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Tax-Free QSBS Gains: The Best Kept Secret in Venture Capital

December 14, 2024

For venture capital investors, Qualified Business Stock (QSBS) is one of the most lucrative tax benefits hiding in plain sight. It offers investors the chance to keep more of their returns by eliminating taxes on gains.

Despite being part of the U.S. Tax Code since 1993, QSBS was unused for decades—overshadowed by shifts in capital gains rates and overlooked by even seasoned investors. But today, thanks to key legislative changes, QSBS is making waves as a game-changer for venture funds, angel investors, and entrepreneurs alike.

In this post, we’ll explore the history and mechanics of QSBS, how it can transform your tax implications, and what you need to know to take advantage of it. If you’re investing in early-stage startups, this might just be the most important tax benefit you’re not fully using—yet.

QSBS first appeared in 1993, but was largely ignored

In 1993, Congress set out to incentivize investment into U.S. small businesses. As a result, Section 1202 of the IRS Tax Code was created as part of the Revenue Reconciliation Act of 1993. The goal was to give tax breaks to investors who purchased Qualified Small Business Stock (QSBS) and held it for more than five years. Initially, the tax break offered a blended tax rate of 14% on the first $10M of qualifying gains, or gains equal to 10 times the investor’s cost basis – whichever was higher. This was achieved by exempting 50% of the gains from taxes and taxing the remaining gains at a special rate of 28%.

At the time of Section 1202’s introduction, the maximum tax rate for long-term capital gains was 28%, making the effective 14% rate on QSBS gains highly attractive. However, very shortly afterwards, Congress reduced the maximum long-term capital gain tax rate to 20%, diminishing the relative impact of the QSBS benefit. By 2003, when the maximum long-term capital gains rate was further reduced to 15%, Section 1202 became virtually irrelevant. Saving 1% was not compelling enough to justify the extra complexity and tracking required.

The 2008 financial crisis sparked a QSBS revolution

The U.S. and global economies were plunged into a deep recession in late 2008 and 2009. In response, Congress incrementally expanded the QSBS tax break over the following years. Initially, these increases were temporary, lasting for short periods and sometimes applied retroactively. It wasn’t until 2015 that QSBS, as we know it today, became a permanent fixture of the U.S. Tax Code.

Key legislative changes included:

  1. The American Recovery and Reinvestment Act of 2009: This act temporarily increased the tax-free exclusion from 50% to 75% for stock acquired after February 17, 2009.
  2. The Small Business Jobs Act of 2010: It temporarily raised the tax-free exclusion to 100% for stock acquired after September 27, 2010, although only for a short period. This act also excluded QSBS gains from Alternative Minimum Tax (AMT) calculations.
  3. The American Taxpayer Relief Act of 2012: This act retroactively reinstated the 100% tax-free exclusion and extended it forward for stock acquired through January 1, 2014.
  4. The Protecting Americans from Tax Hikes (PATH) Act of 2015: This legislation permanently codified QSBS benefits, making qualifying gains 100% tax-free federally, exempt from AMT calculations, and free from the 3.8% Medicare tax. This was the true game-changer!
QSBS is now one of the best tax breaks in U.S. history

Today, QSBS stands out as one of the most impactful tax incentives in the history of the U.S. Tax Code. However, it wasn’t until the late 2010s and early 2020s that investors began to fully recognize the economic advantages of QSBS tax gains.

Here is the current tax treatment for qualifying QSBS gains:

  • Tax-Free Federally: Gains are entirely excluded from federal income taxes.
  • Exempt from Medicare Tax: The 3.8% Medicare tax does not apply.
  • No Alternative Minimum Tax (AMT) Impact: QSBS gains are excluded from AMT calculations.
  • State Tax Benefits: Gains are tax-free in 45 out of 50 states, with exceptions in Alabama, California, Mississippi, New Jersey, and Pennsylvania.

This combination of tax benefits makes QSBS an unparalleled opportunity for investors seeking to maximize their after-tax returns.

Holding Period Requirement

To be eligible for tax-free gains, Section 1202 requires that a taxpayer must hold QSBS stock for at least five years.

Limitations on QSBS gains

Section 1202 limits the amount of tax-free gain from any individual QSBS sale to the greater of $10M or 10 times the investor’s basis in the stock. Notably, this limitation applies on a per-company basis, not per taxpayer. As a result, an investor can claim up to $10M in tax-free gains for each eligible QSBS company they invest in, with no annual or lifetime cap on the total benefit.

