Investor: I’m in! But let’s do it with convertible debt.
Startup CEO: But we get the money, right?
Investor: Of course, this is just a way to manage risk and keep things flexible.
Startup CEO: Cool! When do we get the money?
VPTax: Not so fast. Although convertible debt is on occasion a preferred way to secure outside investment there are business and tax consequences to consider. Here is a tax angle to consider:
No tax deduction is allowed for interest paid (or payable) on a company stock when the payment is at the option of the company itself. So, if the debt looks like a stock grant, tax deductions for interest on that debt may not be allowed. The key factors are:
- the debt carries the option to receive stock/equity (is “convertible”) AND
- there is a reasonable certainty that the holder will choose the stock/equity over cash payments of interest
- So, if the debt is really an equity position in disguise, Startup won’t be entitled to a tax deduction for the interest. If Startup is in a tax loss position, foregoing an additional tax deduction may not be the end of the world. But it is a consideration because tax losses are assets too (but that’s a topic for a different day).
Finally, if you are operating as an S Corp, LLC or straight-up partnership, the partners may be using the deductions/losses that flow through on their Startup K1 against other business income. So they might care that cash is going out of Startup without even a tax deduction to show for it.
Just a thought…
About VPTax, Inc.
VPTax is a professional services firm that provides startup companies with the tax expertise of veteran tax professionals (Big 4 partners and seasoned VPs and Tax Directors) on a fractional basis that match your needs and budget. VPTax is a better alternative to traditional broad-scope accounting firms. VPTax’s fully managed, proprietary tax solution scales to support companies at every stage of development, from inception through rapid growth to IPO and beyond. For more information about VPTax, visit VPTax.com.