Bedrock Memo 02

The Tax Drag Nobody Calculates

November 2024

The True Cost of Selling Concentrated Private Equity
Bedrock Memo 02
By Shaunak Mali
Founder & Managing Partner, Bedrock Bridge Capital

The Simple Math Everyone Does

When shareholders consider selling a portion of their private equity, the calculation seems straightforward.

You have shares worth some amount. A buyer offers some percentage of that value. You net the proceeds after the discount.

If your shares are worth 5 million dollars and a secondary buyer offers 80 cents on the dollar, you receive 4 million dollars. The cost of liquidity appears to be 1 million dollars, or 20 percent.

This is the math most people do. It is also incomplete.

The Tax Reality

The secondary discount is only the first cost. The second, often larger cost is the tax due on the transaction.

For a shareholder in California with long-term capital gains, the combined tax burden looks like this:

For short-term gains or ordinary income treatment, the numbers are higher still - potentially 50 percent or more when federal and state rates combine.

Let us revisit the example.

You sell shares worth 5 million dollars at an 80 percent secondary price. You receive 4 million dollars gross. But your cost basis is low - say, 200,000 dollars from early option exercises. Your taxable gain is 3.8 million dollars.

At 37.1 percent, you owe approximately 1.4 million dollars in taxes.

Your net proceeds: 2.6 million dollars.

You started with shares worth 5 million dollars. You now hold 2.6 million dollars in cash. The combined cost of the secondary discount and taxes was 2.4 million dollars - 48 percent of your starting value.

This is the math most people do not do until after the transaction is complete.

The Forfeited Appreciation

But we are still not finished.

The shares you sold will not appreciate further in your hands. Whatever the company does from here - another funding round, an IPO, an acquisition at a premium - you will not participate in that upside on the shares you sold.

This is obvious in principle but underappreciated in practice.

Consider a shareholder who sells 1 million dollars of stock (at current value) to fund a near-term need. After the secondary discount and taxes, they net perhaps 520,000 dollars.

Two years later, the company goes public at twice the valuation they sold at. The shares they sold would now be worth 2 million dollars.

The true cost of that liquidity decision was not 480,000 dollars. It was the difference between 520,000 dollars in hand and 2 million dollars they would have had - a gap of 1.48 million dollars, or nearly three times what they netted.

This is not a prediction that every company will double. Some will. Some will decline. The point is that selling eliminates your participation in the upside scenario entirely, and that elimination has a cost that does not appear on any statement.

The QSBS Consideration

For shareholders who hold Qualified Small Business Stock, the stakes are higher still.

Section 1202 of the Internal Revenue Code allows for the exclusion of up to 10 million dollars in capital gains (or 10 times the original investment, whichever is greater) on qualifying stock held for more than five years. For founders and early employees at successful companies, this can represent millions of dollars in tax savings - potentially the difference between keeping 6 million dollars and keeping 10 million dollars on the same exit.

But the exclusion requires holding the shares for the full five-year period. Selling before that threshold resets the clock at best and forfeits the benefit entirely at worst.

A shareholder eighteen months from QSBS eligibility who sells today is not just paying 37 percent in taxes on the current sale. They may be forfeiting a future exclusion worth far more than the liquidity they needed.

This is the decision many shareholders make without fully modeling the long-term consequences.

The Alternative Arithmetic

What if there were a way to access liquidity without triggering a sale?

Consider the same shareholder with 5 million dollars in equity who needs 500,000 dollars for a home purchase or diversification.

Option A: Sell shares

To actually net 500,000 dollars after tax, the shareholder would need to sell roughly 950,000 dollars worth of shares at the secondary price - nearly a million dollars of equity permanently surrendered.

Option B: Facility against shares

The comparison:

Sell Shares Facility
Cash received 500,000 500,000
Shares surrendered ~950,000 (at current value) 0
Tax paid ~350,000 0 (at time of facility)
Total cost over 2.5 years ~800,000 (discount + tax + forfeited upside) ~118,000
Upside participation Reduced Full
QSBS status Potentially impaired Preserved

The facility costs 118,000 dollars over the hold period. Selling costs 350,000 dollars in immediate taxes alone, plus the secondary discount, plus the forfeited appreciation on the sold shares.

For any hold period under four years, the facility is unambiguously cheaper. For shareholders with QSBS eligibility at stake, the gap widens further.

Why This Math Is Ignored

If the arithmetic is this clear, why do shareholders still default to selling?

Several reasons:

The tax bill is deferred and abstract.

When you sell in November, the tax is not due until April of the following year. The pain is distant. The cash is immediate. Human psychology favors the concrete present over the abstract future.

Advisors are not always aligned.

Financial advisors who manage liquid assets may benefit when a client sells private holdings and moves capital into managed accounts. The advice to "diversify" is not wrong, but it often ignores the cost of the diversification method.

The alternative is unfamiliar.

Most shareholders are not aware that facilities against private stock exist, or assume they are only for distressed situations. The framing of "borrowing" sounds like leverage and risk, when the structure is actually designed for preservation.

The QSBS calculation is complex.

Many shareholders do not fully understand their eligibility, their remaining holding period, or the magnitude of the benefit they might forfeit. The rules are technical, and the stakes are not always made clear.

The Framework

Before selling any concentrated private equity position, three calculations are worth doing explicitly:

First, the true net proceeds.

Not the gross sale price - the actual cash that will remain after secondary discounts and taxes are paid. For many shareholders, this number is 40 to 50 percent lower than the headline value of the shares sold.

Second, the opportunity cost.

What would those shares be worth in a range of exit scenarios? If the company doubles before exit, what have you forfeited? If it triples? This is not a prediction but a framework for understanding what you are giving up.

Third, the QSBS and holding period impact.

If you are within five years of QSBS eligibility, what is the dollar value of the exclusion you are forfeiting? For many shareholders, this number alone exceeds the liquidity they were seeking.

These calculations do not always point away from selling. There are situations where a sale is the right choice - where liquidity is genuinely urgent, where the company's prospects have deteriorated, where the tax hit is acceptable relative to the risk reduction.

But the decision should be made with the full arithmetic in view, not just the simple version.

The Uncomfortable Truth

The tax code does not reward diversification. It penalizes it.

Shareholders who hold concentrated positions for long periods - particularly those who qualify for QSBS - are treated far more favorably than those who sell and diversify. This is a policy choice, and you may disagree with it. But it is the reality within which decisions must be made.

The shareholders who navigate this reality most successfully are typically those who find ways to access liquidity without triggering the realization event. They borrow against the asset rather than sell it. They pledge rather than transfer. They pay a modest carrying cost to preserve a much larger tax benefit.

This is not tax avoidance. It is tax awareness - understanding the rules as they exist and structuring decisions accordingly.

The alternative is to sell, pay the tax, forfeit the upside, and only later calculate what the decision actually cost.

By then, of course, it is too late to choose differently.

This document is for informational purposes only and does not constitute investment, tax, or legal advice. Shareholders should consult their own advisors regarding their specific circumstances. Tax rates and QSBS eligibility rules vary by jurisdiction and individual situation.

Bedrock Bridge Capital