Three Basic Rules: Dilution, Dilution, Dilution

Take a sample of 100 venture-backed companies successful enough to undertake an initial public offering. In a high percentage of the transactions, the prospectus discloses that the earliest stage investors (founders and angels) wind up with close to trivial equity percentages and thus, puny returns on their investment in the company. One would think that these investors are entitled to the lushest rewards because of the high degree of risk accompanying their early stage investments, cash and/or sweat. The problem, however, is dilution. Most early stage companies go through multiple rounds of private financing, and one or more of those rounds is often a “down round,” which entails a disappointing price per share and, therefore, significant dilution to those shareholders who are not in a position to play in the later rounds.

The problem of dilution is serious because it has a dampening impact on angels and others who are thinking of financing, joining or otherwise contributing to a start up. Estimates put the relationship of angel capital to early stage investments by professional VCs at five dollars of angel capital going into promising start ups for every one dollar of VC investment. But if angels are increasingly discouraged by the threat of dilution, particularly since the meltdown, we don’t have much of an industry; there is no one to start the engines. [1]

There are a variety of fixes for the dilution issue open to founders and angels.

  • Make sure you enjoy pre-emptive rights, the ability to participate in any and all future rounds of financing and to protect your percentage interest. Pre-emptive rights can be, of course, lost if you don’t have the money as founders and angels often do not to play in subsequent rounds.
  • Try to get a negative covenant; this gives you a veto over the subsequent round and particularly the pricing of the terms.

You don’t want to kill the goose of course, meaning veto a dilutive round and then once the Company fails for lack of cash; however, a veto right at least will you the opportunity to make sure the round is fairly prices; that the board casts a wide enough net so that the round is not an inside trade; meaning that the investors in control of the Company, go over in the corner and do a deal with themselves. Those rounds can be highly toxic to the existing shareholders (cram downs, as they are called). Finally, if you don’t have cash try to upgrade your percentage interest with derivative securities, options and warrants (a warrant is another word for option, they are the same security, a call on the Company’s stock at a fixed price but options are if the call was labeled if an employee is the beneficiary is the holder and the warrants are for everyone else). If you are the founding entrepreneur therefore, make sure you are a participant in the employee option program. Often the founder will start off with a sufficient significant percentage of the Company’s equity that she doesn’t feel necessary to declare herself eligible for employee options. This is a major mistake. In fact, I am likely to suggest founder client consider a piece of financial engineering I claim to have invented; the issuance of warrants in favor of the founders and angels at significant step-ups from the current valuation, which I call ‘up-the-ladder warrants.’ To see how the structure works, consider the following example:

Let’s say the angels are investing $1,000,000 in 100,000 shares ($10 per share) at a pre-money valuation of $3 million, resulting in a post money valuation of $4 million ($1 million going into the Company). We suggest angels also obtain 100 percent warrant coverage, meaning they can acquire three warrants, totaling calls on another 100,000 shares of the Company’s stock; however not to scare off subsequent venture capitalists or, more importantly, cause the VCs to require the warrants be eliminated as a price for future investments. The exercise prices of the warrants will be based on pre-money valuations which are relatively heroic win/win valuations, if you like. For the sake of argument, the exercise prices could be set at $30, $40 and $50 a share (33,333 shares in each case).

Let’s use a hypothetical example to see how this regime could work. Since the angels have invested $1 million at a post-money valuation of $4 million, they therefore own 25 percent of the Company–100,000 shares out of a total of 400,000 outstanding. The three warrants, as stated, are each a call on 33,333 shares. Subsequent down rounds raise $2,000,000 and dilute the angels’ share of the Company’s equity from 25 percent to, say, 5 percent–their 100,000 shares now represent 5 percent of 2,000,000 shares (cost basis still $10 per share) and the down round investors own 1,900,000 shares at a cost of $1.05 per share. Assume only one down round. Finally, assume the Company climbs out of the cellar and is sold for $100 million in cash, or $50 per share.

Absent ‘up-the-ladder warrants,’ the proceeds to the angels would be $5 million–not a bad return (5x) on their investment but, nonetheless, arguably inconsistent with the fact that the angels took the earliest risk. The ‘up-the-ladder warrants‘ add to the angels’ ultimate outcome (and we assume cashless exercise or an SAR technique, and ignore the effect of taxes) as follows: 33,333 warrants at $20/share are in the money by $666,660 and 33,333 warrants at $10 a share are in the money by $333,330. While the number of shares to be sold rises to 2,066,666, let’s say, for sake of simplicity, the buy-out price per share remains at $50, meaning the angels get another $999,999–call it $1 million. The angels’ total gross returns have increased 20 percent while the VCs’ returns have stayed at $95,000,000. Even if the $1,000,000 to the angels comes out of the VC’s share, that’s trivial slippage … a gross payback of 47.5 times their investment, vs. 47 times. If the company sells for just $30 a share, the angels get nothing and the VCs still make out.

For more information about raising Private Equity & Venture Capital, please visit VC Experts

Structuring a U.S. Real Estate Fund: A How-To Guide for Emerging Managers – Part Two

By Michael A. Bloom and Sung H. Hwang – Venable LLP (New York)

Read Part One.

4 Legal Structure.

Most, if not all, of U.S. real estate funds are organized as partnerships and, to a lesser extent, as limited liability companies under the laws of a state of the United States.  Delaware is the default state of choice in which to form a U.S. legal entity for transacting business and investments within the United States because Delaware has the most sophisticated corporate governance laws (e.g., laws relating to fiduciary duties of directors, officers, and general partners to shareholders and limited partners) and an efficient court system.  Delaware is not selected for tax reasons.

