A Primer on QSBS

Benefits of Qualified Small Business Stock

AuthorAuthor

Daniel Faierman & Chuck Cotter
July 08, 2025

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Daniel Faierman is a Partner at Habitat Partners, an NYC-based early stage VC firm focused on pre-seed to Series A investments in the consumer and software ecosystems. Learn more about Habitat Partners on their website or notion page. Daniel has invested in numerous startups and previously operated and invested at organizations including PepsiCo, AB InBev, VMG Partners, and Selva Ventures. Daniel was a former Yale tennis 🎾 player & completed his MBA at the Stanford Graduate School of Business.

Chuck Cotter is a Partner in Morrison Foerster’s Emerging Company + Venture Capital practice group in Denver, with experience in the consumer products space, including food, beverage, personal care, beauty, and fashion. He has represented such companies and funds in over 200 🚀 consumer financing and M&A transactions. Chuck was a rugby player at Vassar College and completed his JD at Columbia Law School.

A Quick Primer on QSBS

We hope you enjoyed our last post on fundraising don’ts. Our original intention for this week’s post was to give an overview of antidilution clauses; however, the recent passing of the big beautiful bill (‘BBB’) inspired a different direction. We’ll come back to antidilution in the near future.

Politics aside, the big beautiful bill has some super positive implications for small businesses & the venture community in the form of Qualified Small Business Stock (QSBS) upgrades.

QSBS is quietly a very important concept in the venture ecosystem (for founders but especially for investors). Thus, we decided to complete a primer on QSBS for this week’s content. While founders should have a basic understanding of QSBS (as it can be a incentivization mechanism to solicit investors), it’s an essential concept to understand as an early stage venture investor.

In today’s post, we’ll dive into the following briefly:

What is QSBS? **Pre big beautiful bill changes**

QSBS is tax benefit under Section 1202 that incentivizes investment into small businesses with less than $50 million in aggregate gross asset value.

Investors who purchase stock (common or preferred) directly (as opposed to via secondaries) from a c-corp business with less than $50 million in aggregate gross asset value and hold that investment for > 5 years, followed by a sale of the held stock, can avoid paying capital gains tax.

The tax exclusion can be up to 100% of the gain, subject to limits:

  • The greater of $10 million or 10x the original investment

A few specifications to highlight (feel free to skip):

  • $50 million in aggregate gross asset value means the total value of a company's assets, before accounting for liabilities.

  • The $50 million threshold is tested only at the time that an investor is officially issued stock in the form of common or preferred stock after the closing of a financing. For example, if a startup has $45 million in cash and other assets before a $10 million Series A (all primary), Series A investors would not qualify for QSBS ($55 million would surpass the $50 million threshold).

  • The business must be a domestic C corp.

  • At least 80% of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses during substantially all of the shareholder’s holding period of the stock.

  • Stock options, warrants, etc do not qualify for QSBS. In the case of options as an example, an employee would need to exercise their options (at a time when the companies aggregate gross asset value is < $50 million) and hold for 5+ years after exercising.

  • Not all states conform to Section 1202. Great resource here.

Founder perspective:

The ability to exclude capital gains taxation is a massive benefit to investors.

But as a founder, being able to clearly articulate the benefits of QSBS to prospective investors (especially angel investors or family/friends investors that are less likely to be familiar with QSBS) may make betting on an early stage startup more appealing.

QSBS Examples

Example #1:

  • Chuck invests a $100k angel check into Company X (which meets QSBS requirements) and 7 years later sells his stock for $10 million, a gain of $9.9 million (100x!)

  • Chuck can exclude the entire $9.9 million in gains from federal taxes (<$10 million max threshold and more favorable than 10x his initial investment)

Example #2:

  • Imagine the same scenario above except that Chuck runs a fund and puts in an initial $2M check into Company X (which meets QSBS requirements) and 7 years later sells the stock for $200 million, a gain of $198 million (100x!)

