Lesson #133: How to Avoid Paying Taxes on Startup Investments

For this lesson, I solicited the help of Ira Weiss, a Partner at Hyde Park Venture Partners in Chicago.  He first wrote on this topic for BuiltInChicago, but was gratious enough to let me share his learnings with all of my Red Rocket blog readers.

Taxes are currently on the minds of many investors because of the recent increase in tax rates. However, while taxes went up significantly for most investments, taxes for startup investments just dropped like a rock… all the way down to zero!   Although no investor is going to decide to bankroll a startup just because of tax benefits, taxes do matter to them. And, if you are an entrepreneur searching for capital, you want to give potential investors every reason in the world to say yes. What could be a better excuse than avoiding taxes?

Starting January 1, 2013, capital gains taxes were raised significantly for most investments, from 15% to 20% for some investors.  In addition, capital gains are now subject to a 3.8% Medicare surcharge. This makes the new tax rate closer to 23.8% -- a whopping 59% increase.  Not to mention, ordinary income taxes on any interest income received, grew from 39.6% to 43.4% for the highest income brackets.  This takes a big chunk of the upside out of traditional stock and bond investments.

But, startup taxes went in the opposite direction. As part of the recent American Taxpayer Relief Act of 2012, capital gains on most early stage investments are effectively ZERO because the investment gains are excluded from income.  This gave investors a real incentive to put more of their monies into startup companies, as a real shelter from paying taxes on the gains.

This special tax provision for startup investments is referred to as Qualified Small Business Stock, and it has been around for many years in various forms. The two important criteria for startups are: (i) they must be a C corporation, and (ii) they must have less than $50 million in assets when the investment is made.   In addition to avoiding federal income tax, investors also do not pay any state income tax on this type of investment.  Why?   Because given the way in which this tax provision works, the investment gains on startups are completely excluded in calculating federal income, and therefore none of the gains are passed through to the state tax return.

This startup "tax nirvana", as Ira likes to call it, does have a few restrictions and limitations. An investor can only exclude up to $10 million in gains or a up to 10x return, whichever is greater.  And, the stock must be held for at least five years by the investor.  As a startup entrepreneur, there is nothing you need to do to get your company to qualify. As long as you are a C-corp tax-payer, just complete your regular annual tax return, and be sure to list the amount of company assets on your tax return form.

These favorable tax rules have only been extended through Jan 1, 2014, but any startup investments made in 2013 will permanently qualify for the tax savings.  So, tell all your friends and angel investor targets that 2013 should be the year they start to move more of the investment capital into startups, to enjoy the tax savings while they still can.

Thanks again, Ira, for sharing your insights here.  To follow Ira on Twitter, you can follow him at @iraweiss.

For future posts, please follow me at:  www.twitter.com/georgedeeb.

Lesson #132: Design a Recurring Revenue Model

One of the first things that a venture capitalist looks for in assessing an investment opportunity is the revenue model of the business.  More specifically, they are looking for the frequency of that revenue stream, and whether or not it is recurring and easily predictable.  The rationale being investors prefer businesses that maximize the lifetime value of their consumers, and get maximum leverage and returns on the initial marketing cost of customer acquisition (which they are funding).  This lesson will teach you how to design a winning, recurring and predictable revenue model.

Let's compare two different businesses: iExplore's adventure travel business vs. Verizon's mobile phone service.  iExplore's adventure travel business is very expensive to market to, identifying affluent consumers that can afford a $5,000 vacation.  Let's say the cost of customer acquisition is $1,000 per customer, which eats up a good portion of the $1,500 (30%) gross margin on that trip sold.  Which would be OK, with a high frequency purchase.  But, adventure travelers buy a big vacation like this every couple years, so that is a long time to wait to drive repeat sales and to leverage your upfront marketing investment, hurting the lifetime customer value calculation.