What makes a company qualify for QSBS?

To qualify as a Qualified Small Business (QSB), a company must meet several criteria. While we won’t cover all the details here, the primary high-level requirements pertain to:

  • Corporate structure: The company must be a U.S. C-corporation.
  • Business activity: The company must actively conduct a “qualified trade or business.” (See definition below.)
  • Asset limitation: The company must have less than $50M in aggregate gross assets immediately after the funding round in which the stock is purchased, as well as at all times prior.

What is a “qualified trade or business”?
The IRS defines it by exclusion, specifying what does not qualify. The following types of businesses are excluded:

  • Businesses providing services in fields such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage, where the principal asset is the reputation or skill of one or more employees.
  • Banking, insurance, financing, leasing, investing, or similar businesses.
  • Farming businesses, including those involved in raising or harvesting trees.
  • Businesses engaged in the production or extraction of resources for which deductions under Section 613 or 613A apply.
  • Businesses operating hotels, motels, restaurants, or similar establishments.

Almost all other types of businesses qualify, meaning that the majority of U.S.-based tech startups structured as C-corporations (which is most of them) meet the criteria for Qualified Small Business status during the early years of their operations.

Can you get the QSBS tax break by investing in VC funds?

Yes. The QSBS tax benefit extends to partnerships or LLCs treated as passthrough entities for tax purposes. This means that investors in most early-stage VC funds are eligible for tax-free QSBS gains, provided the VC firm properly tracks these gains and reflects them as QSBS gains on the K-1 tax forms issued to investors each year.

In fact, a VC fund can generate well over $10M in QSBS gains from a single investment, and 100% of that gain can still pass through to its investors tax-free. This is because each individual investor in the fund has their own $10M QSBS limit per investment (as illustrated in Example 3 below).

QSBS tax benefit examples

Example 1:

An investor purchases QSBS in a qualifying company for $200k. After holding the stock for more than five years, they sell it for $5.4M, realizing a $4.4M gain. Under Section 1202 of the U.S. Tax Code, the entire $4.4M gain is tax-free federally. Additionally, the $4.4M gain is not subject to state tax in 45 of 50 states.

Example 2:

An investor purchases QSBS in a qualifying company for $1M. After holding the stock for more than five years, they sell the stock for $25M, realizing a $24M gain. In this instance, the investor exceeds the maximum $10M QSBS tax benefit. As a result, $10M of the gain is tax-free, while the remaining $14M gain is subject to long-term capital gains taxes.

Example 3:

An investor commits capital to a VC fund, which invests $1M in QSBS stock. More than five years later, the fund sells the stock for $30M, generating a $29M gain. How much of this $29M gain will investors receive tax-free? Surprisingly, it’s likely all $29M.

Here’s why: Each individual investor in the VC fund has their own $10M tax-free limit per investment. For example, if a single investor holds a 20% stake in the fund, the IRS treats them as having invested $200k in the company (20% of $1M) and as receiving $6M in liquidity (20% of $30M). This results in a $5.8M gain for that investor—well below the $10M cap—making the entire gain tax-free under QSBS.

But wait, there’s more: Investors can offset QSBS losses with Section 1244

Section 1244 is another lesser-known part of the U.S. Tax Code relevant to QSBS. It provides a unique benefit: If your investment is part of the first $1M invested in a QSBS company and the investment results in a loss, that loss can be deducted as an ordinary loss rather than a capital loss. In practical terms, this means the loss can offset ordinary income, providing a significant tax advantage.

Losses under Section 1244 are capped at $50,000 per year for individuals and $100,000 per year for married couples filing jointly.

Section 1244 has limited relevance in the traditional VC landscape since venture capital firms are rarely involved in the initial $1M invested in a company. Even Pre-Seed stage rounds typically exceed this threshold. However, individual angel investors and VC firms that focus on smaller funding rounds (such as ours) can benefit from this additional QSBS tax advantage.

How RSCM’s strategy benefits from QSBS

Although we didn’t initially design our strategy to take advantage of QSBS when we started our firm in 2012, it turns out that our focus aligns perfectly with the type of small funding rounds the government intended to incentivize. As a result, RSCM funds and investors have benefited greatly from the tax advantages provided under Sections 1202 and 1244 of the U.S. Tax Code. On average, we estimate that more than 80% of the gains from our funds will qualify as QSBS gains, and in some cases will exceed 90%. For example, over 90% of our Fund 1 distributions have been QSBS-eligible.  