  • Chuck can exclude $20 million in gains from federal taxes (this is because 10x his initial investment = $20 million, more favorable than taking the max $10 million cap

More complex examples here…

The downside of SAFE/Note structuring in the context of QSBS

One gray area: While the IRS has not issued clear guidelines, conservatism dictates that SAFEs and convertible notes DO NOT start the QSBS clock. This is because SAFEs and convertible notes do not technically award you stock in a small business until conversion. So the benefit of less legal fees via SAFEs/Notes can harm QSBS potential.

Disclaimer: some SAFEs (i.e., YC SAFE) specifically state intention to be treated as stock for tax purposes. Hence “gray” area.

For more on this topic see here. Daniel works under the assumption that SAFEs/Notes by default will generally not qualify as QSBS.

QSBS Gain Deferral

This is very in the weeds… so skip if you’re short on time!

Abbreviated version: if you have to liquidate a position before the QSBS holding period requirement ends, you can defer the tax on capital gains, by reinvesting the gains into another QSBS qualified business within 60 days of liquidation. You also get to roll over the holding period of the original investment, continuing the clock (as opposed to starting over).

Section 1045 permits a shareholder to defer otherwise taxable gain on the sale of QSBS (“Original QSBS”) by reinvesting their sale proceeds into shares of a different qualified small businesses (“Replacement QSBS”), so long as the taxpayer has held the Original QSBS for at least six months.[4] If a shareholder reinvests sales proceeds under Section 1045, some or all of the gain that would otherwise be recognized on the sale of the Original QSBS will be deferred until the Replacement QSBS is sold.[5] In order to timely take advantage of the reinvestment option under Section 1045, a taxpayer must make the reinvestment within sixty days from the date the Original QSBS is sold.[6]

Example: Michael invested in a company on January 1, 2024, and the corporation’s stock he gets is considered QSBS. The company grew faster than expected and on June 30, 2027, Michael has the opportunity to sell his stock, recognizing a $5 million gain. Since Michael has only held the QSBS for three and one-half years, he cannot exclude any gain from the sale (this is true for QSBS **pre big beautiful bill changes!). So, Michael’s options are to either: sell the position and pay tax on all $5 million OR sell the position and reinvest some or all of the $5 million into another QSBS within 60 days (#DEFERRAL).

Based on the above example, assume Michael sells the position and reinvests $4 million of his proceeds into new QSBS and keeps $1 million in gains. In that scenario, Michael will only pay tax on the $1 million of proceeds retained. Additionally, his holding period in the Original QSBS (3.5 years) will carry over to the Replacement QSBS.

QSBS Documentation Guide

There is no legal requirement to provide documentation to the IRS at the time of purchasing QSBS or at the time of excluding tax via the sale of QSBS; however, it is highly recommended and considered best practice (especially as a major/lead investor) to gather backup in case of an IRS audit from the time of investment until the sale of the investment. If an investor is unable to prove the stock they purchased meets standard QSBS requirements during an audit, legal ramifications can be highly destructive. If an LP were to find out that a fund manager failed an IRS audit, there could be permanent reputational damage.

Ideally, one gathers this documentation starting at the time of investment (not uncommon for a major/lead investor) but this documentation can also be gathered throughout the holding period, or after liquidating a position. With that said, it can be very challenging to acquire all of the necessary evidence for QSBS from a company years after the investment or sale… so the sooner one starts, the better. Some founders will proactively gather this information for their early stage investors after closing a financing or if they expect a liquidation event to occur imminently.

