Optimizing and Diversifying Startup Equity: Exchange Funds and CRTs

Combining Exchange Funds and Charitable Remainder Trusts can create huge lifetime benefits for startup shareholders

· 27th Jun 2024

Key Points:

  • Robin can mitigate risk by tax-free diversification of her $5 million in startup equity, yielding an extra $22 million in lifetime family income through a combined exchange fund and CRT strategy
  • This approach also enables Robin to contribute $27 million to preferred charities (on top of the $22 million income boost)

Successful startup founders face two major hurdles when cashing out: finding buyers for their equity and dealing with hefty tax bills that can claim up to half of their proceeds. However, a powerful solution exists by combining two tools: an Exchange Fund and a Charitable Remainder Trust (CRUT). This strategy offers quick liquidity, risk reduction through diversification, long-term income, and substantial tax benefits.

We'll explore a case study showing how a startup leader can leverage both a CRUT and an Exchange Fund, highlighting the advantages and considerations of this approach. Let's begin by covering the fundamentals.

Understanding Charitable Remainder Unitrusts (CRUTs)

A CRUT is a tax-advantaged vehicle, comparable to an IRA, particularly useful for unsold appreciated assets. By pledging a portion of the trust's funds to charity upon termination, you can postpone taxes on asset sales. This allows for tax-free reinvestment within the trust while providing you with yearly cash payouts. Additionally, you receive an immediate tax deduction when you initially fund the trust.

The financial impact of using a CRUT with an exchange fund versus simply selling assets and reinvesting after taxes can be substantial. This strategy allows you to grow the money that would have gone to taxes over the trust's duration. Our upcoming example will demonstrate how this approach can potentially triple the cash available to you and your family throughout the trust's lifespan.

Understanding Exchange Funds: A Diversification Tool

An exchange fund, also known as a swap fund, functions like a mutual fund but with a key difference: investors contribute stocks instead of cash. This mechanism allows you to trade your concentrated stock holdings for a diverse portfolio of equal value, significantly lowering your financial exposure. Importantly, this exchange doesn't trigger capital gains tax, unlike selling stocks outright. However, without a CRT, you'd face taxes when eventually cashing out your fund interest.

Exchange funds have existed since the 1960s, traditionally focusing on public stocks. Recently, Collective Liquidity introduced an exchange fund that accepts shares from mature, venture-backed private companies, expanding opportunities for diversification in the private market.

Case Study: Strategic Diversification

Robin, a 45-year-old New York City resident, works at Altruist, a private tech firm. Her exercised stock options are now valued at $5 million, with a $250,000 cost basis. This windfall could transform her family's life, but Robin is concerned about having most of their wealth concentrated in one company.

Robin faces two challenges:

  1. Lack of buyers for her private shares, preventing her from cashing out and diversifying.
  2. Potential hefty tax bill if she sells.

Solution Part 1: Exchange Fund

Robin uses an Exchange Fund, which accepts her startup equity as payment. This fund serves as both a buyer and a diversification tool, allowing Robin to own a portion of a varied portfolio of leading companies.

Solution Part 2: Charitable Remainder Trust (CRT)

To avoid an immediate $1.8 million tax bill when redeeming her fund interest, Robin transfers her Exchange Fund interest into a CRT. This provides:

- An upfront tax deduction

- Tax-free redemptions of her fund interest

- Ability to make annual family distributions or further diversify

This strategy allows Robin to diversify her assets, defer taxes, and create a flexible financial plan for her family's future.

Key Assumed Parameters:

  • Initial investment: $250,000
  • Current equity value: $5,000,000
  • Robin's age: 45
  • Projected Exchange Fund performance: 12.5% annual return after fees
  • Objective: Partial use of shares to mitigate financial risk and create family income, with remaining funds reinvested for growth

Exchange Fund Diversification Advantage:

Through one transaction, Robin transforms her $5 million single-company stake into a $5 million diverse portfolio of private growth stocks, incurring no costs. This shift significantly reduces her family's financial risk, allowing Robin to focus on long-term wealth management strategies with greater peace of mind.

Upfront Charity Tax Benefit:

By transferring her exchange fund interest to the trust, Robin qualifies for an immediate tax deduction. Despite complex IRS calculations, the outcome is clear: she can deduct roughly 10% of the contributed exchange fund interest's value. In this case, that's a $500,000 deduction. Given her residence in a high-tax area, this translates to approximately $250,000 in tax savings for the current year.

Simplified Liquidity:

After one year, Robin can start converting her exchange fund interest to cash at its current value. This offers a much simpler path to liquidity compared to finding private buyers. The trust can distribute this cash to Robin annually or reinvest it in other assets.

Tax-Free Transactions Within the Trust:

Robin avoids state and federal taxes on redemptions or asset sales within the trust. Rather than paying the previously mentioned $1.8 million in taxes, she retains this money. She can then distribute some to herself annually while reinvesting the rest tax-free, allowing for compounded growth over time.

Financial Impact Summary:

Using this strategy, Robin can achieve the following results:

(1) Lifetime after-tax withdrawals: $42 million (Assuming 20% withdrawal every 5 years for family expenses)

(2) Additional family wealth: $22 million (Compared to traditional selling and reinvesting)

(3) Charitable contribution: $27 million (Donated after Robin's lifetime)

In essence, by employing the Exchange Fund and Charitable Remainder Trust approach, Robin generates an extra $22 million for her family, even after allocating $7.5 million to charity. This strategy not only provides significant financial benefits but also allows for asset diversification, reducing overall risk.

You can read more about Collective's CRT solution here.


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