When combined with the tax benefits from Section 1244 losses, the federal tax rate for most of our funds is expected to fall within the low-to-mid single digits.

QSBS: Encouraging innovation and benefitting investors

The U.S. government introduced the QSBS tax break to stimulate investment in U.S. startups and small businesses, recognizing the vital role these companies play in innovation, job creation and overall economic growth. By reducing the tax burden on successful investments, QSBS encourages more capital to flow into early-stage companies, helping to fuel entrepreneurship and economic progress.

Although it took years for QSBS to gain traction, it is now recognized within the small business and early-stage venture investment communities as a significant advantage. QSBS has come to fulfill its intended purpose, becoming a powerful tool for investors while supporting the broader goal of a dynamic and growing economy.

‍

‍

This blog post is NOT professional tax advice

This blog exists to summarize the history and benefits of the QSBS tax breaks. It should NOT be construed as a complete or exhaustive overview, nor should it be considered tax advice. There are additional criteria not mentioned in this post that can disqualify a company and its investors from receiving QSBS tax benefits. Please consult a tax professional before making any personal investment decisions.

Further Reading

Enjoyed this post? Here are a few more posts that you might find just as insightful and engaging.

For Investors

Tax-Free QSBS Gains: The Best Kept Secret in Venture Capital

For venture capital investors, Qualified Business Stock (QSBS) is one of the most lucrative tax benefits hiding in plain sight. It offers investors the chance to keep more of their returns by eliminating taxes on gains.

Despite being part of the U.S. Tax Code since 1993, QSBS was unused for decades—overshadowed by shifts in capital gains rates and overlooked by even seasoned investors. But today, thanks to key legislative changes, QSBS is making waves as a game-changer for venture funds, angel investors, and entrepreneurs alike.

In this post, we’ll explore the history and mechanics of QSBS, how it can transform your tax implications, and what you need to know to take advantage of it. If you’re investing in early-stage startups, this might just be the most important tax benefit you’re not fully using—yet.

QSBS first appeared in 1993, but was largely ignored

In 1993, Congress set out to incentivize investment into U.S. small businesses. As a result, Section 1202 of the IRS Tax Code was created as part of the Revenue Reconciliation Act of 1993. The goal was to give tax breaks to investors who purchased Qualified Small Business Stock (QSBS) and held it for more than five years. Initially, the tax break offered a blended tax rate of 14% on the first $10M of qualifying gains, or gains equal to 10 times the investor’s cost basis – whichever was higher. This was achieved by exempting 50% of the gains from taxes and taxing the remaining gains at a special rate of 28%.

At the time of Section 1202’s introduction, the maximum tax rate for long-term capital gains was 28%, making the effective 14% rate on QSBS gains highly attractive. However, very shortly afterwards, Congress reduced the maximum long-term capital gain tax rate to 20%, diminishing the relative impact of the QSBS benefit. By 2003, when the maximum long-term capital gains rate was further reduced to 15%, Section 1202 became virtually irrelevant. Saving 1% was not compelling enough to justify the extra complexity and tracking required.

The 2008 financial crisis sparked a QSBS revolution

The U.S. and global economies were plunged into a deep recession in late 2008 and 2009. In response, Congress incrementally expanded the QSBS tax break over the following years. Initially, these increases were temporary, lasting for short periods and sometimes applied retroactively. It wasn’t until 2015 that QSBS, as we know it today, became a permanent fixture of the U.S. Tax Code.

Key legislative changes included:

  1. The American Recovery and Reinvestment Act of 2009: This act temporarily increased the tax-free exclusion from 50% to 75% for stock acquired after February 17, 2009.
  2. The Small Business Jobs Act of 2010: It temporarily raised the tax-free exclusion to 100% for stock acquired after September 27, 2010, although only for a short period. This act also excluded QSBS gains from Alternative Minimum Tax (AMT) calculations.
  3. The American Taxpayer Relief Act of 2012: This act retroactively reinstated the 100% tax-free exclusion and extended it forward for stock acquired through January 1, 2014.
  4. The Protecting Americans from Tax Hikes (PATH) Act of 2015: This legislation permanently codified QSBS benefits, making qualifying gains 100% tax-free federally, exempt from AMT calculations, and free from the 3.8% Medicare tax. This was the true game-changer!
QSBS is now one of the best tax breaks in U.S. history

Today, QSBS stands out as one of the most impactful tax incentives in the history of the U.S. Tax Code. However, it wasn’t until the late 2010s and early 2020s that investors began to fully recognize the economic advantages of QSBS tax gains.