The choice of partnership form is principally due to its “flow-through” nature for U.S. federal income tax purposes, which will be discussed later.  While the limited liability companies have gained popularity in recent years, a limited partnership is still widely popular, because of many preferential tax and legal landscapes that have existed at the state and local levels governing real estate investments for many years.

A Delaware corporation (commonly known as a “C corp”[2]) is not used as the legal entity of choice for a U.S. real estate fund (or any private equity or hedge fund) because investors in a C corp are subject to “double taxation” in the U.S.[3]  To avoid “double taxation,” most U.S. real estate funds are structured using a “flow-through” entity (e.g., a state law partnership or limited liability company, classified as a partnership for income tax purposes), including ones that invest through REITs.

This article discusses four commonly used structures: (A) a limited partnership, (B) a corporate blocker, (C) a corporate blocker with leverage, and (D) a REIT.

A.   Delaware Limited Partnership.

In our example, Alejandro could structure the Coffee Fund as a Delaware limited partnership (“Coffee Fund LP”), since the fund’s investments will be made in the United States.[4]  Under this structure, Jay Gatsby, Silvio Bellini, and Maple Leaf Pensions would contribute capital to Coffee Fund LP in exchange for limited partnership interests in Coffee Fund LP.  See Chart 1 below.

Chart 1: Delaware Limited Partnership Structure


As mentioned above, partnerships are “flow-through” entities for U.S. federal income tax purposes.  Thus, unlike corporations, partnerships are not subject to income taxation at the federal level.  Rather, each item of income, gain, loss, deduction, and credit (collectively, “Income Items”) of the partnership “flows through” to the partners and is reported on the partners’ individual tax returns for the year.  For each of its taxable years, a partnership files an informational tax return: IRS Form 1065 (U.S. Return of Partnership Income).  Attached to IRS Form 1065 are Schedule K-1s for partners allocating to the partners their distributive shares of the partnership’s Income Items for the taxable year.

The theory of “flow-through” taxation is that partnerships are conduits through which individual partners come together to perform an activity in the aggregate.  As a result, the U.S. income tax rules governing partnerships (subchapter K of the Internal Revenue Code) require that the partnership’s Income Items be allocated among the partners consistent with how the partners have decided to share in the underlying partnership economics.  The dense tax boilerplate found in the partnership and limited liability company agreement of a typical U.S. real estate fund is designed to ensure compliance with these complex tax rules.

Because of the “aggregate” theory of partnerships, foreign investors may be reluctant to invest directly in partnerships operating a U.S. trade or business, as explained below.

(i)                 U.S. Investors.

Turning the page back to the investors, we see that Jay Gatsby is likely content investing in a Delaware limited partnership.  Jay Gatsby would receive a Schedule K-1 from Coffee Fund LP each year, allocating to him his share of Income Items (i.e., income, gains, losses, deductions, and credits).  These Income Items would be reported on his IRS Form 1040 (U.S. Individual Income Tax Return) filed jointly with his wife, Daisy Fay Buchanan.[5] Allocated ordinary income and short-term capital gain would be taxed at normal graduated rates up to 39.6%, at the federal level.  Allocated long-term capital gains would be taxed at the current preferential rate of 20%, plus the 3.8% NII tax.  As compared to a corporate structure, Jay Gatsby is likely content investing in a Delaware limited partnership.

(ii)               Foreign Investors.

The tax treatment of Alejandro’s foreign investors, Maple Leaf Pensions and Silvio Bellini, is more complicated for three reasons:

  1. These investors generally will be taxed on a “net basis” (like Gatsby).
  2. If the foreign investor is a corporation, it will pay an additional 30% branch profits tax on its after-tax income.
  3. Foreign investors that are resident in jurisdictions with which the U.S. has entered into income tax treaties may be entitled to treaty benefits, which usually include exemption from the branch profits tax or reduction in the branch profits tax rate.[6]

The purpose of the branch profits tax is to prevent foreign corporations from avoiding “double taxation” by conducting business in the U.S., but not through a corporate subsidiary (i.e., through a branch), since dividends paid by a U.S. corporate subsidiary to a foreign parent are subject to a 30% federal withholding tax.  Consequently, the branch profits tax rate matches the withholding tax rate on dividends of 30%, subject to treaty elimination or reduction.  As Maple Leaf Pensions (but not Bellini) is a corporation for U.S. income tax purposes, Maple Leaf Pensions would owe an additional 30% branch profits tax on its after-tax income – essentially making Maple Leaf Pensions (unlike Gatsby) tax agnostic between investing in a U.S. corporation or U.S. partnership.

There is, however, another layer of complexity when dealing with foreign investors.  Foreign investors resident in jurisdictions that have entered into income tax treaties with the U.S. may be eligible for elimination or reduction of the federal-level taxes under the treaty.  Some old U.S. tax treaties provide for complete exemption from the branch profits tax, while many recent U.S. tax treaties extend to branch profits tax the same elimination or reduction in withholding tax on dividends.

Whether a foreign investor is eligible for treaty benefits generally depends on whether the U.S. has a tax treaty with the foreign investor’s tax residence under local law.  In our example, Maple Leaf Pensions and Silvio Bellini are residents of Canada and Italy, respectively, and the United States has income tax treaties with these two countries.  Both treaties significantly reduce the dividend withholding tax rate (and the branch profits tax rate) from 30% to 5%, because the Coffee Fund will invest in U.S. real estate.  This rate reduction significantly mitigates the burden of “double taxation.”  For example, because of these treaty benefits, if Silvio Bellini’s investment was made into a U.S. corporation, his combined effective tax rate would be only 38.25% (not 50.4%).[7]  Readers paying careful attention will have noticed that this rate does not include the 3.8% NII tax, as the NII tax generally does not apply to income earned by foreign investors.

