In light of the banking crisis of 2023, many emerging growth and start-up companies have explored alternative cash management strategies, including holding cash in money market funds or investing in cash equivalents such as short-term corporate debt and mutual funds. Some companies have inquired whether such alternative cash management strategies would adversely impact the company's eligibility as a "qualified small business" for purposes of the "qualified small business stock" (QSBS) exemption under Section 1202 of the Code.1 In short, most emerging growth and start-up companies should not worry about jeopardizing their QSBS eligibility as a result of such alternative cash management strategies.
To be QSBS eligible, among other requirements, a company is required to use at least 80 percent (by value) of its assets towards the active conduct of a qualified trade or business. Accordingly, cash and other passive assets cannot exceed 20 percent (by value) of the company's assets. For this purpose, value generally takes into account goodwill and other intangible assets. Further, corporate stock and securities cannot exceed 10 percent (by value) of the company's assets. Importantly, however, assets that are held by the company to finance research and experimentation (R&E) expenditures and working capital for the next two years are backed out of both calculations, so long as such assets do not exceed 50 percent (by value) of the company's assets.
Practically speaking, emerging growth and start-up companies are not likely to exceed this threshold unless the company is holding significantly more investment assets than what it forecasts spending on R&E and working capital over the subsequent two years (a nice problem to have). Companies that follow a more typical fundraising cycle (e.g., two to three years) should be confident they should not jeopardize their QSBS eligibility as a result of holding and investing their cash in alternative investments.
[1] For more information about QSBS, please see here: https://www.wsgr.com/en/insights/understanding-section-1202-the-qualified-small-business-stock-exemption.html.