Here is the current tax treatment for qualifying QSBS gains:

  • Tax-Free Federally: Gains are entirely excluded from federal income taxes.
  • Exempt from Medicare Tax: The 3.8% Medicare tax does not apply.
  • No Alternative Minimum Tax (AMT) Impact: QSBS gains are excluded from AMT calculations.
  • State Tax Benefits: Gains are tax-free in 45 out of 50 states, with exceptions in Alabama, California, Mississippi, New Jersey, and Pennsylvania.

This combination of tax benefits makes QSBS an unparalleled opportunity for investors seeking to maximize their after-tax returns.

Holding Period Requirement

To be eligible for tax-free gains, Section 1202 requires that a taxpayer must hold QSBS stock for at least five years.

Limitations on QSBS gains

Section 1202 limits the amount of tax-free gain from any individual QSBS sale to the greater of $10M or 10 times the investor’s basis in the stock. Notably, this limitation applies on a per-company basis, not per taxpayer. As a result, an investor can claim up to $10M in tax-free gains for each eligible QSBS company they invest in, with no annual or lifetime cap on the total benefit.

What makes a company qualify for QSBS?

To qualify as a Qualified Small Business (QSB), a company must meet several criteria. While we won’t cover all the details here, the primary high-level requirements pertain to:

  • Corporate structure: The company must be a U.S. C-corporation.
  • Business activity: The company must actively conduct a “qualified trade or business.” (See definition below.)
  • Asset limitation: The company must have less than $50M in aggregate gross assets immediately after the funding round in which the stock is purchased, as well as at all times prior.

What is a “qualified trade or business”?
The IRS defines it by exclusion, specifying what does not qualify. The following types of businesses are excluded:

  • Businesses providing services in fields such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage, where the principal asset is the reputation or skill of one or more employees.
  • Banking, insurance, financing, leasing, investing, or similar businesses.
  • Farming businesses, including those involved in raising or harvesting trees.
  • Businesses engaged in the production or extraction of resources for which deductions under Section 613 or 613A apply.
  • Businesses operating hotels, motels, restaurants, or similar establishments.

Almost all other types of businesses qualify, meaning that the majority of U.S.-based tech startups structured as C-corporations (which is most of them) meet the criteria for Qualified Small Business status during the early years of their operations.

Can you get the QSBS tax break by investing in VC funds?

Yes. The QSBS tax benefit extends to partnerships or LLCs treated as passthrough entities for tax purposes. This means that investors in most early-stage VC funds are eligible for tax-free QSBS gains, provided the VC firm properly tracks these gains and reflects them as QSBS gains on the K-1 tax forms issued to investors each year.

In fact, a VC fund can generate well over $10M in QSBS gains from a single investment, and 100% of that gain can still pass through to its investors tax-free. This is because each individual investor in the fund has their own $10M QSBS limit per investment (as illustrated in Example 3 below).

QSBS tax benefit examples

Example 1:

An investor purchases QSBS in a qualifying company for $200k. After holding the stock for more than five years, they sell it for $5.4M, realizing a $4.4M gain. Under Section 1202 of the U.S. Tax Code, the entire $4.4M gain is tax-free federally. Additionally, the $4.4M gain is not subject to state tax in 45 of 50 states.

Example 2:

An investor purchases QSBS in a qualifying company for $1M. After holding the stock for more than five years, they sell the stock for $25M, realizing a $24M gain. In this instance, the investor exceeds the maximum $10M QSBS tax benefit. As a result, $10M of the gain is tax-free, while the remaining $14M gain is subject to long-term capital gains taxes.

Example 3:

An investor commits capital to a VC fund, which invests $1M in QSBS stock. More than five years later, the fund sells the stock for $30M, generating a $29M gain. How much of this $29M gain will investors receive tax-free? Surprisingly, it’s likely all $29M.

Here’s why: Each individual investor in the VC fund has their own $10M tax-free limit per investment. For example, if a single investor holds a 20% stake in the fund, the IRS treats them as having invested $200k in the company (20% of $1M) and as receiving $6M in liquidity (20% of $30M). This results in a $5.8M gain for that investor—well below the $10M cap—making the entire gain tax-free under QSBS.