Thus, there is no meaningful difference in effective U.S. federal tax rates between Bellini and Maple Leaf Pensions on rental and other ordinary income of the fund (39.6% vs. 38.25%), but there is still a pretty big difference on any long-term capital gains (i.e., gain from the sale of capital assets held for more than one year) generated by the fund (23.8% vs. 38.25%).

However, that is not the end of the story for Maple Leaf Pensions.  Many income tax treaties provide for favorable treatment for pension arrangements that meet certain criteria.  If Maple Leaf Pensions can demonstrate that it is a qualifying pension fund under the U.S.-Canada income tax treaty, it may escape the branch profits tax altogether and be subject only to the 35% federal corporate income tax.

(iii)            U.S. Tax Compliance.

Putting aside the rate differences, foreign investors frequently are loath to invest in a U.S. flow-through entity operating a U.S. trade or business, because it requires them to a file U.S. income tax return: U.S. Internal Revenue Service (IRS) Form 1120-F (U.S. Income Tax Return of a Foreign Corporation) or Form 1040-NR (U.S. Nonresident Alien Income Tax Return).  As noted above, partnerships are tax conduits such that their income and loss “flow through” to the partners, and the partners must file U.S. income tax returns reporting this income.  If the foreign partner would not otherwise be required to file a U.S. income tax return, the receipt of such “flow-through” income triggers this new obligation.

A U.S. flow-through entity, such as Coffee Fund LP, will have an obligation to periodically withhold and remit to the IRS an estimated tax with respect to each foreign investor, based on the investor’s distributable share of the fund’s taxable income and gain.  Such withholdings are treated as actually having been distributed to the investors for purposes of the distribution waterfall.  A foreign investor will be required to file an income tax return after the close of each year, where it reconciles the tax withheld with the actual tax liability for the year.  U.S. income tax return filers, therefore, become subject to the investigatory and subpoena powers of the IRS.

In contrast, U.S. corporations are not flow-through entities and are responsible for filing their own U.S. income tax returns (IRS Form 1120, U.S. Income tax Return) and paying their own taxes.  Dividends paid by a U.S. corporation to foreign investors, while taxable in the U.S., are handled through withholding at the source, so foreign investors do not need to file a U.S. income tax return to report dividend income to the U.S. tax authorities.

(iv)             Sponsor’s Share of Fund’s Profits.

Generally, the carry or promote paid to the sponsor will be structured so that it is taxed in a manner that is similar to the way in which the investors who actually put up the cash are taxed on the distributions from the same investment.  Currently taxation of “carried interests” has received significant negative publicity because of the lower tax rates it tends to generate, and there are ongoing discussions about different ways to change the law, so that it is taxed more like service income at higher tax rates.

B.   Corporate Blocker.

Often U.S. tax-exempt investors or foreign investors (Maple Leaf and Bellini) will prefer to invest in a U.S. real estate fund through a “blocker” corporation, as shown below:

Chart 2: Delaware Limited Partnership Structure with a Corporate Blocker

The corporate blocker for a U.S. real estate fund typically is formed as a U.S. corporation, but there are many variations to this approach.  A U.S. tax-exempt investor may use a corporate blocker if the investment strategy is likely to yield income and gain that is taxable as “unrelated business taxable income” (UBTI).  UBTI is income that is generated in a manner and purpose inconsistent with the tax-exempt purpose of the investor, and is taxable at corporate tax rates.  Generating UBTI can create perception issues and, in limited instances, result in tax penalties and/or the disqualification of tax-exempt status. For foreign investors, investing through a blocker also avoids their having to file a U.S. income tax return.

Thus, the foreign investors’ income from the Coffee Fund is “blocked” from direct U.S. income taxation and reported by the U.S. corporation (the “Coffee Fund Blocker”).  Earnings distributed from Coffee Fund Blocker to Bellini and Maple Leaf are taxed again as a corporate dividend from a U.S. corporation to a foreign person.  Interposing a corporate blocker may result in increased U.S. tax cost to foreign investors, depending on the facts and circumstances.

In our example, Bellini’s effective federal tax rate on ordinary income actually goes down slightly, from 39.6% to 38.25%, while his U.S. federal tax for long-term capital gain jumps from 23.8% to 38.25%.  Since the Coffee Fund is counting on the economy of scale and better management fetching higher valuations (i.e., capital appreciation), Bellini’s U.S. federal tax cost could increase significantly if he invests through the Coffee Fund Blocker.

In addition, because of the compliance costs, such as annual separate accounting, tax, and registration costs, a corporate blocker is a high-maintenance proposition for some foreign investors.  Bellini, being a man of numbers, decides that the Coffee Fund Blocker is not warranted, especially since Italy has a tax system comparable to that of the U.S., allowing a degree of tax credit for income tax paid overseas, defraying a significant portion of his U.S. tax cost.

Read Part Three on 3/28/2017.


[2] The term “C Corp” comes from the fact that, without a special entity tax classification election, it is taxed pursuant to Subchapter “C” of the Internal Revenue Code.

[3] Specifically, U.S. corporations are taxed at the entity level on their worldwide income, currently at rates as high as 35% at the federal level.  After being taxed at the corporate level, corporate earnings are taxed again when distributed to shareholders as a dividend.  Dividends from a C corp in the hands of an individual investor currently are taxed at rates as high as 20% at the federal level, and are subject to an additional 3.8% Medicare tax on net investment income (the NII tax) that exceeds an income threshold.  This translates into a combined 50.47% effective tax rate at the federal level on the fund’s income.

