Reverse Vesting And Holdback – Good News For Entrepreneurs?

"In this world nothing can be said to be certain, except death and taxes." Benjamin Franklin strikes again. However, in the world of high tech and Israeli tax there has been some uncertainty as to whether entrepreneurs, whose shares are subject to a reverse vesting mechanism or a holdback upon their sale, should be paying income or capital gains tax.

Reverse Vesting Most start-ups are founded by several entrepreneurs and the equity is divvied up among them. This is a good thing, it is hard to create a successful venture alone, and the composition of the founding team will be a factor in an investor's investment decision. The risk however is that an entrepreneur will leave the venture prematurely and with his shares. To reduce this risk, and to ensure that all entrepreneurs have skin in the game, we advise both entrepreneurs and early investors that entrepreneurs' equity should be subject to a reverse vesting schedule.

In other words, the entrepreneurs' shares are tied to their continued performance and involvement in the start-up. If they leave within a predefined period, they are required to return a portion of their shares. However it is not a perfect solution. The risk is that the tax authorities may view the shares as consideration for employment and therefore subject to income tax at a rate of up to 50%, rather than capital gains tax which has a lower tax rate of 25% - 32%.

Earlier this month the Israel Tax Authority (ITA) published a draft circular presenting its position that provided the following conditions are met, the sale of such equity should be considered a capital gain and not income: (i) The reverse vesting mechanism was agreed in advance and in writing at the time the company was incorporated (or soon thereafter), or was a result of a substantial investment in the company (at least 5%). (ii) The reverse vesting mechanism dictates that only the company or other existing shareholders are entitled to buy the forfeited shares, and that such sale shall be for no consideration or for their par value. (iii) The shares subject to the reverse vesting mechanism are ordinary shares, with identical rights to the other ordinary shares in the company. (iv) But for the reverse vesting mechanism, the gain from the sale of the shares would have been considered a capital gain.

Holdback

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