Typical backup includes:

  • At the time of investment:

    • Company Attestation: statement from the company stating their belief that their stock qualifies for QSBS (i..e, gross asset value < $50 million)

    • Proof of C Corp status at time of stock issuance

    • Investor stock purchase agreements and subscription docs (proof of original issuance in the form of primary stock)

    • Financial statements (balance sheet that shows aggregate gross asset value < $50 milion)

  • Throughout the holding period

    • Records of stock issuances 

    • Holding period records (stock certificates with issuance dates)

    • Active business documentation (evidence that the company continues to operate via business plans, financial records, etc)

  • Time of sale

    • Stock sale and purchase agreement

Key BBB QSBS Updates (IMPORTANT)

QSBS Post Big Beautiful Bill:

tldr ➡️ the incentive level to invest in small businesses is even higher.

CHANGES

1️⃣ tiered capital gain exclusion starting after 3 years of holding stock as opposed to after 5 years

Tier 1: 3 year holding period, 50% applicable exclusion

Tier 2: 4 year holding period, 75% appicable exclusion

Tier 3: 5+ years holding period, 100% applicable exclusion (same as before)

Thus, investors can start excluding 50% of capital gains tax after holding an investment in a small business for just 3 years.

This is particularly timely considering the challenging liquidity environment in which secondaries are surging and will persist in popularity as a DPI ramp for early stage funds. If a great secondaries opp arises after year 3 of a held position, QSBS can potentially apply!

2️⃣ Gain exclusion cap increased from $10 million to $15 million

Larger pie to potentially avoid taxes on (although 10x cap not impacted and still live)

3️⃣ gross assets test amount increases from $50 million to $75 million

C corps with aggregate gross assets up to $75 million now considered "small business" & QSBS qualified

Interestingly, the QSBS gain exclusion has actually enjoyed bipartisan support (what a concept). Section 1202 was enacted in '93 by Clinton, enhanced under Obama, and now pushed even further by Trump 🤝

With that said, it is estimated that the gain exclusion will cost $45 billion from 2025 to 2034 (increased by $17 billion due to the new amendments outlined above).

Resources for QSBS:

If you enjoyed this article, feel free to view recent prior articles:

Ongoing Term Glossary

Automatic Conversion: in the context of convertible notes (or SAFEs), a clause that triggers a convertible note to automatically convert into equity at maturity

Bridge Financing: when investors agree to provide temporary financing to secure a company’s cash balance before the company raises their next priced round - aka the bridge that gets you to your next priced round.

Capped Price: conversion price per share awarded to noteholder (or SAFE holder) if investor exercises valuation cap

Change in control: a significant shift in the ownership or control of a company, often triggering specific rights or obligations for investors (M&A most commonly)

Clawback provisions: provisions that give the company the right to buy back vested shares at the original issue price or at fair market value after dismissing an employee under defined circumstances (leaving for a competitor, severe misconduct, etc)

Co-Invest: triggered when a fund raises “one-off” new capital from LPs/investors (as opposed to pulling from existing permanent fund) to unlock ability to execute an investment; associated management fees and carry (if any) typically flow back to the fund or individual who raised the co-invest capital. Funds often give major LPs prioritized “co-invest“ rights, which gives such LPs the first rights to participate in the co-invest opportunity before others.

Comparable Company Analysis: a valuation methodology that entails identifying comparable companies and transactions to the company being valued as a means of deriving multiples that can be used to generate a landed valuation

Confidentiality: prevents the startup from disclosing the terms of a term sheet to outside parties (i.e., other investors, startups). This enables both parties to negotiate in good faith.

Convertible Note: a debt instrument that can be converted to equity based on the occurrence of certain events (most commonly during a priced equity financing round).

Conversion: convertible notes (and SAFEs) automatically convert into equity if certain triggers occur. The most common trigger that leads to the conversion of a convertible note (or SAFE) into equity is a priced equity financing round

Debt repayment terms: in the context of convertible notes, defines specifics associated with principal, interest rate, maturity date, and default provisions.