On the other hand, Verizon's mobile phone service appeals to most everyone, regardless of demographics.  Everyone needs a mobile phone these days, so they are not looking for a needle in the haystack to whom to market their service.  So, their cost of customer acquisition will be a lot lower, closer to $300.  And, at $100 per month for their service, they will drive a large and recurring revenue stream over a five year period totaling $6,000 (assuming clients will remain with them and their service stays competitive over that period). 

That is a 20x relationship between between revenues and initial marketing cost for Verizon, and a 10x relationship for iExplore (assuming two vacations purchased in a five year period).  But, what Verizon has that iExplore does not is high predictability of future revenues.  Customers are locked up in two year contracts, and customers largely stay with the same carriers beyond the initial contract, assuming they are happy with the service.  So, they have pretty much locked-in good visibility to their future revenues for the next few years.  Where iExplore's customers may or may not buy a second vacation, in a market that is high cyclical and subject to big economic swings in demand for discretionary products of this nature.

It is pretty clear that Verizon beats iExplore, in terms of who has the better revenue model.  Their service appealed to a lot more potential customers. Their cost of acquisition was a lot lower.  Their lifetime value of customer revenues was a lot higher.  And, most importantly, their future revenue stream was a lot more predictable, which in the world of startups seeking capital from venture capitalists, means everything.

So, as you design your revenue model, make sure it is highly-recurring and highly-predictable, to maximize odds of securing capital for your business.

For future posts, please follow me at:  www.twitter.com/georgedeeb

[VIDEO] George Deeb Teaches Startups How to Pitch Venture Investors

I had the pleasure of mentoring the 2013 class of entrepreneurs at Founder Institute Chicago. Here is the presentation I delivered on "How to Pitch Venture Investors". The lesson provides high level guidance on: (i) how to sharpen your elevator pitch; and (ii) what points to drive home in your initial conversation. This lesson helps entrepreneurs learn what venture capitalists are listening for from startup pitches, and how to communicate your story in a way that maximizes your chance for funding.


George Deeb Teaches "How to Pitch Venture Investors" to Founder Institute Chicago Class from George Deeb on Vimeo.

The matching slide show can be found here:
http://www.slideshare.net/redrocketvc/how-startups-should-pitch-venture-investors

For future posts, please follow me at:  www.twitter.com/georgedeeb

Digital Trends for 2013

This year was another exciting year in digital the space, with many items on my list of 2012 trends continuing to see good traction.  Pinterest grew to the #3 social networking site.  We saw the IPOs of many big digital companies, like Groupon, LinkedIn, Zynga and Facebook (with very mixed outcomes).  We saw mobile computing continue to take share with the mass proliferation of smart phones and tablets, which included Google acquiring Motorola.  We saw Apple continue their meteoric success, in the first year post Steve Jobs.  And, Congress passed the Jobs Act, laying the groundwork for crowdfunding for startups in years to come. 

But, enough about 2012; let's talk about the key trends I am seeing for 2013:

Consumers Taking Control from Brands/ Brand Shouting Evolves to Consumer Listening via Personalized Omni-Channel Techniques.  Brands no longer have control of a one-directional conversation with their customers, where they shoutout mass-marketing messages and force feed consumers one-size-fits-all products they may or may not want.  Enter the era of omni-channel marketing, that puts the customer at the center of all business decisions leading to highly personalized products and user experiences based on  listening to the desires of their consumers.  This evolution will material benefit both the consumer, through personalization, and the brand, who will now have a direct communication line into their customers.  This shift will ultimately hurt and disintermediate retailers, who have historically controlled all communications with customers as the intermediary for the brands.  Look for brands to evolve social media marketing efforts from buying display ads pushing products, to buying social listening research to help learn what consumers want.

Advertising Shifting from Demographics to Behaviors.  Demographics-driven advertising based on a target customer's age, income, gender, education, etc.  is quickly evolving into behavior-driven targeting, based on the psychographics, lifestyle behaviors and passions of like-minded customers, regardless of demographics.  As an example, a frisbee seller is no longer looking for 10-20 year olds who they are guessing would like to buy a frisbee based on historical company purchase data, they are better targeting people passionate about playing frisbee regardless of age.  This is going to trigger a massive evolution in the way media sellers are going to have to track and serve their advertising to brand buyers, who are going to demand different types of targeting.