[4] Forming a Delaware limited partnership requires filing a Certificate of Limited Partnership with the Delaware Division of Corporations in accordance with the Limited Partnership Act of the State of Delaware.

[5] In this hypothetical, Gatsby and Daisy are married.

[6] For a list of countries that have an income tax treaty with the U.S. see international-businesses/united-states-income-tax-treaties-a-to-z.

[7] 38.25% = 35% (corporate income tax) + (1-35%)*5% (branch profits tax)



Michael Bloom is counsel in Venable’s Tax and Wealth Planning Group, where he provides tax advice on all types of corporate transactions, such as mergers & acquisitions, restructurings, and venture capital investments. He is based in New York. In particular, Michael’s tax practice focuses on advising emerging fund managers on fund formation and portfolio acquisitions.

Sung H. Hwang

Sung Hyun Hwang is a partner in Venable’s Tax and Wealth Planning practice, based in New York. He focuses on the full spectrum of business tax law, from complex structured financial products to multi-partner business joint ventures. Mr. Hwang has significant experience in domestic and cross-border transactions involving real estate partnerships and funds, private equity funds, hedge funds, asset managers, family offices, and financial institutions. Mr. Hwang also has significant experience in the tax credit space, including the energy-based tax credit area.

Venable LLP

Venable ( has taken a two-pronged approach to building its global reach, one which delivers superior value, and maximizes the quality lawyering and client service that its clients expect. In many cases, it provides counsel directly to U.S. and foreign-based companies, institutions and individuals. Venable frequently deliver value to its clients in a number of very specialized areas where international recognition and scope are imperative. Examples include: FCPA; Tax; Privacy, Data Protection and Internet; International Trade; Intellectual Property; Advertising, Marketing and New Media.

Structuring a U.S. Real Estate Fund: A How-To Guide for Emerging Managers – Part One

By Michael A. Bloom and Sung H. Hwang – Venable LLP (New York)

1 Introduction.

There is always a line at Starbucks.  That line means steady rents for landlords leasing to Starbucks tenants.  A common real estate fund model is to “roll up” multiple freestanding, single-tenant commercial properties, like Starbucks, into a single asset that accomplishes an economy of scale, diversifies risks, and achieves a portfolio size that is palatable to investors with real money.  These funds can offer investors steady cash flows, capital appreciation, tax-sheltered returns from depreciation deductions, and portfolio diversification away from stocks and bonds.

For emerging fund managers in this space, the structuring legalese can be confusing; but it is important.  Legal structures directly impact investor returns and risk management profile.  In general, tax considerations are foundational to any real estate fund legal structure.  The goal of these tax considerations is simple: minimize taxes on investor earnings and management compensation without undue complexity.  This article walks the reader through a basic structuring analysis.[1]

2 The Economics of Real Estate Funds.

Before we wade into the tax pond, let’s review a typical real estate fund’s economics in broad strokes.

A typical U.S. real estate fund will have a limited life span of not more than 10 years.  Its life cycle will comprise an initial investment-reinvestment period during which the fund will seek out and purchase real property that meets the investment criteria set out by its sponsor (a/k/a “general partner” and/or “managing member”), followed by a longer holding period, during which the fund will seek to increase the value of the real property (whether by mere passage of time or through improvements made to the real property) and, last, a liquidation period when the properties are disposed of and the cash is distributed to investors.  Often, the fund will have one or more optional extension periods to deal with unexpected changes in investment values or disposition strategies.

The limited life of a U.S. real estate fund often is ascribed to the fact that real estate is very illiquid, not homogeneous, typically cyclical, and sensitive to economic conditions and investor sentiments.  A sponsor generally will identify what he perceives to be a niche in the real estate valuation for a particular type of property during a particular period, and devise an investment strategy to exploit the niche.

Given the characteristics of real estate noted above, however, a real estate fund will be able to identify only so many investment opportunities that fit the fund’s investment strategy during any given period.  For example, some funds will attempt to exploit perceived valuation distortions, while some will seek to increase the property value through turn-around strategies, and others will seek stable, income-producing properties.  In addition, investing in real estate takes a significantly greater amount of time and money compared with other assets, especially liquid securities.

Because of this “lead-in” and “lead-out” nature of a U.S. real estate fund’s activities, a U.S. real estate investment fund rarely changes its investment strategy midcourse, barring unforeseen circumstances, such as a radical shift in asset values.  Often a fund will not be able to change its investment strategy without investor consent, since investors invested on the basis of that strategy.  Thus, when the real estate investment landscape changes significantly after a fund is formed, the sponsor typically will simply cease making investments from one fund and form a new fund rather than try to change the direction of an existing fund.

The same peculiarities of real estate investment also require that a sponsor heavily regulate the cash flows into and out of a fund to manage the fund’s liquidity and valuation.  A typical real estate fund will raise funds through subscriptions made by investors in one or more closings of limited partnership interests (or limited liability company membership interests) over a limited period, once the sponsor identifies an investment strategy and makes his business case to potential investors through the offering materials (e.g., the “Private Placement Memorandum” or PPM).  The PPM lays out the terms of the offering.  The PPM is often presented to potential investors at meetings and presentations – called “road shows,” subject to the applicable requirements of the securities law (e.g. the general solicitation and advertising rules).

The first one or two investors often get preferential treatment and are called “seed investors.”  Investors coming in through later closings typically pay an interest factor to compensate the early birds for footing the bill for the first investments.  New investors will not be allowed into the fund after the investment-reinvestment period has ended.

