Accounting and finance PRO Business MS

Pro Business MS

Accounting and finance

Software companies

While many of the accounting and tax issues faced by software companies are common in other industries as well, there are certain areas in which software companies must be well-versed in order to establish and maintain credibility with investors and lenders and minimize exposure to taxes. These areas (arranged roughly chronologically over the life cycle of the typical software company) include:

Choice of entity type – Software companies often start out as a flow-through entity (S-corp or LLC) in order to enjoy the flow-through of tax losses and credits, avoid the potential for double taxation, and provide maximum flexibility in an exit transaction, but later find it more advantageous to convert to C-corp status (perhaps to accommodate a significant venture capital or foreign investor).  Other times, software companies find it advantageous to move in the opposite direction (from C-corp status to flow-through status). Great care must be taken in the initial choice of entity type, as well as any subsequent change (since significant adverse tax consequences can result).

Debt and equity transactions – Rapidly growing software companies often have various types of owners, including founders, key employees, angel investors, and institutional venture capital funds, and multiple types of debt and equity, including senior debt, convertible debt, common stock, and potentially multiple series of preferred stock with differing rights and preferences.  In general, amounts associated with debt (other than principal repayment) will result in a tax deduction, while any amounts associated with equity (including costs incurred to raise the equity) do not result in a tax deduction.

Stock-based compensation – Software companies often use restricted stock, stock options and other forms of equity-based compensation to attract and retain key talent.  It is important to understand the financial accounting and tax ramifications of such, both from the perspective of the company and the employee.  The company will generally want to try to minimize any charge to financial statement earnings, while enjoying an income tax deduction for any amount included in income by the employee.  From the employee’s perspective, it is important to avoid having a W-2 income inclusion at a time when there may be no cash involved with which to pay the resulting tax, and to try to structure for long-term capital gains treatment (rather than having ordinary income).