This article is part of our ongoing series exploring key tax considerations across the biotech lifecycle—from funding through exit.
The “birth” of a biotech company is always accompanied by a need for financing. Given the risk associated with early-stage investments, the funding rarely takes to the form of typical financing structures (e.g., common stock, indebtedness). From early-stage capital raises through later venture rounds, companies often rely on a mix of preferred equity, simple agreements for future equity (“SAFEs”), convertible debt, and warrants. These instruments are designed to provide upside for investors, but they can also create tax consequences that affect financing efficiency, investor economics, and long-term exit outcomes. That is, the structure of an instrument can affect tax classification, deductibility, investor holding periods, future tax attributes, and can even result in current (and “dry” or “cashless”) income accrual to holders.
How funding structures shape tax treatment
The analysis often begins with classification. Common biotech funding instruments – particularly convertible debt and SAFEs – do not always fit neatly into traditional tax categories of debt or equity. Depending on their terms and the surrounding facts, they may be treated as debt, equity, or, in the case of SAFEs, derivatives like prepaid forward contracts. That determination can drive very different results for both the company and its investors.
As a theme of tax, and the topics discussed in this note, the tax classification question does not stop at labels alone. If an instrument is respected as debt, the company may be able to claim interest deductions under section 163, subject to applicable limitations. If it does not qualify as debt, or is debt that is treated as payable in equity, those deductions may not be available. For early-stage biotech companies managing cash burn and frequent capital needs, that distinction can directly affect the after-tax cost of capital.
Why funding structures matter to investors
The implications also extend beyond current-year deductions. The classification of an instrument as stock (or not) can affect certain tax advantages including Qualified Small Business Stock (QSBS) eligibility, which can produce significant tax benefits on exit. For certain instruments that ultimately become stock, the QSBS holding period does not begin until conversion into equity. As a result, investors may not satisfy the required holding period when they expect to, which can materially affect exit outcomes. From a QSBS perspective, there may also be opportunities to enhance the tax benefits of QSBS by delaying an issuance.
Foreign investors are another group that can be adversely affected by the tax classification of an instrument. For example, the classification of stock as preferred or common stock (which may include participating preferred stock) for tax purposes can affect the accrual of dividend income in periods where no dividends are actually paid. This is because the US tax regime can impute dividend income in certain circumstances where dividends are deemed to be paid on preferred stock. Dividends paid to non-US investors can entail withholding tax that may not be reduced to 0% under tax treaty. This can be a particularly onerous result where cash dividends are not actually paid but cash tax is imposed.
How future funding rounds can affect tax attributes
As companies move through additional funding rounds, issuances can result in ownership changes that may trigger limitations under sections 382 and 383. Sections 382 and 383 are an anti-tax attribute monetization provisions that restrict the use of net operating losses and other tax attributes generated in earlier years. The policy of the provisions is most easily appreciated in the context of a profitable corporation’s 100% acquisition of a loss corporation, which theoretically could be based largely or exclusively on the loss corporation’s valuable tax attributes. However, the rules under section 382 are broad and also capture ownership changes occurring gradually over time. For biotech companies with significant research and development losses, that have experienced numerous rounds of financing, sections 382 and 383 can reduce the value of an important tax asset.
This analysis becomes more complicated when preferred stock, SAFEs, other convertible instruments, and warrants are layered into the cap table across multiple rounds. In practice, that means companies often need to monitor ownership changes proactively rather than trying to reconstruct the analysis later in the context of a financing, restructuring, or exit transaction.
Why early planning matters
All of the issues described above are interconnected with the birth of the biotech and its early-stage financing. A single instrument can affect deductibility, investor holding periods, cap table analysis, and future tax attributes at once, with tax ramifications that persist for years. For biotech companies operating in a capital-intensive, highly regulated environment, tax planning should be part of the financing strategy from the outset—not a later cleanup exercise.
How we help
WilliamsMarston works with biotech companies and investors to evaluate funding structures with a forward-looking lens, considering not only immediate tax consequences but also implications for ownership, QSBS eligibility, and eventual exit. If you are evaluating your next financing round or reassessing prior structures, we encourage you to reach out and we can help identify potential risks and planning opportunities.