Definitive documents:  the legal contracts between the investors and the company that detail the terms of the transaction and are drafted by a lawyer

Dilution (D): losing a portion of your ownership as the company sells equity to investors

Discounted Cash Flow Analysis (DCF): a valuation methodology that entails forecasting the future cash flows of a business and discounting the cash flows by a determined cost of capital to derive an enterprise value

Discount: a discount is a term awarded to the convertible noteholder (or SAFE holder) that drives a reduction in the conversion price per share that they are awarded during a qualified financing. Discounts typically range from 10-30% with 20% being the most common.

Down Round: when the pre-money valuation of a future financing is lower than the post-money valuation of the prior financing; often seen as a negative sign for the company

Double-trigger: requires two events to occur to accelerate the completion of your vesting. The first trigger is the acquisition, and the second trigger is the founder or employee getting terminated by the acquirer without cause or good reason in a specified period (typically one year)

Employee Option Pool (EOP): stock that is reserved for existing and future employees to compensate, retain, and motivate workforce

Equity conversion terms: in the context of convertible notes, defines the specific event(s) that triggers conversion of debt to equity, the formula used during conversion (considering the impact of the valuation cap and/or discount – to be discussed), the type of equity received upon conversion by the note holder (common vs. preferred equity), and any associated rights the new equity holders will get after their convertible note is converted to equity (voting, dividends, etc).

Exclusivity: often referred to as a “no shop,” this provision locks parties into negotiating only with each other for a defined period (i.e., 30-60 days)

Exercise (options): buy options at the strike price

Fund Model: a forecasting exercise that a VC conducts to project what a successful fund will look like in terms of returns from each investment. VCs typically build a pathway to 3.0x net DPI

Indifference point: the price per share at which the noteholder or SAFE holder is indifferent between exercising the discount or valuation cap

Interest Rate & Payments: convertible notes often feature interest rates. Unlike a traditional loan, startups rarely pay the interest in cash to the convertible noteholder periodically. Instead, convertible notes accrue interest until the time of conversion.

Lead Investor: primary investor(s) (co-leads can exist) in a funding round that set terms and typically are writing the largest check(s); often take a board seat

Legally nonbinding: refers to the nature of term sheets. A signed term sheet does not legally mandate a deal be completed

Liquidation Preference: is one of the rights that makes preferred stock more valuable than common stock and a large part of why investors agree to purchase the right to preferred stock (i.e., SAFEs or convertible notes) or purchase preferred stock directly during financings. Liquidation preference is the legal entitlement to receive a pre-determined portion of a company’s value in the event of a sale or liquidity event before the holders of common stock (i.e. the right to get paid first in an exit).

Ownership (O): the % of a company a shareholder possesses prior to or post-closing of a financing

Participation (Liquidation Preferences): is the right of a preferred stock to participate in remaining acquisition proceeds (on an as-converted to common stock basis, along with common stock) after the initial multiplier liquidation preference is satisfied. When preferred stockholders have a participation preference it’s called “double dipping” as preferred stockholder enjoys preferential return of capital in liquidation preference and then enjoys pro rata share of remaining proceeds. Participation can be capped (limited to a certain multiple) or uncapped.

Prepayment: in the context of convertible notes, payment of the principal and accrued interest by the startup before the note matures. This is generally only allowed if there is a majority of supermajority vote in favor of prepayment by the noteholders.

Major Investor: refers to a participating investor in a financing that surpasses a certain check size threshold, unlocking certain rights. I.e., “all those who invest over $500k will be deemed major investors and shall receive information and pro rata rights”

Maturity: the date at which the debt (plus any accrued interest) is due for repayment. This is typically 12, 18, or 24 months from the issuance of the convertible note. We will talk about conversion momentarily but the norm for a convertible note is that it has converted into equity prior to the maturity date

Maturity Extension: in the context of convertible notes, this entails moving the maturity date back. A common alternative to repayment is for the company and noteholders to agree to an extension on the maturity date of the note

Multiple: a ratio that is calculated by dividing the valuation of an asset by a specific item on the financial statements

Multiplier (Liquidation Preferences): Multiplier refers to the multiple on the original price per share of a class or series of preferred stock an investor is entitled to receive before others get paid. A 1x preference means getting paid one times the original investment, a 3x preference would mean getting paid three times the original investment back before the next most senior preference is paid.

