Income Taxes: A Potential Hidden Cost of Down Round Financing

At a glance

• The main takeaway: “Down round” funding, in which a start-up company sells its stock at a lower price than previous rounds of initial financing, can have significant income tax consequences in addition to potential liquidity or cash-raise issues. 
• Impact on taxpayers: Start-up companies that are forced to reduce share prices on subsequent financing rounds due to missing previously stated milestones or benchmarks, must be wary of the effect of ownership changes on the use of tax attributes, such as net operating losses or unused general business tax credits, carried forward from years in which the company did not generate sufficient taxable income to utilize them.
• Next steps:  Aprio’s Transaction Advisory team can guide you through the tax and funding implications of differences in share price from initial funding to subsequent financing rounds. 

Schedule a consultation with an Aprio Transaction Advisory professional today.

The full story:

Start-up corporations commonly raise funds through a series of funding rounds. A round may consist of the issuance of debt, equity, or a combination of both. During fundraising, a corporation will typically set milestones or benchmarks that are used by investors to evaluate the performance of the corporation and derive a value for the business. As a successful company proceeds through subsequent funding rounds, the growth of the business is typically accompanied by an increase in the valuation of the corporation. The increased valuation, in turn, provides the corporation an opportunity to obtain subsequent funding at higher valuations. 

A “down round,” however, is an equity funding round in which the company sells its stock at a price per share that is less than the price at which it sold shares in an earlier round. Down rounds are common when the expected milestones and/or benchmarks have not been met. These milestones can include product or service development, revenue generation and profitability milestones, production output, and/or the hiring of key personnel. 

Down rounds have negative consequences that extend beyond funding levels

Venture-backed corporations are typically unprofitable, risky endeavors with illiquid stock that requires consistent evidence of rapid growth to continue to attract and retain capital and talent. A down round, which signals that the corporation needed to raise capital and was willing to do so at a declining price, can be a significant blow to employee morale.

Additionally, investors typically provide funding to venture-backed corporations in exchange for preferred stock, which sometimes has special anti-dilution protections. The anti-dilution rights can magnify the dilution to common stockholders. Similarly, if the prior round was at a highly negotiated price and/or the prior price was based on assumptions that have proven to be untrue, investors may attempt to renegotiate the price of the prior round to reflect the value more closely with the benefit-of-hindsight.

Finally, when a corporation undergoes a down round, existing fund investors may have an obligation to write down the value of their existing holdings for financial reporting purposes. Such a write down can negatively impact the investor’s fundraising efforts and perhaps even the ability of general partners of the fund to receive distributions. 

Net Operating Losses and General Business Credits

Start-up corporations that have undergone several rounds of funding typically have net operating loss (NOL) carryforwards. If a corporation has deductions for a taxable year that exceed gross revenue for the taxable year, the corporation has an NOL. NOLs arising in tax years beginning before December 31, 2017, may be carried back two years, and carried forward up to 20 years to be utilized to offset taxable income in those years. NOLs arising in tax years beginning after December 31, 2017, generally may not be carried back but may be carried forward indefinitely and may offset only 80% of taxable income. However, the Coronavirus Aid, Relief and Economic Security (CARES) Act created a five-year carryback period and temporarily removed the 80% limitation for NOLs arising in taxable years beginning after December 31, 2017, and before January 1, 2021.

General business credits are also a valuable tax attribute for corporations. General business credits provide a significant tax benefit in the form of a dollar-for-dollar reduction to income tax liability. These credits, enumerated in Section 38 of the Internal Revenue Code (IRC), can be generated by a broad range of business activities ranging from hiring certain classes of employees (e.g., the work opportunity, Indian employment and empowerment zone employment credits), utilizing certain resources in the manufacturing process (e.g., the renewable electricity production credit) and increasing research activities. Most unused general business credits may be carried back one taxable year and carried forward up to 20 taxable years. 

Limitations on the utilization of NOL and General Business Credit carryforwards

IRC Section 382 restricts a loss corporation’s ability to utilize an NOL carryforward following an “ownership change” by limiting the amount of post-ownership change income that may be offset by pre-ownership change NOL carryforwards. Generally, an ownership change occurs when the “5-percent shareholders” of a corporation increase their ownership percentage by more than 50 percentage points in aggregate during a three-year testing period ending on a testing date.​ Ownership for purposes of Section 382 is based on value, not voting rights. Additionally, the term “5-percent shareholder” can include multiple groups of shareholders that individually own less than 5%. Complex aggregation and segregation rules will determine how these groups are created and may result in a large stock issuance triggering an ownership change, even if most of the stock is issued to shareholders with less than a 5% ownership interest. Finally, if a corporation has had more than one ownership change and NOLs have been carried forward through those ownership changes, the lowest limitation will apply. 

The base annual Section 382 limitation is generally equal to the equity value of the loss corporation immediately before the ownership change, multiplied by the applicable long-term tax-exempt federal rate in effect for the month of the ownership change (currently 3.29% for January 2023). The base annual Section 382 limitation may be increased or decreased depending on, in part, the tax basis of the assets of the corporation at the time of the ownership change. ​

Similar to Section 382, Section 383 limits a corporation’s ability to utilize general business credit carryforwards following an ownership change. The Section 383 annual limitation is generally the difference in US federal income tax computed with and without a deduction for any excess Section 382 limitation after the application of the Section 382 limitation to NOL carryforwards. Thus, if a corporation has utilized NOL carryforwards to the full extent of the amount of the Section 382 limitation, the corporation will not have any excess Section 382 limitation and will not be able to utilize any general business credit carryforwards. 

The bottom line

As noted above, Section 382 measures ownership by examining cumulative increases in ownership over a three-year period ending on the testing date. This means that an ownership change may be triggered by one or more rounds of financing that occurred during the three-year period. Additionally, because increases in ownership are measured by value, the likelihood of an ownership change may be greater when a down round occurs. 

If the issuer corporation subsequently turns the corner and generates taxable income, management may be surprised to learn that income taxes are due even though the corporation has NOL carryforwards far in excess of taxable income. Furthermore, if the corporation ultimately enters a negotiation phase of a sale, the corporation may be able to monetize NOL and credit carryforwards. The buyer, however, will request that the corporation have a robust Section 382 study to support the amount of any existing Section 382 limitation.

To learn more about Sections 382 and 383, or how you can utilize your NOL and credit carryforwards, contact Aprio’s Transaction Advisory Services team for a consultation.