The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
Think of an exchange fund as a specialized mutual fund designed for holders of concentrated stock positions, particularly in illiquid assets like private company equity. Instead of contributing cash, you contribute your startup shares. In return, you receive shares in the exchange fund itself. This fund then invests in a diversified portfolio of other assets, which can include late-stage private companies, real estate, and other investments.
Let’s explore how an exchange fund can benefit a startup employee holding a significant equity stake. We’ll follow the journey of Sarah, an employee at a successful late-stage startup.
Sarah’s Situation:
Sarah has been with her company since its early days and holds a substantial amount of stock options. While excited about the potential IPO, her wealth is heavily concentrated in a single, illiquid asset. She’s worried about the risks of overexposure to one company, but selling her shares before the IPO would trigger a large tax bill.
The Exchange Fund Solution:
Sarah decides to explore an exchange fund. She contributes $1 million worth of her shares to the “Diversified Growth Fund.” In exchange, she receives shares in the fund, which holds a diversified portfolio of late-stage private companies, real estate, and other alternative investments.
Let’s assume the Diversified Growth Fund performs reasonably well, averaging a 7% annual return.
At this point, Sarah can choose to take distributions or roll her investment into a new fund. When she eventually sells her shares in the Diversified Growth Fund, she will realize the capital gains and pay taxes on the profit.
Let’s assume the company goes public, and Sarah’s shares become liquid. We’ll consider two possibilities:
Scenario 2B: the company underperforms or fails: Her initial $1 million stake could stagnate, decrease in value, or even become worthless. This highlights the risk of concentrated positions.
Scenario 2A: the company performs well: Her initial $1 million stake grows at a similar 7% annual rate. After 7 years, her shares are worth approximately $1,500,730. When she sells, she’ll pay capital gains taxes on the $500,730 profit.
| Scenario | Outcome after 7 years (Approx.) | Tax Impact | Diversification |
|---|---|---|---|
| Exchange Fund | $1,500,730 (Diversified) | Taxes deferred until sale | Yes |
| Holding shares (Successful IPO) | $1,500,730 | Immediate taxes upon sale | No |
| Holding shares (Underperformance/Failure) | Potentially much less, possibly $0 | No immediate taxes unless shares are sold at a loss | No |
For Sarah, the exchange fund offers a compelling way to diversify her startup wealth, defer taxes, and potentially achieve long-term growth. While it’s essential to weigh the fees and lock-up period, the benefits of diversification and tax deferral can be significant, especially when considering the risks of holding a concentrated position in a single startup.
We’ve built a platform to give everyone access to the tax and wealth-building tools typically reserved for wealthy individuals with a team of accountants and lawyers. We make it simple and seamless for our customers to take advantage of these hard-to-access tax-advantaged structures. With Valur, you can build your wealth more efficiently at less than half the cost of competitors.
From picking the best strategy to taking care of all the setup and ongoing overhead, we make things simple. The results are real: We have helped create more than $3 billion in additional wealth for our customers. If you would like to learn more, please feel free to explore our Learning Center. You can also see your potential tax savings with our online calculators or schedule a time to chat with us!
