Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Rollover Equity to Delay Taxes in Exits
Transcript
- Lucas: So there is this one exit strategy that sounds almost too good to be true. You sell your company, but instead of getting cash, you take stock in the acquirer. And you pay zero tax on that transaction. At least not right away. Luna: Zero tax? That's the dream. But I assume there's a catch, or maybe a few catches. Lucas: A few. But the basic mechanism is called rollover equity, and it's been around for decades. Under Section 368 of the tax code, if you structure an acquisition as a stock for stock exchange, the founder can defer capital gains taxes until they eventually sell the acquirer's shares. Luna: So it's not a tax avoidance. It's a deferral. Still, if you're planning to hold the acquirer's stock for years, that's a huge advantage. Lucas: Exactly. And in the current market, with the Nasdaq composite down about 3 percent this week and the broader volatility we're seeing, founders are thinking hard about timing. If you take cash now, you lock in a tax bill at whatever your basis is. If you roll into equity, you keep your money working. Luna: Let's talk mechanics. How does a founder actually do this? Is it something you negotiate in the letter of intent? Lucas: It has to be structured from the start. The acquirer offers a mix of cash and stock, and the founder elects to receive all or mostly stock. The key requirement for tax-free treatment is that the founder ends up owning at least 80 percent of the acquirer's stock after the deal. That's the control threshold in the code. Luna: Eighty percent is a high bar. That means the acquirer is basically paying you in their own shares, and you become a controlling shareholder. That's not most acquisitions, right? Lucas: Right. It works best when the acquirer is a private company or a public company that issues new shares to the founder as part of the deal. It's common in mergers of equals or when a larger private company acquires a smaller one and the founder becomes a major stakeholder. Think of it like a reverse merger where the founder's company essentially rolls into the acquirer's structure. Luna: So if you're a founder of a startup that gets acquired by, say, a private equity-backed platform, you might end up with 20, 30 percent of the combined entity. That's not 80 percent, so you'd still pay taxes on the portion that's cash. Lucas: Exactly. But you can structure a partial rollover. You take some cash to cover your tax liability, and roll the rest into equity. That's often the sweet spot. You get liquidity for your tax bill, but you keep a large stake in the future upside. Luna: And the tax deferral applies only to the rolled-over portion, right? So if you take $10 million in cash and $40 million in stock, you pay tax on the $10 million now, and defer tax on the $40 million until you sell the stock. Lucas: Correct. And one nuance: The stock you receive has to be voting stock. Non-voting shares don't qualify for the tax-free treatment. So acquirers often issue a new class of voting common or preferred. Luna: What about earnouts? Those are common in acquisitions to bridge valuation gaps. Do they affect rollover treatment? Lucas: They can, if they're structured as contingent consideration. The IRS looks at whether the earnout is payable in stock or cash. If it's stock, it can be part of the rollover. If it's cash, it's taxable as ordinary income when received. Founders need to be careful here. Luna: Let's bring in a real-world example. I'm looking at Palantir's stock down 16.6 percent over the last five days. That's a huge drop. If a Palantir founder had rolled equity from an earlier acquisition into Palantir stock, they'd be sitting on a big loss right now. That's the risk, isn't it? Lucas: That's exactly the risk. You're trading a known tax bill for an unknown future price. If the acquirer's stock tanks, you've deferred taxes but your net worth is crushed. It's a concentrated stock position, and we've seen that blow up many times. The dot-com bust, the financial crisis — founders who rolled into acquirer stock lost everything. Luna: So it's a bet on the acquirer's future. And if you're a founder who just spent years building your own company, you might not want to bet everything on another company's management. Lucas: Exactly. That's why many founders hedge. They might sell some of the acquirer's stock immediately after the deal closes, even if it triggers a tax event. Or they use collars and prepaid variable forwards to lock in a price while deferring taxes. It's complex, but there are strategies. Luna: And the current environment — with the Nasdaq down, rates still elevated, and IPO windows opening and closing — makes rollover equity more attractive for some and less for others. How do you decide? Lucas: I think the key question is: Do you believe in the acquirer's business more than you believe in your own ability to invest the after-tax cash? If you think the combined entity has a better growth trajectory, rollover makes sense. If you want diversification, take the cash and pay the tax. Luna: And there's also the emotional side. Founders often feel attached to their company's mission. Rolling into the acquirer lets them stay involved and continue building. That's not a financial consideration, but it matters. Lucas: That's a really important point. In fact, many acquisitions are structured with rollover equity specifically to retain the founder as a key executive. The acquirer wants the founder to have skin in the game post-close. So it's not just about taxes — it's about alignment. Luna: Speaking of alignment, I want to circle back to something you mentioned earlier about the 80 percent control threshold. If a founder takes less than that, they're taxed on the entire gain, even the stock portion. That seems harsh. Lucas: It is. But there's a workaround: the founder can form a corporation that exchanges its stock for the acquirer's stock. If the founder owns more than 50 percent of that corporation, the exchange can still qualify. It's called a triangular merger. Very common in practice. Luna: So the legal structure matters a lot. Founders need good M&A tax counsel. This is not a DIY area. Lucas: Absolutely not. One mistake in the structuring and you could owe millions in unexpected taxes. I've seen deals where the founder assumed it was tax-free and then the IRS recharacterized it as a taxable sale. Ruined their retirement. Luna: And you mentioned earnouts earlier. How do they interact with rollover? If a founder gets stock now and then an earnout in cash later, is the earnout taxed as ordinary income? Lucas: Typically yes, unless it's structured as additional stock. The IRS treats contingent cash payments as compensation or additional purchase price, taxed at ordinary rates. But if it's stock, it can be part of the rollover if it's issued within a certain time frame. That's another reason to negotiate for stock earnouts. Luna: Let's talk about the current market for exits. We've seen a lot of headlines about AI companies raising huge rounds, but not many exits yet. Do you think rollover equity will become more common as M&A picks up? Lucas: I do. With interest rates still at 4.5 percent or so, acquirers are cautious about paying all cash. They'd rather use their stock as currency. And founders are more willing to take stock if they believe in the acquirer's vision. So rollover equity could be a bridge between buyer and seller on valuation. Luna: That's a great point. And if you look at the data, companies that use stock as acquisition currency tend to have higher returns post-deal. So maybe it's not just a tax strategy — it's a signal of confidence. Lucas: Exactly. And if these conversations about exit strategies are useful for what you're building or running — we just want to mention that listener support is what keeps this podcast ad-free and independent. If you find value in the show, you can support us at buy me a coffee dot com slash fexingo. It's a small way to help us keep digging into these structures. Luna: Yeah, and we really appreciate everyone who has chipped in. It lets us spend time on topics like rollover equity that don't get covered elsewhere. Lucas: Alright, back to the mechanics. One more thing I want to highlight: the holding period for the acquirer's stock. When you roll over, your holding period from the original shares carries over. So if you held your startup shares for more than a year, the acquirer's stock is considered long-term when you eventually sell. That qualifies for lower capital gains rates. Luna: That's a huge benefit. So you defer the tax and also get a lower rate when you eventually pay. It's almost like a double benefit. Lucas: As long as the acquirer's stock performs. And as long as you don't need the cash before you sell. Because another risk is liquidity — if you roll into a private company's stock, you might not be able to sell for years. So you're locking up your wealth. Luna: Which brings us back to the trade-off. Cash gives you freedom. Rollover gives you potential upside and tax deferral. There's no one right answer. Lucas: And that's really the takeaway. Rollover equity is a powerful tool in the right circumstances, but it's not for every founder. Know your own risk tolerance, get good advice, and negotiate the structure that fits your goals.