Investors will not fund all of their capital commitments in their subscriptions upfront.  Instead, they gradually fund the investments as they are identified and purchased in accordance with the fund’s investment criteria.  Once invested, investors typically will not see the bulk of their funds until the back end and, therefore, typically will expect a minimum rate of return to compensate for the time value of their invested money, generally known as the “preferred return.”

An investor generally will not be able to receive distributions, or redeem its interests in the fund, or withdraw from it, ahead of other investors, unless a compelling legal or regulatory justification (often the tax status of the investor being jeopardized without the withdrawal) exists.  An investor will not be able to sell or otherwise transfer its interest in the fund without the consent of the sponsor.

While there are a myriad of ways to “slice and dice” the way investment proceeds are distributed among the investors and the sponsor, often a real estate fund will allocate cash pursuant to a distribution “waterfall” (either on a per-investment or the aggregate basis) that identifies the timing, amount, and priority of each distribution.  Generally, a fund will pay investors, first, a preferred return on the invested capital, then a return of capital, and then divide the remaining funds between the investors and the sponsor.

The sponsor’s share of these remaining proceeds is often called “carry” or “promote,” which sometimes is subject to a “holdback” or “clawback” obligation to ensure appropriate promote sharing based on the economic performance of a fund during its entire life cycle.  This right to carry or promote often is called “carried interest” or “promote interest” or “sweat equity” and, in tax jargon, “profits interest.”

Often, because of the complexity of tax rules, actual tax liability of an investor for an investment in a U.S. real estate fund will differ from the investor’s actual amount and timing of cash receipts.  Therefore, frequently, a fund will build in the concept of a “tax distribution” to help investors pay their taxes on taxable income allocated to them ahead of the actual receipt of corresponding cash.  Such tax distribution is generally structured as an advance against the recipient’s share of regular distribution that will come later, similar in concept to loaning to self-employed individuals to pay their estimated taxes during the course of a year before reconciliation through the year-end tax return.

A sponsor typically will earn this promote, plus a management fee (to pay for and reimburse its management and operating expenses).  The management fee is typically computed as a percentage of the capital commitment during the investment-reinvestment period and, afterward, as a percentage of the invested capital, which may or may not include any leverage employed in making the investments.  In addition, investors may ask the sponsor to make its own capital investment on the same terms as the investors, to have some “skin in the game.”

3 Hypothetical Example.

Let’s assume a hypothetical example.  Alejandro Java, a 35-year-old graduate of the Michigan Ross School of Business, wants to leave his job at Blue Corners Capital to launch his own U.S. real estate fund – “the Coffee Fund.”

Alejandro has identified 30 properties in Illinois and Michigan under long-term leases with Dunkin Donuts tenants.  Alejandro believes he can add immediate value by the purchase and consolidated management of all 30 properties.  To do so, Alejandro needs capital.  Specifically, he needs $150MM because he has valued the 30 properties at an average of $5MM each.  Assuming that he can finance the acquisition price with 60% bank debt, Alejandro needs to raise $60MM of equity capital.

Alejandro prepares the PPM and other offering materials and travels on a road show around the world to meet with select investors.  He meets privately with potential investors and finally reaches commitments with the following three investors, the “seed investors,” for the first closing of his offering:

  1. Jay Gatsby, a resident of Long Island, NY – $24MM
  2. Silvio Bellini, a resident of Italy – $24MM
  3. Maple Leaf Pension, a Canadian pension fund – $12MM

Because of his stellar presentation, Alejandro will not be required to contribute his capital to the Coffee Fund (thus, no “skin in the game”) and will receive a 20% promote and a 2% management fee.

The Coffee Fund will have a life of 10 years, with two 1-year extensions at the sponsor’s disposal.  The first 3 years will be its investment-reinvestment period, during which it intends to acquire the 30 Dunkin Donuts properties.  The fund will hold the properties for appreciation due to traffic increase in their geographic areas and plans to start their sales in year 8 of the fund’s life until all of the investments are sold and the fund is liquidated in year 10.

Alejandro is elated, but does not want to pursue further capital through additional capital commitments at this point and wants to begin working right away.  How should the Coffee Fund be structured to make his business case as enticing as it was? Let’s look at the most often used legal structure for U.S. real estate funds.

Part Two posted 3/21/2017.


[1] This writing was prepared for marketing purposes and does not constitute tax opinion or advice to any taxpayer.  Each taxpayer should consult its own tax advisor for the application of the tax laws to its own facts.  In addition, this writing is based on current U.S. federal income tax law, and the authors will not update any reader on any future changes, including those with retroactive effect, in U.S. federal income tax law.  This article does not address any state, local, foreign, or other tax laws, except as used in the writing for illustrative purposes only.



Michael Bloom is counsel in Venable’s Tax and Wealth Planning Group, where he provides tax advice on all types of corporate transactions, such as mergers & acquisitions, restructurings, and venture capital investments. He is based in New York. In particular, Michael’s tax practice focuses on advising emerging fund managers on fund formation and portfolio acquisitions.

Sung H. Hwang

Sung Hyun Hwang is a partner in Venable’s Tax and Wealth Planning practice, based in New York. He focuses on the full spectrum of business tax law, from complex structured financial products to multi-partner business joint ventures. Mr. Hwang has significant experience in domestic and cross-border transactions involving real estate partnerships and funds, private equity funds, hedge funds, asset managers, family offices, and financial institutions. Mr. Hwang also has significant experience in the tax credit space, including the energy-based tax credit area.