Multiple on Invested Capital (MOIC): compares the value of an investment on the exit date to the initial equity contribution

Non-priced financing: financing round in which founder and VC do not explicitly set a share price and thus do not set an associated pre-money valuation (i.e., convertible notes, SAFEs)

Option pool: an amount of common stock primarily reserved in the cap table for future employees (in certain cases, options can be pulled out of the option pool for existing employees/founders as well)

Optional conversion: in the context of convertible notes, entitles the noteholder to convert their note into equity if desired if the note is still outstanding on the maturity date

Post-Money Valuation (PO): the valuation of the company after the round size is invested by the VC(s)

Pre-Money Valuation (PM): what the investor is valuing the company at TODAY, prior to the investment

Priced round/financing: a round of financing in which the valuation and price per share of a unit of stock being sold is officially determined (as opposed to a SAFE or convertible note in which case the valuation is left officially undetermined)

Price Per Share (PPS): the cost of acquiring a share of company x, typically determined by pre-money valuation and fully diluted shares outstanding prior to close of financing

Principal: in the context of convertible notes, the amount of investment provided by the noteholder (investor) to the company through the convertible note. In an unfortunate scenario where the note never converts to equity (we will discuss this), the principal (plus any accrued interest) is what the company owes the noteholder (unless nuanced legal terms dictate otherwise). Assuming the note does convert to equity (the norm), the principal (plus any accrued interest) is the quantity used to calculate how many shares the note holder will receive upon conversion into equity.

Pro rata rights: give investors the right (but not obligation) to participate in future rounds of financing to maintain their initial level of percentage ownership in the company.

Pro rata on a dollar-for-dollar basis: gives the investor the right to invest an amount equal to or less than the amount invested in their first round à VC Z invested 200K in the seed round and has the right to invest 200k in the Series A

Pro rata on a fixed sum basis: least common, investors get the right to continue investing an amount as agreed upon that is decoupled from the investment amount. VC Z, who invested $1M in a seed, negotiates pro rata rights up to $700K - they will be able to invest up to $700K in each subsequent round of financing.

Pro Rata ROFR: gives particular investor(s) the right to another investors voluntarily waived pro rata in a future financing  

Qualified financing: in the context of convertible notes/SAFEs, the round size of an equity financing typically must meet a certain dollar threshold to trigger conversion into equity.

QSBS: a tax benefit under Section 1202 that incentivizes investment into small businesses (often startups) with less than $50 million in aggregate gross asset value. Investors who purchase stock (common or preferred) directly (as opposed to via secondaries) from a c-corp business with less than $50 million in aggregate gross asset value and hold that investment for > 5 years, followed by a sale of the held stock, can avoid paying capital gains tax. The tax exclusion can be up to 100% of the gain, subject to limits: the greater of $10 million or 10x the original investment. Recently big beautiful bill updates: 1/ asset value threshold up to $75 million, 2/ cap limit extended to higher of $15 million or 10x investment, and 3/ exclusion starts to come into play after just three years (at 50% exclusion potential).

QSBS Gain Deferral: if you have to liquidate a position before the QSBS holding period requirement ends, you can defer the tax on capital gains, by reinvesting the gains into another QSBS qualified business within 60 days of liquidation. You also get to roll over the holding period of the original investment, continuing the clock (as opposed to starting over).