Big Data Evolves to Smart Data.  We all know big data is exploding, creating tons of learning opportunities for companies, but creating lots of growing pains in the process, given the lack of sophisticated tools to funnel such data into actionable insights. As an example, brands no longer track overall sales each month, they know sales by minute, by SKU, by customer, by location, by retailer, etc.  So, look for companies with expertise in funneling big data into usable intelligence with sophisticated analytics packages or machine learning techniques, to do quite well.

CMOs Becoming CTO/CIOs.  Given the three major trends above, the successful CMO of the future is getting a crash course in information systems and technology development, to help them better design omni-channel platforms, better track customer data and drive insights from the firehose of big data coming in.  And, more than ever, CEO's are going to demand higher accountability and ROI from the activities within the marketing organization.  It will be less important a CMO has a background in advertising or brand management, and more important they understand sophisticated information systems design.  Technologies that can assist in creating these cross-channel CMO dashboards will be in heavy demand. 

Second Screens/TV & Web Merging.  Consumers are consuming content in materially different ways than they have in the past.  No longer are they watching TV at night, or working on their PC during the day, they are streaming video to whatever device they want, and simultaneously engaging in social media or checking their email on their smart phones at the same time, as an example.  So, the lines are quickly blurring between what is a TV experience vs. a web experience vs. a mobile tablet experience, and consumers are looking for ways to concurrently multitask on whatever devices they happen to be using (how they want, where they want, and when they want).  We are not too far away from you being able to click on the video of Kramer while watching Seinfeld, and be taken to an e-commerce link to buy the shirt he is wearing in that scene.  Or, seeing your Facebook friends reactions streaming real-time on the screen while watching the same football game.  A very exciting time for consumers, but a very disruptive time to the big players in the media world.

Mobile Dominates/Desktop PC on Life Support.  The king is dead, long live the king.  But, this time, instead of the king (Apple) selling iMac PC's for your desktop, they are selling iPhone smart phones and iPad tablets for our busy lives on the go, lives that were never intended to be tied to a desk or tethered to a cord.  The growth of mobile devices is fast taking share away from desktops, and millions of apps are being developed that are tapping into a user's mobility and locality.  If you are one of these app developers, just make sure you are building a real business model that can quickly scale revenues in order to attract capital, as VC's are certainly at the point of saying "if the word app is your business", don't bother calling.

Hyperlocal Marketing/In The Aisle.  No longer will we be getting mass-marketing coupons in Sunday newspapers or paper coupons after checking out at the store register, post shopping.  Now you will be using your grocery store smart phone app to be scanning bars codes of products as you are shopping through the store real time, partly to enable one-click check out and avoid lines at the register, and partly to push you real time coupons as you are shopping.  As an example, if you just scanned peanut butter, here is a coupon for jelly.  Or, you bought Skippy brand for $4, but if you exchange it for Jif, you can save $2 right now.  Location-based technologies are moving beyond the street level, to the store shelf level, which opens up a whole world of real time marketing opportunities, dis-intermediating old school marketing techniques in the process.

eCommerce Evolving to Discovery Engines.  People love to browse, in their offline shopping experience.  To date, e-commerce is been less about browsing, and more about keyword searching for specific items in a very "solution driven" user experience.  That is starting to change.  The newest generation of e-commerce sites are now being designed to help you browse categories of products, learning about new items that you may or may not know you even wanted.  As an example, StyleSeek here in Chicago is a good example of that, helping to build your "StyleDNA", and recommend interesting fashion items based on such profile and the purchase behavior of like-minded individuals.

