubators in the top universities and able to leverage their relationships, oh, we’ve got a relationship, we can get your product into Target. I’ve got a relationship at Salesforce; I can help you partner with Salesforce. That’s what venture managers are doing, which is totally different and distinct from somebody who invests through an investment club or a neighbor who invites you to participate in opportunity. These companies are built to be turbocharged and they’re built specifically with 1202, as an underlying thesis because that’s, that’s the vision, that’s the vision with the VC manager. That’s the vision with the founders which is a lot different than, as Matt mentions, you know, you’ve got some high net worth who, like the business case, maybe like the founders, and they make an investment. It’s not, it’s not built to scale. The way investing with the VC manager is what hasn’t existed until today is that accredited clients have not had access to VC managers because it’s a million dollar or $5 million minimum, or it’s a three-year commitment period. That historically doesn’t work well for an accredited investor. So that’s why we’ve put together Seedbrite. But certainly, that’s the underlying thesis of it.
Matt Chancey 33:22
Look, and if you think about it a little bit, it’s almost kind of like Shark Tank a little bit, right? You have these small companies come on Shark Tank, they pitch to try to get money from these sharks, which are basically VC managers. And sometimes those sharks are like, I’m willing to put money in that deal, and by the way, I can make a couple of phone calls and I can get you in here and I can get you in there. We’re taking, and then imagine not having to invest in one Shark Tank company, but getting to invest in every Shark Tank company that got the capital that they needed and the access they needed in one season bundled up into a diversified portfolio. Some of those may hit, you know, but it’s further been de-risked because it’s not just at the very beginning or the very origin. Some of are certainly going to go nowhere. Some of them are going to go sideways, but some of those are going to take off and you’re going to have, you know, significant multiple expansion and then by structuring it properly with 1202, now you’re getting tax benefits on those ones that do become shooting stars. And that’s, that’s a real upside opportunity.
Damon Elder 34:19
I want to dive into some more specifics, Justin, on the Seedbrite offering, but before I do a question came in from the audience that might be a good one for you, Brad, and others, please feel free to jump in. But obviously the 1202 benefit is with the Internal Revenue Code, so it’s a federal benefit, but are there also state benefits or opportunities that accrue to QSBS investors?
Brad Updike 34:41
I’m going to pass that to Justin. We are, I am not aware.
Justin Reich 34:45
Yeah, the answer Brad, is absolutely. So, only five states do not have some QSBS oriented benefit, and I think 42 states have a hundred percent benefit. So, there’s some that are less than a hundred, but like I said, only five have either, five have no benefit and, 42 states I think have the full hundred percent benefit and the remainder is something less than a hundred percent.
Matt Chancey 35:17
And I think one of the ironic situations in that is, state California’s nonconforming on this benefit, right?
Justin Reich 35:24
California is unfortunately one of the nonconforming benefits, but the state of New York, oddly enough, is a conforming and a hundred percent exclusion for QSBS.
Matt Chancey 35:33
Well, I think the irony in that is that a lot of people think tech incubation comes out of California and not the respondent, but yet California doesn’t want to give the benefit.
Justin Reich 35:43
Right? And they have the highest state income tax, so it’s kind of an odd duck for sure.
Matt Chancey 35:48
Yeah, for sure. Justin, talk up a little bit about the process that they came through from some of those venture managers. I mean, how much of a coaling process or of a grooming process maybe would you say that those underlying companies have gone through?
Justin Reich 36:03
It’s amazing. Some of the kind of the underlying, Brad brings up diligence all the time. I mean, these VC managers, they might review 2,500 deals in a year, maybe 250, get moved to a second stage of due diligence, and then they might make 30 or 20 investments for the whole, you know, holding period of their fund. So, I think there’s a huge funnel that these companies have to go through. And the other thing is, as I mentioned earlier, it’s not just about capital, it’s about access. So, these VC managers are identifying companies that fit squarely with what their specific skill sets and relationships are. The shark tank example is a great example. They know the relationships they have; they know the doors that they can open. These companies, these founders, they come through top universities, top incubator programs, top business competitions. There’s a lot of demand in terms of getting in front of these VC managers. Now VC, they have to just pick the opportunities where they can make a difference, not just the difference with their capital, but a difference with their access.
Brad Updike 37:08
Yeah, I mean, they’re looking for the very best opportunities. It’s opportunities that you know, could potentially end in a unicorn valuation as an IPO. From a due diligence perspective, they’re looking for products, you know, that are impactful that can achieve market acceptance very quickly. And then they’re also looking to, you know, parlay that with a management team that’s been in the sector long enough to know how to be disruptive and know how to improve these products in terms of their operations, quality, and just branding positions. And when you, yeah, they’re looking for the combination of that.