But wait, there’s more: Investors can offset QSBS losses with Section 1244

Section 1244 is another lesser-known part of the U.S. Tax Code relevant to QSBS. It provides a unique benefit: If your investment is part of the first $1M invested in a QSBS company and the investment results in a loss, that loss can be deducted as an ordinary loss rather than a capital loss. In practical terms, this means the loss can offset ordinary income, providing a significant tax advantage.

Losses under Section 1244 are capped at $50,000 per year for individuals and $100,000 per year for married couples filing jointly.

Section 1244 has limited relevance in the traditional VC landscape since venture capital firms are rarely involved in the initial $1M invested in a company. Even Pre-Seed stage rounds typically exceed this threshold. However, individual angel investors and VC firms that focus on smaller funding rounds (such as ours) can benefit from this additional QSBS tax advantage.

How RSCM’s strategy benefits from QSBS

Although we didn’t initially design our strategy to take advantage of QSBS when we started our firm in 2012, it turns out that our focus aligns perfectly with the type of small funding rounds the government intended to incentivize. As a result, RSCM funds and investors have benefited greatly from the tax advantages provided under Sections 1202 and 1244 of the U.S. Tax Code. On average, we estimate that more than 80% of the gains from our funds will qualify as QSBS gains, and in some cases will exceed 90%. For example, over 90% of our Fund 1 distributions have been QSBS-eligible.  

When combined with the tax benefits from Section 1244 losses, the federal tax rate for most of our funds is expected to fall within the low-to-mid single digits.

QSBS: Encouraging innovation and benefitting investors

The U.S. government introduced the QSBS tax break to stimulate investment in U.S. startups and small businesses, recognizing the vital role these companies play in innovation, job creation and overall economic growth. By reducing the tax burden on successful investments, QSBS encourages more capital to flow into early-stage companies, helping to fuel entrepreneurship and economic progress.

Although it took years for QSBS to gain traction, it is now recognized within the small business and early-stage venture investment communities as a significant advantage. QSBS has come to fulfill its intended purpose, becoming a powerful tool for investors while supporting the broader goal of a dynamic and growing economy.

‍

‍

This blog post is NOT professional tax advice

This blog exists to summarize the history and benefits of the QSBS tax breaks. It should NOT be construed as a complete or exhaustive overview, nor should it be considered tax advice. There are additional criteria not mentioned in this post that can disqualify a company and its investors from receiving QSBS tax benefits. Please consult a tax professional before making any personal investment decisions.

For Investors
For Founders

Report: How Are Pre-Seed and Seed VC Firms Investing in 2024?

The venture market bottomed out from historic highs last year. Total deal volume slumped roughly 50% from 2021’s peak, exit activity hit a ten-year low, and venture fund performance dropped across the industry. These rapid changes have created a new landscape for venture capital, and it’s affected how VCs are investing.

Right Side Capital surveyed 110 Pre-Seed and Seed VCs from February 2024 to May 2024 on their investment activity and strategies in 2023 and their plans for 2024, with a focus on Pre-Seed Rounds and Seed Rounds. VCs revealed that they are optimistic about the funding landscape in 2024 and that they have high expectations for revenue levels and growth rates from portfolio companies.

Below we share what we learned.

VCs Were Active in Pre-Seed Rounds in 2023

Surveyed VCs revealed that they were fairly active in Pre-Seed investment last year. Of the VCs surveyed, 87.0% made at least one investment in round sizes of $1M to $2.5M, and 35.2% made more than five investments at this stage.

Seed Round Deal Volume Was Less Than Pre-Seed Round Deal Volume in 2023

VCs reported less deal volume in Seed Rounds in 2023 as compared to Pre-Seed Rounds during the same period. Only 12.1% of surveyed VCs made more than five investments at this stage, and 25.9% made no investments at all. The majority (62.0%) made between one and four investments at this stage.

Investment Outlook Is Optimistic in 2024

Nearly half (45.4%) of respondents plan to make five to nine new investments in 2024, which is a significant increase from 2023, and 24.1% said they planned to make 10 or more investments this year. All respondents planned to make at least one investment, which indicates a more positive outlook from 2023.