Offline Retail Dying a Slow Death.  Gone is Borders (thanks to Amazon), gone is Tower Records (thanks to iTunes), gone is Blockbuster (thanks to Netflix), and the rest of the other big box verticals are not far behind.  Consumers do not want to get in their car and hope you have what they want in stock.  They want to know it is in stock and order it online with the convenience of shopping in their pajamas 24/7.  I think the office supply guys like Office Max and Office Depot will be next to close or downsize stores, but still be in business with healthy e-commerce sites.  And, Best Buy is teetering at the edge, given how many of their departments have been cannibalized by online alternatives, and how consumers are simply using their stores as showrooms to get educated on products that they will ultimately pull out their smart phones and buy cheaper online.  I sure wouldn't want to be a strip mall developer.

HR Sites Seeing a Major Overhaul.  I think we can all agree that the job search process is completely broken for both the hiring companies (sucking the firehose of inbound resumes, especially in a down economy) and for the job candidates (applying to tons of positions without any response).  This inefficiency will hurt the major job listing sites, like Monster.com, and help next-generation job search sites that are creating more of an "eHarmony-like" match making experience.  Paper job postings and resumes will be replaced by videos for the same, which can tell a better story and are much more engaging.  And, backend HR software packages will do a much better job of automating formerly manual steps in the hiring process (e.g., resume screening, candidate tracking, onboarding, training).  I really see a lot of low hanging fruit to fix in HR.

Niche Social & Business Networks.  Yes, we are all still going to be using Twitter, Facebook and LinkedIn for years to come, but they each perform a certain role in our lives.  Niche social and business networks will begin to develop that will help us dig deeper on specific needs in our lives.  For example, maybe you are a die-hard cook looking to engage with other cooks on the hottest new recipes.  Or, look at what Built-In Chicago has done in terms of creating a very powerful business network of like-minded individuals in the digital startup scene in Chicago (at a much deeper level than LinkedIn is doing for all general business people).  And, long term, it is exactly these niche networks, that will dominate the marketers' mind share, as they evolve from demographics to passion-based decision making.

Crowds and Clouds.  How can you argue with the cost efficiencies and ease of tapping into crowds for human services and clouds for technology services.  As an example, why buy hardware and software licenses and  hire expensive people to maintain such technology, when you can simply store your information in the cloud for a fraction of the price.  We have already seen the success of sites like Crowdspring, for crowdsourcing graphic designers.  We are going to see niche crowds develop for every single human process within a business organization.  Heck, my old company MediaRecall was crowdsourcing metadata writers for videos, as a needle in the haystack solution.  That said, this does not bode well for long term job creation in the U.S., as expensive jobs get replaced by cheaper crowd-based solutions.

Crowdfunding Kicks Off.  No longer are startups going to be required to hunt down accredited angel investors or venture capitalists to fund their startups.  Many will go to crowd donations sites, like Kickstarter, or crowdfunding sites, like RocketHub, and raise their required cash from hundreds of mom-and-pop investors.  There are literally hundreds of these crowdfunding sites that are being developed, in every imaginable niche industry, to take advantage of the passing of the Jobs Act in 2012.  This will be good for startups that otherwise could not raise capital elsewhere, but I think there will be high risk that uneducated mom-and-pop investors may risk their limited life savings on what they think is the next hot new startup, to only find out that 9 of 10 startups funded in these crowdfunding sites may end up going out of business, and they lose it all.  Which could result in an unforeseen negative economic impact a few years from now, unless the proper startup screening and investor education controls are put in place, right from the start.

Privacy Evolving to Publicity.  Every year, it feels like "Big Brother" (e.g., Google and others) is loosening up on their privacy policies to learn more about their users' behaviors and interest, to allow advertisers ways to better target their messages.  Senior citizens hate it, and kids could care less.  My take is, as long as you are telling me you are doing it, and I have a chance to opt out if I don't like it, I think opening up my user behavior will ultimately improve my user experience as I start to get targeted offers that really matter to me.  But, look for "privacy policies" to evolve to "publicity policies" over time.

Let me know if you are seeing any other trends.  But, focusing your startup efforts in any of the categories above, should help position you for long term success.

I originally wrote this post for Technori, and am re-running here for my readers.

For future posts, please follow me at:  www.twitter.com/georgedeeb