What is QSBS and Why Does It Matter?

Qualified Small Business Stock (QSBS), defined under Section 1202 of the U.S. Internal Revenue Code, is stock issued by eligible small businesses that provides significant tax benefits to investors. Qualified stockholders can exclude up to 100% of capital gains from federal taxes when selling their shares, provided they meet certain conditions. Maintaining detailed records of QSBS status is essential to ensure compliance and maximize tax benefits when a material event occurs.

QSBS compliance matters to all stockholders, including founders, because:

• Tax Savings on Capital Gains: Founders holding significant equity may exclude up to 100% of capital gains from federal taxes upon a liquidity event, subject to caps under Section 1202.
• Increased Attractiveness to Investors: QSBS compliance makes the company more appealing to current and future investors due to potential tax advantages.
• Encourages Long-Term Growth: The five-year holding period requirement aligns all stakeholders toward long-term success rather than short-term gains.

Criteria for QSBS

For a company to be considered QSB, the company must be a U.S. C corporation, engage in a "qualified trade or business" and have aggregate gross assets of less than $50,000,000. Additionally, a QSB must use at least 80% of its assets to conduct one or more "qualified trade or business" activities. The holder must hold the QSBS for more than five years at the time of sale. If the company conducts a disqualifying redemption from investors or any stockholders, the company may lose QSB status for up to 2 years.

A disqualifying redemption happens when a company buys back its own stock in a manner that violates QSBS rules. This can disqualify the stock from QSBS tax benefits. Redemptions become disqualifying when they occur within 1 year before or after the stock is issued and exceed 5% of the company's total stock value.

Repurchase of shares related to employee termination is not a QSBS disqualifying redemption.

Ongoing Requests for Information from Post-Seed Companies

OCV retains the right to request information periodically to document QSBS status for companies it has helped to launch. OCV does not produce any formal memo or evaluation of QSBS status with this information and only requires updated documentation to be supplied at the time of any material events that might impact QSBS (i.e. any new funding rounds).

Investor Right to Information

Under the covenant agreement outlined in investment terms, post-seed companies are required to provide ongoing information to document status with QSBS provisions. This right may appear differently depending on the term sheet format signed. For example:

• Specific QSBS Provisions: Some term sheets may explicitly outline provisions requiring commercially reasonable efforts to maintain QSBS status and periodic reporting obligations.
• General Investor Rights: In other cases, term sheets may include broader provisions granting major investors (e.g., those who meet a specified investment threshold) general information rights, inspection rights, first refusal rights, co-sale rights, and pre-emptive rights. These rights may implicitly or explicitly include the ability to request information related to QSBS compliance.

Regardless of the language, the right to request information ensures that transparency is maintained and compliance with QSBS regulations is documented effectively. The specific provisions governing these rights should be reviewed in your company’s signed term sheet and investment agreements.