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Many startup employees become concerned with the percentage of their net worth tied up in just one equity holding.  This often is a double-edged sword as wise investors never want to be over-concentrated but early-stage startup employees are motivated by their perceived impact on the stock price. 

These equity holdings, which often include restricted stock units (RSUs), can pose unique financial and tax challenges due to their concentrated nature. We often find some of our clients feeling “trapped” as they are unsure if they want to hold a substantial amount of stock in one company, long term.  In some cases, it makes sense to hold the current equity positions while in other cases, some alternative maneuvers should be explored. 

Deep dive into the mechanics of exchange or swap funds

Exchange or “swap funds” offer a strategy for investors holding large positions in a single stock to achieve diversification without incurring immediate tax liabilities. 

These funds involve pooling together stock holdings from various investors, each heavily concentrated in their own company’s stock.  With diversification comes some perceived risk mitigation for the employee. 

  1. Participation criteria and eligibility to enter into the fund: Entry into a swap fund requires meeting rather strict criteria, typically involving the minimum size of stock contributions, which must be from publicly traded companies. These funds are also only available to Accredited Investors.  Investors who want to simply dip their toes into the water by contributing a small amount may be disappointed to discover the funds will require a substantial amount of stock contributed. 
  2. Valuation and equity exchange process: When investors contribute their stock to a swap fund, the fund's administrators assess the fair market value of the stocks to determine the proportionate shares of the fund that each participant should receive. 
  3. Management and fiduciary responsibilities: Swap funds are managed by highly skilled and specialized managers.  These fund managers are tasked with maintaining portfolio balance, within their strategic investment objectives, and ensuring compliance with various regulatory and tax requirements.

Diving deeper into the valuation and exchange process

The valuation and equity exchange process in swap funds is crucial to understand before entering into this transaction.

Step 1: Initial stock valuation

  1. Fair market value assessment: The value of the stock each participant contributes is determined based on the current market price (as these are public companies), adjusted for any recent volatility or known events. This might involve using an average price over a set period to account for market fluctuations.
  2. Adjustments for liquidity and marketability: For stocks that are less liquid or have market restrictions, adjustments such as discounts might be applied to reflect these factors. For smaller companies, this is normal but this may also cause some complexities. 

Step 2: Proportional share calculation

Once the fair market value is established, the fund calculates how many shares each participant will receive, based on their stock's value relative to the total pool.  Thus, step 1 is crucial to execute properly as this could severely impact your ultimate holding.

  1. Proportional equity exchange: Each participant’s equity contribution is converted into a proportional share of the swap fund. For example, if a contribution accounts for 5% of the total pooled value, the contributor receives 5% of the fund's shares. 
  2. Issuance of fund shares: Contributors receive their calculated shares of the swap fund, which they hold until they decide to redeem, subject to any fund terms and lock-up periods.

Step 3: Maintenance of the valuation over time

The fund managers will revalue the portfolio from time to time to ensure any fluctuation in stock prices is accounted for.  Again, this is very important, especially with smaller, more volatile companies.  

Tax implications and possible strategic advantages

One of the appeals of these funds lies in their capacity to offer tax-efficient diversification for those who feel overexposed to their company’s stock holdings.

Deferral of capital gains

By participating in a swap fund, investors will defer recognition of capital gains on their contributed stocks. 

There is no immediate taxable event upon the contribution to the fund.

The taxable event is deferred indefinitely until the investor chooses to redeem their shares in the fund.  Lock-up periods will prevent quick sales so the investor should understand how long their lock-up period may be. 

Long-term potential for reduced tax rates

By deferring the recognition of capital gains, participants may benefit from lower tax rates in the future. For example, if their income is lower upon retirement, they might qualify for a lower capital gains rate than in their high-earning years.

Despite their benefits, swap funds do have downsides to consider:

  1. Lock-up periods: Investors typically face lock-up periods during which they cannot withdraw from the fund unless there is a pre-approved circumstance. These periods require a long-term commitment to the investment, which must be weighed against the need for financial flexibility or liquidity in an emergency situation. 
  1. Fees and expenses: The costs associated with swap funds, including management fees and administrative expenses, should be considered given they will eat into your returns. These fees can vary significantly between funds so it is important to vet this up front. 
  1. Control over investment decisions: Participants in swap funds relinquish direct control over the specific stocks held within the fund's portfolio. Some may not realize that investment decisions are made by the fund managers, which requires trust in their expertise and you should seek alignment with the overall fund’s objectives. 

Key takeaway on exchange funds

For executives and employees with significant holdings in company stock, swap funds represent a sophisticated tool for diversification and tax management. However, the complexity of these instruments requires a thorough understanding and a strategic approach to financial planning.  Before going down the road of a swap fund, it is important to understand the fees associated with the fund as well as lock-up periods which catch some by surprise.  However, in the right cases, these funds offer a unique and potentially lucrative investment opportunity for some.

The information provided in this article does not constitute accounting, legal or financial advice and is for general informational purposes only. Please contact an accountant, attorney, or financial advisor to obtain advice with respect to your business.

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Co-CEO, Anomaly
Greg co-founded Anomaly CPA with John Malone, JD to specialize in working with entrepreneurial clients who own startups, high growth small businesses, and real estate investors growing into more complex tax and financial issues. His experience includes advanced tax planning and business advisory for a wide array of individuals, start ups and real estate investors. In 2020, Greg was named a Top 5 National Finalist for the Tax Planner of the Year by the AICTC, from a pool of over 850 qualified Tax Planners from across the US and Greg was named the #1 Tax Strategist in the United States by the AICTC in 2023. Greg was a 2023 and 2022 40 Under 40 and has helped lead Anomaly to the #1186 ranking on Inc5000 list.
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