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Exchange Funds

TL;DR There’s an investment vehicle called an “exchange fund” that can help startup employees and founders diversify post-IPO without triggering taxes, though there are significant downsides to consider. An exchange fund might make sense for you if you are highly concentrated in one company’s stock or have highly appreciated stock that would be subject to large capital gains taxes if you sold your shares. The fund pools your shares with other concentrated shareholders to try and match the allocation of an index. You usually must be a qualified purchaser to use an exchange fund, and most funds have investment minimums (~$500k). Since there is a significant lockup period (~7 years), you should only pursue this option if you want to diversify and do not have liquidity needs in the short-to-mid term.

What is an exchange fund?

An exchange fund is a limited partnership (most commonly organized as an LLC) that takes concentrated shareholders of different companies and pools their shares within the limited partnership. This pooling of assets allows each investor to “exchange” their large holding of a single stock for units in the partnership without triggering taxable gain because the original stock was merely contributed to the partnership. Exchange funds thus provide investors with an easy way to diversify their holdings while deferring capital gains taxes, though there are notable drawbacks that we dive into below.

Usually, exchange funds try to mimic an index like the S&P500 or S&P1000, though the success of that diversification depends on which concentrated stocks were contributed to the fund. An important thing to note is that in order to contribute to the fund, a fund must be actively accepting your company’s specific stock at the time. Funds will restrict the types of stock that may be contributed if those stocks will put the fund out of balance against its targeted index. 

Who is this for and why would I want to use one?

Exchange funds may be an attractive option for people who have significant ownership of a company’s stock, so long as all the pros and cons are fully considered.

For example:

  • Sally has $2M worth of Company X’s stock. She wants to diversify but doesn’t want to pay the capital gains taxes that get triggered when you sell stock. Instead, she puts $500k worth of the stock in an exchange fund. That stock sits in the exchange fund and is invested in that benchmark index. Sally is shielded from experiencing the volatility of a single stock. When the lockup period ends, Sally gets a basket of stocks back with the same cost basis as the shares she originally contributed to the fund which she can either sell, keep in the fund, or contribute to a new exchange fund. If she chooses to sell them, she will pay long-term capital gains.

Some things to keep in mind:

  • You need to be at least an accredited investor to use an exchange fund. Individuals need to make an annual income exceeding $200,000 (or $300,000 for a household), or have a net worth that exceeds $1 million in order to reach accreditation. More likely, you will need to be a qualified purchaser, which requires having at least $5M in investments. This depends on the fund.
  • Depending on your company policy, you may or may not be restricted from contributing your stock.
  • There is typically an investment minimum (~$500k). You can combine stocks to meet that minimum as long as the fund accepts the combined stocks you wish to contribute. (i.e. you can combine Facebook and Google stock to reach the minimum.)
  • You won’t get to participate in the long-term growth of one company’s stock. Since you’re diversifying out of your concentrated position, you won’t experience the upside if that one company’s stock greatly appreciates. So carefully consider if you are bullish on that particular company’s growth for the next ~7 years.
  • They are private. Exchange funds are private investments that are neither publicly traded nor publicly audited.
  • They usually don’t just contain stock. Tax law requires that 20% of the exchange fund must be held in illiquid assets called “qualifying assets,” which only the manager gets to select. Most often these are real estate assets.

What are the downsides of using an exchange fund? There are a few.

  • There’s a seven year lockup period for your stock. The typical lockup period is the maturity of the fund, which is about seven years. So, once you transfer shares to the fund, you won’t own shares of that company directly anymore; you will own shares in a fund instead for at least seven years. Only pursue this option if you don’t need the funds in the near term. This also means you can’t borrow against your stocks because the partnership units you get in exchange are not liquid. 
  • Your taxes are not reduced, they’re just deferred. You will eventually have to pay taxes when you sell your shares.
  • You may owe taxes while you participate in the fund. If the fund sells some asset or liquidates another investor’s interests in the fund during the term in which you are invested, you may be allocated gain from that sale because you are a limited partner in the fund, and thus be required to pay relevant tax.
  • You can’t choose what company’s stock you get back. If you put in Google stock, you don’t get to choose Google stock on the way out after the lockup period. You get whatever stocks the exchange fund chooses to liquidate. 
  • There are management and early withdrawal fees. You’ll have to pay management fees (~1%) on top of any taxes owed. Some exchange funds charge higher management fees than others, so do your research when selecting a fund. There’s also a separate fee of ~1-3% for taking your funds out early. 
  • Taxes might go up (or down). Taxes might go up in the future (meaning it may be advantageous to pay any taxes you owe today rather than in 7-10 years) or they might go down. It’s impossible to predict so you’re taking a gamble.

Bottom Line

You’ve done a great job picking a startup to join, the company IPO’d, and you’ve since left to explore your next gig (or retire!). Over the past couple of years, your position has appreciated, but you’re heavily concentrated and you now want to diversify into other securities. Exchange funds allow you to do that without triggering taxes from a sale. If you foresee your company experiencing lots of growth, this strategy might not make sense for you since there is a lockup period and you will miss out on that future upside by diversifying. However, if you still want to diversify your position, then contributing to an exchange fund may be the right move for you. Just be sure to fully weigh all the pros and cons.

Disclosure
Compound Financial Inc. (“Compound Financial”) offers software-based financial management and planning tools. Investment advisory services are provided by Compound Advisors, Inc. (“Compound Advisers”), an SEC-registered investment adviser (CRD# 306341/SEC#: 801-122303). Registration as an investment adviser does not imply any level of skill or training. Compound Tax, LLC (“Compound Tax”) provides tax consulting and compliance services. Compound Advisers and Compound Tax are wholly owned subsidiaries of Compound Financial. Altogether, we refer to our business as “Compound.” The information contained in this communication is provided by Compound for general informational purposes and should not be considered as financial or tax advice. Compound is not a licensed lender, law firm or insurance agency, and Clients should consult with their personal investment, insurance, tax or legal advisors or brokers regarding their particular circumstances as needed before making any final financial decisions. This communication is not an offer to sell securities. All investing involves risk, including the possible loss of any or all of the money invested, and past performance never guarantees future results. Please see Compound Advisers' Form CRS here, and ADV Part 2A Brochure here.