Venable LLP

Venable ( has taken a two-pronged approach to building its global reach, one which delivers superior value, and maximizes the quality lawyering and client service that its clients expect. In many cases, it provides counsel directly to U.S. and foreign-based companies, institutions and individuals. Venable frequently deliver value to its clients in a number of very specialized areas where international recognition and scope are imperative. Examples include: FCPA; Tax; Privacy, Data Protection and Internet; International Trade; Intellectual Property; Advertising, Marketing and New Media.

What Not To Say In a Business Plan

Guest Post by: Barry Moltz

The following is an excerpt from his e-book entitled, Growing Through Rants and Raves. Barry Moltz is also the writer of a book entitled You Have to Be a Little Crazy, which delivers irreverent, straight talk about the complex intersection of start-up business, financial health, physical well-being, spiritual wholeness and family life. This title and other publications by Barry can be viewed at his website,

Sometimes I find that the company’s founder is so far ‘outside the box’ that they ‘stretch the envelope.’ As an angel investor, I review more than 500 business plans each year. Unfortunately, many are so riddled with economy lingo, business jargon and clichés, that they do not communicate any real business value. In my opinion, terminology, such as disintermediation, sweet spot, ASP, best of breed, and win-win should be outlawed for the next 100 years. For building a real business, these terms are meaningless. Another challenge when reviewing business plans is that the introductory sentences sometimes stretch for an entire paragraph as the entrepreneur looks for that all-encompassing way to describe their business. Forget it! There isn’t one. Many times I want to strangle the writer to simply tell me what they do in five words or less. Poor choice of words: This business makes mechanical gasoline fueled devices, used for transportation, more efficient by periodically sending them through an applied for patent machine to loosen the terra firma from these vehicles to make them more conducive at performing their task. Solid choice of words: We run a car wash. Another frequently used practice is to create a business plan using template software or by working from an existing plan. I do not recommend this practice and like to refer to William Sahlman in his Harvard Business case study “Some Thoughts on Business Plans.” This case study has continuously inspired me to see beyond clichés and catchphrases and better interpret misleading statements within business plans.

If the plan says: “Our numbers are conservative.” I read: “I know I better show a growing profitable company. This is my best-case scenario. Is it good enough?” Since all numbers are based on assumptions, projections in business plans are by their very nature a guess and are not conservative.

If the plan says: “We’ll give you a 100 percent internal rate of return on your money.” I read: “If everything goes perfectly right, the planets align, and we get lucky, you might get your money back. Actually, we have no idea if this idea will even work.” No one can predict what an investor’s return will be. Let them decide.

If the plan says: “We project a 10 percent margin.” I read: “We kept the same assumptions that the business plan software template came with and did not change a thing. Should we make any changes?” Ensure you have developed your financial projections from the ground up.

If the plan says: “We only need a 5 percent market share to make our conservative projections.” I read: “We were too lazy to figure out exactly how our business will ramp up.” Know what it will cost to acquire customers. Gaining 5 percent market share is not an easy task in a large market.

If the plan says: “Customers really need our product.” I read: ” We haven’t yet asked anyone to pay for it.” or “All our current customers are our relatives” or “We paid for an expensive survey and the people we interviewed said they needed our product.” The definition of a business is when people pay you money to solve their problems. This is the only way to prove people “need it.”

If the plan says: “We have no competition.” I read: Actually … I stop reading the plan. Always beware of entrepreneurs that claim they have no competitors. If they are right, it’s a problem and if they are wrong, it is also a problem. Every business has competitors or else there is a current solution to this customer need. If there are no competitors for what the entrepreneur wants to do, there is a good chance there also is no business. So what should an entrepreneur do? Write the plan in plain and proper English. Please understand that the reader comes to the plan with no knowledge of your business. No fancy words, clichés or graphs will make them want to invest. Understand every part of your plan and be able to defend it. Use your own passion to describe your plan. Make your plan your own.

The 11 things that matter in a business plan:

  • What problem exists that your business is trying to solve. Where is the pain?
  • What does it cost to solve that problem now? How deep and compelling is the pain?
  • What solutions does your business have that solve this problem?
  • What will the customer pay you to solve this problem? How solving this problem will make the company a lot of money.
  • What alliances can you leverage with other companies to help your company?
  • How big can this business get if given the right capital?
  • How much cash do you need to find a path to profitability?
  • How the skills of your management team, their domain knowledge, and track record of execution will make this happen.

Please remember, the business plan is basically an “argument” where you need to state the problem and pain, then provide your solution with supporting data and analogies.

After a Down Round: Alternatives for Employee Incentive Plans

*Excerpt from VC Experts Encyclopedia of Private Equity & Venture Capital

Employee Incentive Plans for Privately-Held Companies

Despite the recent improvement in capital markets activity, many small, privately-held technology companies continue to face reduced valuations and highly dilutive financings, frequently referred to as “down rounds.” These financings can create difficulties for retention of management and other key employees who were attracted to the company in large part for the potential upside of the option or stock ownership program. When down rounds are implemented, the investors can acquire a significant percentage of the company at valuations that are lower than the valuations used for prior financing rounds. Lower valuations mean lower preferred stock values for the preferred stock issued in the down round, and as preferred stock values drop significantly, common stock values also drop, including the value of common stock options held by employees.

Consequently, reduced valuations and “down round” financings frequently cause two results: (i) substantial dilution of the common stock ownership of the company and (ii) the devaluation of the common stock, particularly in view of the increased aggregate liquidation preference of the preferred stock that comes before the common stock. The result is a company with an increasingly larger percentage being held by the holders of the preferred stock and with common stock that can be relatively worthless and unlikely to see any proceeds in the event of an acquisition in the foreseeable future.

