I'm thinking about joining a pre-revenue startup that has had 2 convertible notes so far. I would be receiving 20% of the RMUs, but I'm worried about the tax liabilities involved. The whole reason for convertible notes is not to have a valuation, but how does the IRS look at this? I'd be taking a huge pay cut and don't want to be faced with significant additional expenses in terms of taxes on those shares. So how does the IRS calculate the value of a pre-seed, pre-revenue 6-month old startup?
The IRS does not determine your valuation. Income and expense at the c-corp level only affects you IF you receive salary.
Upon startup, the initial cost basis, $/share, is established during incorporation. Typically startups issue a very low nominal amount per share because most startups are prerevenue. You don’t want to be hit by an unrealized tax impact due to an actual valuation when in reality, you have not realized any actual income.
I assume you mean RSU (restricted stock units), not RMU. RSUs are unusual in a startup because of the issue you have identified, the inability to accurately value them, and normally for companies that are already public or have some form of liquidity.
Nearly all startups use RSOs (restricted option units) with a strike price set at grant. The company should have done a 409A valuation filing to establish the value at the grant so that the price is reflective of the strike price and does not have an intrinsic value that is lower which could trigger a taxable event. However, all units (RSU or RSO) will have a vesting period which will limit when that taxable event occurs. Only your RSU/RSOs that are vested on day one would be subject to taxation. If a 409 has not been done (must be done by an outside firm) you have some exposure - both in intrinsic value or having the strike significantly over the current value.
Effective value of the shares you do receive will likely be determined at a conversion of the notes to equity (if that is the debt deal), yet, due to preferences and discounts due to the investors, will not be an exact conversion.
E.G. (very simplistic hypothetical without doing all the math exactly) If the company takes in $1 mm in notes, convertible at a Seed round of at least $5 mm, there will be discounts (perhaps 20% of the pre-money value for the Seed) and then have a preference (not always, but normal) of "1x participating" (be careful what terms are included - if there is a 2x then all these double) which means that, if liquidated at $6.2 mm (the notes with the 20% discount plus the Seed), the common equity has no value. If the company, in this hypothetical exits at $10 million. then the investors get $6.2 mm (the $5 mm PLUS the $1 mm Plus the 20% discount for the note holders) and the common gets $3.8 mm. In that example, if all 20% of your units are vested at the exit, you would be entitled to about $760k. Again, this is very simplistic, but should provide some framing for you.
Because you will be taking personal risk and be a significant shareholder, it is reasonable for you to understand the terms of the notes and the plans for follow on funding.
Jett, forgive me if this is very basic question. What is RMUs?
The IRS does not look at valuation or debt, they only look at actual income and expenses. It's that simple. Please talk to a tax professional with your specifics to make sure there's not something important about your scenario that you haven't disclosed.