Structuring Venture Capital, Private Equity, and ...

1 Structuring VentureCapital, Private Equity, and EntrepreneurialTransactions2017 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 July 5, 2017 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 223 2300 Federal Securities Laws, Rules, and RegulationsA 243 2400 Bankruptcy CodeA 307 2500 State Fraudulent Conveyance StatutesA 317 2600 Delaware Corporate, Partnership, and LLC StatutesA 331 2700 CasesA 397 2800 Other MaterialsA 479 Table of Internal Revenue Code SectionsT 1 Table of Treasury RegulationsT 5 Table of Treasury/IRS RulingsT 7 Table of Federal Securities Laws, Rules, and RegulationsT 9 Table of Bankruptcy Code SectionsT 11xiiiTable of State Fraudulent Conveyance StatutesT 13 Table of Delaware Corporate, Partnership.

3 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 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 OI and STCG1 16(2) Top federal income tax rate for an individual s LTCG1 16(3) Top federal income tax rate for an individual s QDI1 17(4) Disguised additional federal individual income-based taxes1 17(a)Uncapped Medicare tax on compensation andself-employment income1 18(b)Uncapped Medicare tax on passive income1 18(c)Scope of the two Medicare taxes1 21(d) Itemized deduction disallowance1 22(e)

4 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) 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 General2 14 Parachute Penalty Tax Rules2 15 Vesting2 17 Code 83(b) Election2 17 83(b) Election or Failure to LegendCertificate2 20 83(b)

5 Election2 20 to Legend Stock Certificate2 21 Deduction2 22 s CG on Sale2 24 Subsequently Imposed onOutstanding Vested Stock2 25 Issues2 28 Buy-Back from E2 28 Charge2 28 Stock Option to E2 28 Sale of Stock to VC2 29 s Deferred Compensation2 29 203 SEVERAL ALTERNATIVE capital STRUCTURES2 29 Convertible Debenture or Convertible Preferred2 30xviDetailed Table of Contents Participating Double-Dip Preferred Stock2 31 204 TERMS AND TAX ASPECTS OF VC s DEBENTURE ANDPREFERRED STOCK2 32 205 Structuring CONTROL OF NEWCO s BOARD2 32 Relationship Between Equity Split and Board Seats2 32 s Proposal2 32 s Proposal2 32 Compromise2 32 Compromise2 33 Newco s Directors from Personal Liability2 33 206 CONTROL OVER SUBSEQUENT Private OFFERING, IPO, ORSALE OF NEWCO2 34 207 SEC COMPLIANCE2 34 to Register Securities with SEC2 34 from SEC Registration2 35 Placements SEC Reg.

6 D2 36 5042 37 D Definitions and Exceptions, IncludingAccredited Investor and 1934 Act ReportingCompany2 40 5062 44 Integration Doctrine2 49 Through2 53 D2 55 capital Without 1933 Act or 1934 ActRegistration2 56 Sales to Service Providers SEC Rule 7012 57 Corporation s Private Placement SEC Rule 10012 58 Offering with Abbreviated Registration Statement SEC Reg. A2 59 on Resale of Newco Securities2 61 Securities2 61 Securities2 62 SEC Registration Rights2 62 Resistance2 62 Offering2 63 Offering2 63 S-32 64 A2 64 Resales of SEC-Restricted Stock Rule 1442 64 65 208 COMPLIANCE WITH STATE SECURITIES LAWS2 68 209 NATURE OF VC2 69 Qualifies as SBIC2 69 or PE Is Member of BHC Group2 75 , Volcker Rule.

7 And Federal Reserve Act inGeneral2 75 Y and the 5/25 Rules2 76 Is SBIC2 77 K Businesses2 77 Banking Activity2 78xviiDetailed Table of Contents Related to Banking andFinancial-in-Nature Activities2 81 Rule Restrictions onProprietary Trading2 82 Reserve Act 23A and 23B Restrictions2 82 Is Insurance Company2 85 210 ADDITIONAL LTCG TAX ADVANTAGES FOR INDIVIDUALS2 85 211 KEY ISSUES AND APPENDIX REFERENCES2 86 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 Pension Plan andOther ERISA Liabilities3 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 14 on Entity and Shareholders3 15 for Avoiding Arbitrary Restrictionson S Corp Shareholders and S Corp Stock3 16 Partnership or LLC3 16 Instrument with Warrantsor Conversion Privilege3 17 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)

8 Delaware statutory ambiguity3 27xviiiDetailed Table of Contents(4)Transactions between GP and GP s affiliate3 28(5)Delaware precedents re non-waivableimplied covenant of good faith and fair dealing3 29(6)Comparing (i) effect of conclusive-presumption clause on non-waivablecovenant of good faith and fair dealing to(ii) effect of such clause on contractualfiduciary duty breach3 32(7)Delaware courts reliance upon partnershipagreement s precise language in evaluatingLP s breach of fiduciary duty claimagainst GP3 34(8)Conclusion: careful drafting essential3 37 Income Tax Aspects3 37 Entity-Level Tax3 37 Compared to S Corp3 39 Taxation3 43 on Achieving Partnership Tax Flow-ThroughTreatment3 43 Traded Partnership Taxed as C Corp3 43 Classification Rules3 44 Who Is a Partner3 45 of Service Provider on Receipt of or WhileHolding Partnership Interest3 46 83 and LV Rather Than FV3 46 Character Flow-Through Regime3 49 Legislation Altering PartnershipCharacter Flow-Through Regime3 50 409A Issues3 52 Issues3 53 53(1) Traditional IPO3 53(2) Up-C Structure3 53 ( )

9 Person3 55 Sharing Arrangements3 55 Issues and Appendix References3 55 303 NEWCO AS LLC3 57 Liability and General Characteristics3 57 57 Liability3 58 Duties3 59 Issues3 60 Income Tax Aspects3 60 and Other Taxation3 62 Issues and Appendix References3 62 304 TAX LIMITATIONS ON NEWCO s DEDUCTIBLE EXPENSES3 63 Start-Up Expenses and OrganizationExpenses3 63 63 Issues and Appendix References3 63xixDetailed Table of ContentsChapter 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 7 Non-Tax Issues4 11 Example4 12 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 RataPreferred Stock Dividend4 27 of Preferred Stock Dividend Plus Interpositionof Newco to Own All of Oldco s Common (and Part ofOldco s Preferred)

10 Stock4 29 Effects of Newco s Interposition4 31 Additional Newco Common Shares (or Options)to Executives4 32 Issues and Appendix References on Preferred StockDividend Plus Interposition of Newco and SelectiveIssuance of New Common Stock or Options4 33 405 PASSIVE SHAREHOLDER INCENTIVE TO REDUCECOMMON OWNERSHIP4 35 406 OLDCO AS PARTNERSHIP, LLC, OR S CORP4 35 or LLC4 35 corp4 37 407 IRS ANTI-ESTATE-FREEZE RULES4 37 2701 Imputed Gift from Older Passives to YoungerRelated Actives4 37 Code 27014 38 Exception4 38 Exception4 38 Exception4 42 Exception4 43 Securities4 43xxDetailed Table of Contents Code 2701 Gift4 43 Subtraction Method 4 43 Rule4 45 408 ECONOMICS AND TAXATION OF EXECUTIVE STOCKOPTIONS4 46 Tax Ramifications4 47 Income Tax Ramifications4 47 NQO Not In-The-Money atGrant4 47 NQO In-Th