In the face of substantial dilution of the common stock and significant devaluation in equity value, companies are faced with the difficulty of retaining key personnel and offering meaningful equity incentives. Potential solutions can be very simple (issuing additional options to counteract dilution) or quite complex (issuing a new class of stock with rights tailored to balance the concerns of both investors and employees). Intermediate solutions range from effecting a recapitalization that will result in an increase in the value of the common stock to implementing a cash bonus plan for employees that is to be paid in the event of an acquisition. Each approach has its advantages and disadvantages, and each may be appropriate depending on the circumstances of a particular company, but the more complex alternatives can offer companies greater flexibility to satisfy the competing demands of employees and investors. This article briefly reviews three of the solutions that can be implemented-the use of additional options, recapitalizations and retention plans (cash and equity based).

Granting Additional Options

The simplest solution to address the dilution of common stock is to issue additional employee stock options. For example, assume that, prior to a down round, a company had 9,000,000 shares of common and preferred stockoutstanding and the employees held options to purchase an additional 1,000,000 shares. Also assume that, in the down round, the company issued additional preferred stock that is convertible into 10,000,000 shares of common stock. On a fully-diluted basis (i.e., taking into account all options and the conversion of all preferred stock), the employees have seen the value of their options reduced from 10% of the company to 5%, or by 50%. In this case, the company might issue the employees additional options to increase their ownership percentage. It would require additional options to purchase in excess of 1,000,000 shares to return the employees to a 10% ownership position, although a smaller amount would still reduce the impact of the down round and might be enough to help entice the employees to stay.

If the common stock retains significant value, the grant of additional options can be an effective solution. It is also relatively straightforward to implement; at most, stockholder approval may be required for an increase in the optionpool. In many cases, however, the aggregate liquidation preference of the preferred stock is unlikely to leave anything for the common holders following an acquisition, particularly in the short term. In that event, the dilution of the common stock becomes less relevant – 5% of nothing is the same as 10% of nothing. Companies with this kind of common stock devaluation will need to consider more intricate solutions.


If the common stock has been effectively reduced to minimal value by the down round, a company could increase the common stock value through a recapitalization. A recapitalization can be implemented through a decrease in the liquidation preferences of the preferred stock or a conversion of some preferred stock into common stock, thereby increasing the share of the proceeds that is distributed to the common stock upon a sale of the company. This solution is conceptually straightforward and certainly effective in increasing the value of the common stock. In most cases with privately-held venture capital backed companies, however, the holders of the preferred stock are the investors who typically fund and implement the down rounds and in nearly all cases the preferred stockholders have a veto right over any recapitalization. Accordingly, implementing a recapitalization would require the consent of the affected preferred stockholders, which may be difficult to obtain, particularly because the preferred stockholders may not like the permanency of this approach. In addition, a recapitalization can be quite complicated in practice, raising significant legal, tax and accounting issues.

Retention Plans

Another approach is the implementation of a retention plan. Such plans can take a number of forms and can use cash or a new class of equity with rights designed to satisfy the interests of both the investors and employees. These solutions are more complicated, but also more flexible.

Cash Bonus Plan

In a cash bonus plan, the company guarantees a certain amount of money to employees in the event of an acquisition. This amount can equal a fixed sum or a percentage of the net sale proceeds, to be allocated among the employees at the time of the sale, or it can be a fixed amount per employee, determined in advance. Allocations can be based on a wide variety of parameters, enabling a high degree of flexibility. Often these plans have a limited duration (such as 12 to 24 months, or until the company raises a specified amount of additional equity).

A cash bonus plan is easy to understand, provides the employees with cash to pay any taxes that may be due and can be flexible if the allocations are not determined in advance. However, there are a number of hurdles. Many acquisitions are structured as stock-for-stock exchanges (i.e., the acquiring company issues stock as payment for the stock of the target company) because such exchanges may be eligible for tax-free treatment. A cash bonus plan may interfere with the tax-free treatment and, thus, may reduce the value of the company in the sale or may be a barrier to the transaction altogether.

A cash bonus plan can also be problematic in that it requires cash from a potential acquirer in the event there isn’t sufficient cash on hand in the target company. A mandatory cash commitment from an acquiror may also make the company less attractive as a target. Typically, a cash bonus plan can be adopted (and amended and terminated prior to an acquisition) by the board of directors, although a cash bonus plan creates an interest that may in effect be senior to the preferred stock, which requires consideration as to whether the consent of the preferred holders is required.

New Class of Equity

A stock bonus or option plan utilizing a new class of equity, although more complicated, shares many of the benefits of the cash bonus plan, but avoids some of the major disadvantages. A newly created class of equity, such as senior common stock or an employee series of preferred stock, permits the use of various combinations of rights. The new class of equity can be entitled to a fixed dollar amount, a portion of the purchase price or both. These rights can be in preference to, participating with or subordinate to any preferred holders, and the shares may be convertible into ordinary common stock at the option of the holders or upon the occurrence of certain events. Referring to our earlier example, the company might return the employees to their pre-down round position by issuing them senior common stock entitled to 10% of the consideration (up to a certain amount) in any sale of the company. Although a return of the employees to their pre-down round position may not be acceptable to the preferred stockholders and may not be necessary to keep the employees incentivized, the new class of equity can be tailored to fit whatever balance is acceptable to the investors.

This type of approach has several advantages. First, unlike a simple issuance of additional options, it gives real value to employees that were affected by a devaluation of their common stock. Second, unlike a cash bonus plan, it does not require an acquiror to put up cash when they purchase the company and the acquirer is less likely to discount the purchase price. Third, unlike a cash bonus plan, it will not affect the tax-free nature of many stock-for-stock acquisitions. Finally, it provides certainty to the participants, who know exactly what they will be entitled to receive upon a sale of the company.

