Structuring Venture Capital, Private Equity, and ...

1 Structuring VentureCapital, Private Equity, and EntrepreneurialTransactions2015 EditionJack S. LevinKirkland & Ellis LLPD onald E. RocapKirkland & Ellis LLPS pecial EditorsMartin D. GinsburgGeorgetown University Law CenterRussell S. LightKirkland & Ellis LLPThis volume is current through June 22, 2015 Professor Ginsburg, the finest tax lawyer and human being of all time, passedaway on 6/27 of ContentsAbout the Authors and Special EditorsviiAcknowledgmentsxiDetailed Table of Contentsxv1 Introduction1 12 Structuring Start-Up Transaction2 13 Structuring Newco as Flow-Through Entity3 14 Structuring Growth- equity Investment in Existing Company4 15 Structuring Buyout5 16 Debt and equity Securities and Executive Deferred Compensation6 17 Structuring Consolidation of Fragmented Industry7 18 Structuring Turn-Around Investment in Overleveraged orTroubled Company8 19 Exit Strategies.

2 Structuring IPO or Sale of PE/VC-FinancedPortfolio Company9 110 Structuring Formation of Private equity Fund10 1 Appendix:Statutes, Rules, Regulations, and Other PrecedentsSummary of Contents for PrecedentsA 1 2000 Internal Revenue Code of 1986A 3 2100 Treasury RegulationsA 173 2200 Revenue Procedures and Revenue RulingsA 225 2300 Federal Securities Laws, Rules, and RegulationsA 245 2400 Bankruptcy CodeA 309 2500 State Fraudulent Conveyance StatutesA 319 2600 Delaware Corporate, Partnership, and LLC StatutesA 335 2700 CasesA 405 2800 Other MaterialsA 487 Table of Internal Revenue Code SectionsT 1 Table of Treasury RegulationsT 5 Table of Treasury/IRS RulingsT 7 Table of Federal Securities Laws, Rules.

3 And RegulationsT 9 Table of Bankruptcy Code SectionsT 11xiiiTable of State Fraudulent Conveyance StatutesT 13 Table of Delaware Corporate, Partnership, and LLC StatutesT 15 Table of CasesT 17 Table of Other LawsT 19 Table of Other MaterialsT 21 IndexI 1xivSummary of ContentsDetailed Table of ContentsAbout the Authors and Special EditorsviiAcknowledgmentsxiChapter 1 Introduction 101 NATURE AND USE OF THIS TREATISE1 2 102 GENERAL DESCRIPTION OF Private equity ANDVENTURE capital INVESTING1 3 103 DISTINGUISHING Private equity / Venture CAPITALINVESTING FROM OTHER TYPES OF INVESTING1 3 104 HIGH COST OF Private equity / Venture capital MONEY1 7 105 TYPICAL Private equity / Venture CAPITALTRANSACTIONS1 8 Start-Up Transaction1 8 Transaction1 8 Turn-Around Investment1 9 or

4 Management Buyout1 10 Consolidation1 11 Strategies1 12 of Private equity , Venture capital , or Buyout Fund1 13 106 HISTORY OF Private equity / Venture CAPITALINVESTING1 13 History1 13 Revolution and Merchant Bankers1 14 in the 1940s and Thereafter1 15 107 THE SHIFTING SANDS OF FEDERAL TAX RATES1 15(1) Top federal income tax rate for an individual s OI1 16(2) Top federal income tax rate for an individual s LTCG1 16(3) Top federal income tax rate for an individual s QDI1 16(4) Disguised additional federal individual income-based taxes1 17(a)Uncapped Medicare tax on compensation andself-employment income1 17(b) Uncapped Medicare tax on passive income1 18(c)Scope of the two Medicare taxes1 21(d) Itemized deduction disallowance1 22(e) Personal exemption phase-out1 22(5) Top federal income tax rate for C corp1 22(6) Reduced top federal income tax rate for individual or C corp onbusiness net income from production activities1 22(7) Top federal individual estate tax rate1 23 108 FREQUENTLY USED DEFINITIONS1 24xvChapter 2 Structuring Start-Up Transaction 201E s PROPOSED STRUCTURE ALL COMMON STOCK2 5 83(a)

5 Adverse Tax Effect on E2 6 s Code 83(a) OI on Bargain Purchase ofNewco Stock2 6 Approaches for Avoiding or MinimizingCode 83(a) OI2 7(1)Property contribution2 7(2)Temporal differentiation2 7(3)Substantive differentiation2 8 of Proceeds If Newco Not Successful2 8 of Proceeds If Newco Successful2 9 Deduction2 9 s Internal Rate of Return2 9 s Good-Faith Investment2 9 s Conditional Right to Retain Newco Stock2 10 202VC s PROPOSED STRUCTURE NON-CONVERTIBLESENIOR SECURITIES IN ADDITION TO COMMON2 10 Senior Claim2 10 s Purchase of Common Stock2 11 Code 83(a) OI Risk2 11 Note2 12 Note2 13 s Interest Deduction2 13 14 to Repurchase from E at Cost2 14 Vesting2 14(1)In general2 14(2)Golden parachute penalty tax rules2 15 Vesting2 17 Code 83(b) Election2 17 83(b) Election or Failure to LegendCertificate2 20(1)Code 83(b) election2 20(2)

6 Failure to legend stock certificate2 21 Deduction2 21 s CG on Sale2 24 Subsequently Imposed on OutstandingStock2 24 Issues2 27 Buy-Back from E2 27 Charge2 28 Stock Option to E2 28 Sale of Stock to VC2 28 s Deferred Compensation2 28 203 SEVERAL ALTERNATIVE capital STRUCTURES2 29 Convertible Debenture or Convertible Preferred2 29 Participating Double-Dip Preferred Stock2 30xviDetailed Table of Contents 204 TERMS AND TAX ASPECTS OF VC s DEBENTURE ANDPREFERRED STOCK2 31 205 Structuring CONTROL OF NEWCO s BOARD2 31 Relationship Between equity Split and Board Seats2 31 s Proposal2 31 s Proposal2 31 Compromise2 32 Compromise2 32 Newco s Directors from Personal Liability2 32 206 CONTROL OVER SUBSEQUENT Private OFFERING, IPO, ORSALE OF NEWCO2 33 207 SEC COMPLIANCE2 33 to Register Securities with SEC2 33 from SEC Registration2 34 Placements SEC Reg.