Matt Chancey 37:42
If you understand how factors apply to like a total return perspective in public markets. If you apply factors to like the VC market in the private equity market, it outsize returns tend to skew to so smaller managers over and there’s a ton of research that supports this. And so, a lot of times when people are looking for private market access, they tend to look for these much bigger managers that are raising billions of dollars of capital that are trying to redeploy it. And historically that has weighed down their returns by trying to take that approach. If you can find quality and size and a slant to small from a size perspective that’s typically been the sweet spot to be. So if you’ve got a really good defined process that’s going to give you early access to completely vetted and structured deals that skew small you really are setting yourself up for an outsized return opportunity, which is I think why most investors want to access this in the first place, because you should never let the tax tail wag the investment dog. It’s just the cherry on top.
Justin Reich 38:42
Yeah, in venture our research shows that venture managers with under 400 million AUM, it’s the same for everything. Law of large numbers, It becomes more difficult to replicate a return profile as you grow. So that, VC managers that have under 400 million AUM performs substantially better than those who have, you know, meaningfully more billion, 2 billion, 5 billion. The other piece is managers that have say more than 400 million AUM probably going to have a tough time doing most of their deals in 1202 eligible companies. If you’re investing 400 or 800 or 2 billion, you can’t invest enough dollars into companies that have less than 50 million gross asset value. You would have to, you know, it just wouldn’t work. The economics wouldn’t work. You’d have to own too much of the company. The founders wouldn’t get to own any of it, it just wouldn’t work. So, 1202 eligible companies are likely to come from venture managers that are a hundred million AUM 200 million AUM.
Damon Elder 39:45
Okay. So, I mean, obviously when you’re looking to make startup investments, there’s tremendous headwinds for retail investors particularly, I mean, you know, Matt, you talked about that with, you know, people just doing friends and family deals into perhaps one company or another with a potentially high failure rate.
Matt Chancey 40:03
Well, I think that’s the real argument that we’re making here as a way to access this that makes the most sense, you know, for anybody that, first of all, most people don’t have access to consistent deal flow of small business opportunities to be able to co-invest in. They just don’t see enough deal flow. So not only does this solve for potentially for a deal flow issue, it then, and the analogy that I make and the way I describe it to people is imagine if you went to the Kentucky Derby and you got to bet on every horse in the starting gate at the same time. Some of those horses might literally die along the way, and that, that doesn’t happen very often, but some of those horses are going to win. And if you’ve invested in every single horse in the starting gate, like if you know what a trifecta is, win play show like, and the magnitude of the outcome, that’s the equivalent of getting to bet on every horse at the same time and potentially having a unicorn in the portfolio. When you put the tax benefits on top of it, that becomes a great opportunity for an investor. So instead of them having to look at each individual company one at a time and make a decision about, oh, do I think this is going to work? Do I understand their business strategy? You’re more investing in the process. And if you understand the process creates quality on the backside more times than not, then it’s just by taking a diversified approach to, into that process that lets you have access to some of those outsized returns and some of those outside winners. And when you blend that overall, into a total portfolio allocation, I think you’re getting the return stream or the MOIC that you’re really looking for those type of investors.
Justin Reich 41:35
Yeah, you know, I like the way that that Matt’s thinking about this. I mean, most people don’t have, even if you want to allocate 50, 250, a million dollars to a venture strategy as accredited investor, how are you going to find 20 companies, 30 companies, 40 companies? You don’t have the ability to do it and you probably can’t get into any VC fund, you know, unless you have some serious either relationships and or net worth. So, you know, if you can invest $50,000 and get a piece of 15 companies or 30 companies, I mean that’s the way to do it. And this, this really is a you know, we’ve heard certain advisors work with the endowment model and some do and some don’t, but venture in certain aspects makes up, you know, a material portion of different private ALTs strategies.
Matt Chancey 42:30
Sure. And look, I can tell you I’ve been in this space for a few years investing in these types of companies even before Seedbrite came to market through other family office relationships and stuff that I have that I now get access to be able to see and invest in myself in their deal flow. And it’s complicated coming from so many different sources cause they all show the information in a different way, or you gain access at different stage. There’s no consistency in what the deal flow looks like. And so, the time it takes to vet each opportunity on its own merits compared against one another is extremely cumbersome. So to know that you have a defined process and where they’re coming through the ecosystem and there will be similarities to them every single time, is definitely going to smooth out that process over time and make it much more efficient and easier to gain trust in the process than having to look at each individual company and thinking you might be right or you might be wrong depending upon what that specific opportunity might be.
Damon Elder 43:22
Okay. Well, like I said, very interesting. Looking forward to seeing how you do and to seeing, I’m assuming there are dozens of investment managers out there right now, watching this and pouring through the tax code and going to be very interested in following Seedbrite’s trail into the 1202 market. Cause it certainly sounds very interesting and again, it just provides another great opportunity, I think, to the retail space. So, we’ll be watching Justin, looking forward to speaking with you again and hearing more about what’s happening with Seedbrite and the 1202 opportunities you’re bringing to market and all three of you gentlemen, thank you so much for your time and your insights. Certainly, appreciate it. And thank all of you for watching and we’ll see you again soon.
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