Should you invest in startups in a tax free account?

Imagine being able to invest in a small startup, and after 5–10 years, you strike absolute gold with a big payout. And better yet, because it is in a tax-free account, you don’t even need to pay any capital gain taxes. It’s good right? Let’s dig into the numbers to see if it is actually worth it over the long haul, as taxes, capital gains and losses, must be taken into consideration. Particularly capital losses that can be used immediately against other capital gains before the big winner acquisitions or IPOs occur. It also depends on the number of investments you make and how many winners and how large each winner is of course.

Some equity crowdfunding platforms will allow you to be able to invest in your tax free investment accounts and have set this service up on a complimentary basis. But other platforms this luxury may not exist. For example, on a leading Canadian equity crowdfunding platform, Frontfundr, there is an administrative fee for this option. Initial 3rd party trust account is $75 to create, then an annual $145 trustee fee. All fees are payable to and collected by the applicable trust company. This would apply if you had multiple investments under frontfundr, so the price would not increase with more investments. Consider that the average check size written on equity crowdfunding platforms is approximately $1,000. And let’s assume it would take 10 years to materialize in an acquisition or IPO. This would imply that for one company investment, the cost for 10 years would be $75+ $145*10= $1,525, 1.5x the price of the investment itself. Now there’s a chance that this investment could 100x in those 10 years. With half of the gains taxable, that would be $50,000 taxable, let’s say at a high rate of 50%, at $25,000 tax paid. So that $1,525 would have saved far more in taxes. But like all things, we must consider opportunity cost. That $1,525 could have been spent in each year allocation towards an additional investment. A present value of this at approximately 4–5% would be another $1,000 to use towards another investment. Considering how there is a 75% chance of venture backed companies to go bankrupt, all of a sudden, it makes more sense to have 2 investments at $1,000 rather than just one with the rest going toward costs. Even if investing in 10 companies per year tax free, you would still be able to have an extra investment with the costs involved. I’d rather have the extra company, an extra lottery ticket if you will. Because the odds of hitting winners are rather low, and additionally, the wins will come mostly from one company. More on the math below.

The other thing to consider too is tax losses will not be allowed to be used as a capital loss in tax free accounts. Assuming investing only in venture backed companies, the bankruptcy rate is still at 75% over the long term according to statistics, which is rather high. Let’s consider some randomly assigned amounts during investment and see a comparison, knowing that capital losses cannot be used towards gains in tax free accounts as they are simply lost forever. We’ll assume a portfolio construction of $1,000 placed towards 100 companies each, with no subsequent money invested in any company, even if they raised money at future valuations. If an investor repeated investments into startups they had conviction in at higher valuations, those winners will be producing the extreme asymmetrical results, which could skew the example of results below.. A reasonable breakdown could be as follows:

75 companies go bankrupt, returning (75*1000*0)= 0

5 companies return an average of 50 cents on the dollar (0.5*1000*5)= 2500

5 companies get around breakeven (1*1000*5)= 5000

5 companies get around double (2*1000*5)= 10000

1 company gets 4x (1*1000*4)= 4000

1 company gets 6x (1*1000*6)=6000

1 company gets 8x (1*1000*8)= 8000

1 company gets 10x (1*1000*10)= 10000

1 company gets 12x (1*1000*12)= 12000

1 company gets 14x (1*1000*14)= 14000

1 company gets 16x (1*1000*16)= 16000

1 company gets 20x (1*1000*20)= 20000

1 company gets 25x (1*1000*25)= 25000

1 company gets 30x (1*1000*30)= 30000

1 company returns 50x (1*1000*50)= 50000

In this example, 100 companies invested for $100,000 would return $212,500. Per the Pareto principle, it’s likely that the highest gainer may garner even more than 50x, and that the 3rd and beyond investments will return little, so the results will be even more asymmetrical.

In a tax free account, the final value would be $212,500. The losses would not be able to be used or carried forward into future years.

In a regular account, the capital loss on the 75 companies going to zero + 5 companies losing 50% value would be 75000+2500 = $77,500. The capital gain would be $212,500-$100,000= $112,500. So the taxable capital gain, assuming all of this happened in the same year would be $112,500-$77,500 = $35,000. With half of that taxable, that’s $17,500. Assuming a high 50% tax, that would be= $8,750 in taxes paid. So if there was no cost to using tax free accounts, it would be beneficial to use it.

The only question is if there is a unavoidable cost associated with using the tax free account having to store the investments. In the above example, the cost over 10 years would be $1,525. Given the current EV, the return on that money would be $3,240.63. That would still be a discount against the $8,750 in taxes paid. The higher conviction you have in your winners, the more likely it would make sense to use a tax free account, especially if you are going to be putting a large amount of money over a long period of time towards startups. The less conviction, and if you only have smaller amounts of money to play with, the tax advantage would be negligible.

The other time-based consideration would be that the capital gains would occur later on, and so those capital losses would not be able to be used immediately. Having those capital losses around could be useful if they are allowed to be used against any other type of capital loss. If you may be planning on having capital gains elsewhere, such as sale of a non-resident piece of real estate, stock market gains, etc, then having earlier reduced taxes could actually be more profitable, as it would leave you with more money in the then and now to re-invest or use for other purposes. So if capital gains are to be made with the early capital losses, then using a regular tax account would be the play.

In tax deferred accounts, if the capital loss could be used on an indefinite basis against any gain in the account, this too would depend on what gains could be allocated the losses against. Similar to above, if the losses wouldn’t be able to be used against other gains that were planned, this may be the suboptimal decision.

Conclusion

Although using a tax free or tax advantaged account would produce higher returns in the long-run when investing in startups, in the near decade of investing, those capital losses if the person will have capital gains, would prove to be more beneficial by being able to use them to harvest gains to not pay taxes in the short run. Delaying the tax penalty towards the future is accounting financials 101, getting the gains upfront and delaying the liability into the future. So counterintuitively, if you plan on having other capital gains, use regular accounts. Only if you don’t plan to have them would using tax free accounts be better. Unless you are an amazing startup investor who will get multiple outsized returns, then you would also use tax advantaged/tax free accounts.

Disclaimer

This is not Financial Advice. This article is meant only for educational and perhaps entertainment purposes.

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