7 D2 35 5042 35 D Definitions and Exceptions, IncludingAccredited Investor and 1934 Act ReportingCompany2 36 5052 39 5062 41 Integration Doctrine2 46 Through2 50 D2 51 Reg. D Amendments2 52 capital Without 1933 Act or 1934 ActRegistration2 53 Sales to Service Providers SEC Rule 7012 54 Corporation s Private Placement SEC Rule 10012 56 Offering with Abbreviated Registration Statement SEC Reg. A2 56 on Resale of Newco Securities2 58 Restricted Securities2 58 Securities2 59 Registration Rights2 59 Resistance2 59 Offering2 60 Offering2 60 S-32 61 A2 61 Resales of Restricted Stock Rule 1442 61 62 208 COMPLIANCE WITH STATE SECURITIES LAWS2 65 209 NATURE OF VC2 65 Qualifies as SBIC2 65 or PE Is Member of BHC Group2 71 , Volcker Rule.

8 And Federal Reserve Act inGeneral2 71 Y and the 5/25 Rules2 72 Is SBIC2 73 K Businesses2 74 Banking Activity2 74xviiDetailed Table of Contents Related to Banking andFinancial-in-Nature Activities2 77 Rule Restrictions onProprietary Trading2 78 Reserve Act 23A and 23B Restrictions2 78 Is Insurance Company2 81 210 ADDITIONAL LTCG TAX ADVANTAGES FOR INDIVIDUALS2 81 211 KEY ISSUES AND APPENDIX REFERENCES2 82 Chapter 3 Structuring Newco as Flow-Through Entity 301 NEWCO AS S CORP3 4 Liability and General Characteristics3 4 4 Liability3 4 Piercing3 5 Cleanup3 5 Plan and Other ERISAL iabilities3 5 Participation inNegligent or Wrongful Act3 6 Income Tax Aspects3 7 Entity-Level Tax3 7 Corp Compared to C Corp3 7 Corp Compared to Partnership or LLC3 12 Taxation3 14 Tax Limitations on Use of S Corp3 14 Class of Stock3 14 Limitation3 15 on Entity and Shareholders3 16 Issues and Appendix References3 19 302 NEWCO AS PARTNERSHIP3 20 Liability Issues and General Characteristics3 20 20 in Achieving GP Limited Liability3 20(1)Use of limited-liability entity intermediary3 21(2)Qualification as LLP3 21 in Achieving LP Limited Liability3 24 Duties3 25(1) General3 25(2) Delaware statutes3 26(3)

9 Delaware statutory ambiguity3 27(4) transactions between GP and GP s affiliate3 28(5) Delaware precedents re non-waivable impliedcovenant of good faith and fair dealing3 29(6) Delaware courts reliance upon partnershipagreement s precise language in evaluatingLP s breach of fiduciary duty claim against GP3 33xviiiDetailed Table of Contents(7) Conclusion: careful drafting essential3 35 Income Tax Aspects3 36 Entity-Level Tax3 36 Compared to S Corp3 37 Taxation3 41 on Achieving Partnership Tax Flow-ThroughTreatment3 41 Traded Partnership Taxed as C Corp3 41 Classification Rules3 42 Who Is a Partner3 43 of Service Provider on Receipt of or WhileHolding Partnership Interest3 44 83 and LV Rather Than FV3 44 Character Flow-Through Regime3 46 Legislation Altering PartnershipCharacter Flow-Through Regime3 47 409A Issues3 49 Issues3 50 50(1) Traditional IPO3 50(2) Up-C Structure3 50 ( )

10 Person3 52 Sharing Arrangements3 52 Issues and Appendix References3 52 303 NEWCO AS LLC3 54 Liability and General Characteristics3 54 54 Liability3 55 Duties3 56 Issues3 57 Income Tax Aspects3 57 and Other Taxation3 59 Issues and Appendix References3 59 304 TAX LIMITATIONS ON NEWCO s DEDUCTIBLE EXPENSES3 60 Start-Up Expenses and OrganizationExpenses3 60 60 Issues and Appendix References3 60 Chapter 4 Structuring Growth- equity Investment in ExistingCompany 401 PROPOSED GROWTH- equity TRANSACTION4 4 s Characteristics4 4 Proposed Investment4 5 402 REARRANGING OLDCO s equity THROUGH REDEMPTION4 6 Tax Characteristics4 6 Non-Tax Issues4 11 Example4 12xixDetailed Table of Contents Redemption Issues and Appendix References4 14 Additional Oldco Common Shares (or Options)to Executives4 15 403 REARRANGING OLDCO s equity THROUGH TAX-FREERECAPITALIZATION4 16 Tax Characteristics4 16 Non-Tax Issues4 24 Example4 25 Recapitalization Issues and Appendix References4 25 404 REARRANGING OLDCO s equity THROUGH PREFERREDSTOCK DIVIDEND PLUS FORMATION OF NEWCO TO HOLDALL OF OLDCO s COMMON (AND PART OF OLDCO sPREFERRED) STOCK4 27 Tax Characteristics of Oldco s Pro Rat