The main disadvantage of creating a new class of equity, at least from the employees’ standpoint, is that the employee will either have to pay fair market value for the stock when it is issued or recognize a tax liability upon such issuance, when they may not have the cash with which to pay the taxes. This disadvantage can be partially ameliorated by the use of options for the new class of equity, rather than issuing the new equity up front, which at least allows the employee to control the timing of the tax liability by deciding when to exercise. Moreover, for many employees an option may qualify as an incentive stock option under federal tax law, thus allowing the employee to defer taxation until the sale of the underlying stock. A new class of equity will also be somewhat more difficult for most employees to understand, at least when compared to traditional common stock options.

In addition, a new class of equity adds complexity from the company’s perspective. It may raise securities and accounting issues, and shareholder approval of an amendment to the company’s charter will be required. At a minimum, it will require more elaborate documentation than some of the simpler alternatives, such as a cash bonus plan, and thus it will likely be more expensive to implement at a time when the company may be particularly sensitive to preserving its cash. A new class of equity may also result in future complications such as separate class votes or effective veto rights in certain circumstances. As with the other solutions that address the devaluation problem, there may be resistance from the existing preferred holders, whose share of the consideration upon a sale of the company would thereby be reduced.

These complexities are surmountable and companies may find that they are more than balanced by the advantages that a new class of equity provides over other solutions in addressing issues of reduced common stock valuations and dilution.

A Founder’s Guide to Making a Section 83(b) Election

Guest Post by: Kevin E. Criddle, Associate, DLA Piper

One of the more important tax decisions founders of early-stage companies will face is whether or not to make an election under Section 83(b) of the Internal Revenue Code for stock awards or other acquisitions of shares subject to vesting. By making this decision promptly upon acquiring the shares, founders can avoid missing the 83(b) filing deadline and protect themselves from significant tax consequences down the line. Below, we have set out six of the most commonly asked questions by our clients:

1) What is a Section 83(b) election?

Section 83(b) of the Internal Revenue Code allows founders, employees and other service providers to accelerate the time for determining taxable income on restricted stock awards or purchases subject to vesting. A Section 83(b) election is made by sending a letter (a sample form can be found here) to the Internal Revenue Service requesting to be taxed on the date the restricted stock was granted or purchased rather than on the scheduled vesting dates.

Founders that decide to make an 83(b) election need to do so promptly to ensure that they do not miss the 83(b) filing deadline. An 83(b) election must be filed with the IRS within 30 days after the grant or purchase date of the restricted stock. The last possible day for filing is calculated by counting every day (including weekends and holidays) starting with the day after the grant date.

 2) What are the benefits of an 83(b) election?

There are several reasons why filing an 83(b) election may be beneficial for a founder. Most notably, Section 83(b) of the Internal Revenue Code allows founders to accelerate the determination of taxable income on an award or purchase of restricted stock to the date it was granted rather than on the date(s) the shares vest. If the restricted stock is purchased for an amount equal to its fair market value, an 83(b) election will result in no recognition of income as of the purchase date. Additionally, an 83(b) election advances the beginning of the one-year long-term capital gain holding period, often resulting in preferential capital gain rather than ordinary tax treatment upon sale (long-term capital gain tax rates are 0, 15 and 20 percent for most taxpayers). Simply stated, an 83(b) election can result in significant tax savings under the right circumstances.

3) What happens if a founder does not file an 83(b) election?

If a Section 83(b) election is not filed by the deadline, a founder would pay taxes on restricted stock grants at each vesting date. The founder’s tax would be assessed at ordinary income rates on the amount by which the stock’s value on the vesting date exceeds the purchase price, if any. This may result in a significant tax obligation if the value of the shares has increased substantially over time.

4) What are the risks of an 83(b) election?

Despite its benefits, the 83(b) election is not without risk. Making a Section 83(b) election accelerates the date that taxable income is recognized from the vesting date to the date the restricted stock is granted or purchased. This means that if a founder makes an 83(b) election, pays taxes on income based on the fair market value of the shares on the grant date, and then later forfeits his or her shares, the founder may have paid tax on unrealized income.

5) What scenarios could make an 83(b) election more or less advantageous?

All things considered, a Section 83(b) election will likely be more (or less) advantageous for a founder in the following scenarios:

Section 83(b) Election is More Advantageous Section 83(b) Election is Less Advantageous
  • the amount of income reported at grant is small
  • the amount of income reported at grant is large
  • the stock’s growth prospects are moderate to strong
  • the stock’s growth prospects are low to moderate
  • the risk of stock forfeiture is very low
  • the risk of stock forfeiture is moderate to high

6) What are the steps to filing an 83(b) election?

To make an 83(b) election, the following steps must be completed within 30 days of the grant date:

  1. Complete a Section 83(b) election letter—a sample form can be found here.
  2. Mail the completed letter to the IRS within 30 days of your grant date:
  • Mail to the IRS Service Center where you file your tax return—the address for your IRS Service Center can be found here.
  • Preferably send the letter by certified mail and request a return receipt.
  1. Mail a copy of the completed letter to your employer.
  2. Retain one copy of the completed and filed letter for your records and retain proof of mailing.

As always, founders should consult with their tax advisors to determine how a Section 83(b) election applies to their individual circumstances.

Kevin E. Criddle, Associate, DLA Piper

Kevin Criddle’s practice focuses on securities and corporate finance, mergers and acquisitions, venture capital and private equity investments and general corporate counselling.