Repayment: in the context of convertible notes, the process of paying back the debt (plus any accrued interest) due to noteholders

Restricted Stock: company stock given to employees, usually as a bonus or additional compensation; does not have a strike price unlike options; usually awarded to company directors and executives and is subject to vesting

Round Size or Investment Amount (R): how much capital the founder is raising for the financing or VC round

RSUs: refers to an agreement by a company to issue employees shares on a future date. One RSU is the right to get one common share. RSUs, like options, are also subject to a time-based vesting schedule and can be trigger based; however, RSUs don’t have a strike price and are instead released directly to the recipient after vesting without any need to “exercise” or buy them; typically awarded to lower level employees than restricted stock

SAFE: an agreement between an investor and a company that converts into equity in the next financing round if certain conditions are met

Seniority (Liquidation Preferences): refers to whether preference is senior, junior or even (pari passu) with other preferred stock. Senior preference means having a first-tier liquidation right, junior preference means having a liquidation right that is paid after the senior preferred and pari passu means preference amongst different preferred stock is the same time.

Single-trigger: states that only one event must occur to accelerate the vesting of your equity. If the company is acquired, you gain complete ownership over all your options

Stock options: incentive mechanisms granted to employees, advisors, and consultants. Employees joining a VC-backed startup typically receive an option grant, which allows them to acquire company common shares in the future at a certain price by “exercising vested options”

Strike Price: the predetermined price an employee pays to exercise (aka purchase) their stock options and turn their stock options into actual shares of the company owned outright. Tax regulations (IRS Section 409a) require options grants to have a strike price equal to or above the fair market value of the underlying company stock on the date that the option is granted

‘Success disaster’: employees run the risk of being harmed financially for building a succeeding business that has grown in value significantly

Uncapped Note/SAFE: a convertible note (or SAFE) that lacks a valuation cap

Up Round: when the pre-money valuation of a future financing is higher than the post-money valuation of the prior financing; often seen as a positive sign for the company

Valuation: the process of deriving an enterprise value for a company

Valuation Cap: a valuation cap is an investor favorable terms that puts a ceiling on the conversion price at which a convertible note or SAFE would convert into the equity security sold at the qualified financing.

VC Valuation Method: a valuation methodology that entails projecting a company’s exit value in the future and a VC’s required MOIC in order to back into an implied valuation and ownership level at time of investment (starting with the future and backing into the present)

Vesting: the process of gaining ownership over granted stock options

Voluntary conversion: in the context of convertible notes, gives the investor (noteholder) the power to convert into equity whenever desired (even before maturity) under specified details, negating any prepayment potential

Warrants: when issued/contracted, give the warrant holder the right to buy a certain number of shares of the company’s common or preferred stock at a predefined price over a specified period

PM + R = PO ➡️ the pre-money valuation plus the round size = the post-money valuation

PO – R = PM ➡️ the post-money valuation minus the round size = the pre-money valuation

PM / FDSO = PPS ➡️ the pre-money valuation divided by shares outstanding = price per share

R / PO = O ➡️ round size divided by the post-money valuation is the amount of ownership acquired in a financing by participating investors

D / PO = Daniel’s O ➡️ Daniel’s investment divided by the post-money valuation is the amount of ownership Daniel is acquiring in a financing

Fundraising

Rule #1: Communicate early and consistently. Goal: build long term relationships with a roster of investors before you kick off a process.

Rule #2: Ask for help. The only way to get maximal value out of your cap table is by asking for help. Especially when times are tough, great investors can potentially be the difference between make or break.

Rule #3: Keep knocking. As hard as it is, keep communicating with rejectors and make them aware of your progress.

Dont #1: OVER-FOMOing

Don’t #2: Focusing on who instead of what

Don’t #3: Exaggerating objectively “auditable” traction

Don’t #4: Asking for follow up intros from rejectors

Is there a topic you’d like us to cover? Don’t be a stranger! Ever want to dive deeper on a topic in VC Investing or Law?

We can be reached here:

Daniel Faierman ➡️ [email protected] 

Chuck Cotter ➡️ [email protected]

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✍️ Written by Daniel Faierman and Chuck Cotter 

Disclaimer: The information provided in this entry does not, and is not intended to, constitute legal or investment advice; instead, all information, content, and materials available in this entry are for general informational purposes only.