Pre-Seed Fundraising: What VCs Expect from Founders in 2024

At the Pre-Seed fundraising stage, only 46.3% of surveyed VCs will invest in a pre-revenue startup, 27.4% will invest in a startup with sub-$150K annual recurring revenue (ARR), and 14.7% require $150K – $499K in ARR. For some surveyed VCs, revenue expectations can be even higher: 11.7% said they required startups to have $500K or more in ARR.

Growth expectations are high for Pre-Seed Rounds, with 34.8% of surveyed VCs expecting startups to double year over year at this stage, and 37% expecting startups to triple year over year.

Seed Fundraising: What VCs Expect from Founders in 2024

Expectations vary a lot for startups raising their seed rounds. At this stage, 17% of surveyed VCs will invest at pre-revenue, but 24% want to see ARR of $1M or more. That’s a big change from four years ago, when $1M or more in ARR was the criteria for Series A funding.

Surveyed VCs expect aggressive growth at this stage, with 47% investing in startups that are doubling year over year and 34% investing in startups that are tripling year over year.

Most VCs Recommend 6-12 Months of Runway

The majority (53.7%) of surveyed VCs advise their portfolio companies to maintain six to twelve months of runway before raising their next round. Only 29.6% of VCs advise startups to have over 18 months of runway.

Capital Efficiency Is More Important Than Ever

VCs reported that, in this leaner landscape, they are placing a greater emphasis on capital efficiency for portfolio companies. For 81.5% of respondents, capital efficiency is more important than ever before. The survey included an option for respondents to indicate that capital efficiency was unimportant, but not a single respondent selected it.

Roughly One Third of VCs Have Changed Their Investment Thesis

We asked respondents to write in answers about how their firm’s investment thesis has changed in 2024. Below we break down the results of those write-in answers.

Summary of Investment Thesis Changes in 2024

No Change (58%) The majority respondents indicated that their investment thesis has not changed significantly from 2023.

More Focus on Specific Areas (15%) Some VCs have an increased focus on specific sectors such as health, cyber, AI, and cybersecurity. They’re putting a greater emphasis on software, particularly AI-powered applications, and avoiding certain sectors like consumer and hardware.

“Like everyone else, [we have] more interest in AI-powered applications.”

– Survey respondent

Adjustments in Investment Strategy (10%) Some VCs are shifting to smaller check sizes. They indicated more capital allocation for Pre-Seed and they are rightsizing investment amounts to achieve more significant ownership.

Greater Sensitivity to Valuations and Due Diligence (7%) VCs are more sensitive to valuations, ensuring companies have more runway, and conducting more thorough due diligence. They’re also focusing on financing risk, revenue, traction KPIs, and efficient use of capital.

“[We’re] thinking more about financing risk and making sure companies have more runway.”

– Survey respondent

Increased Sector Preferences and Deal Dynamics (5%) A small subset of VCs have a growing preference for companies with experienced founders, significant revenue, and efficient burn rates. They’re avoiding overinvested spaces like sales-enablement software and sectors that are seen as high risk for next-round funding.

“[We’re] rarely taking pre-product risk unless the team has prior operating experience.”

– Survey respondent

No Specific Answer or N/A (5%) Some responses were “N/A” or did not specify a change in investment thesis.

Final Conclusions from the RSCM 2024 VC Survey

The venture capital landscape in 2024 has adapted to a leaner and more cautious environment. Right Side Capital’s survey reveals a higher bar for revenue expectations and a greater emphasis on capital efficiency than in more bullish periods.

Despite the challenges of 2023, VCs are optimistic about 2024 and plan to increase new investment volume. Overall, VCs are adopting a resilient and forward-looking approach, emphasizing sustainability and capital efficiency to navigate the transformed economic landscape.

‍

For Founders
For Investors

Understanding the RSCM Difference

RSCM is different from the vast majority of startup investors.

We are one of the only ones that is completely transparent on our Web site about our criteria and completely open access to any founders that think they meet them. Then we are fast. We make decisions in days and fund in weeks

If you’re familiar with how other investors work, you might find our behavior confusing. But once you understand our perspective, you’ll hopefully appreciate the rationality of our approach.

We look at the investment process like engineers:

  • There are very large numbers of both startups and investors.
  • The probability of any particular startup and any particular investor overlapping in their requirements is small.
  • Startups and investors both want to find the best match.
  • Time is valuable.

Conclusion: as an investor, (1) you want to be very up front with your target profile so startups outside this target don’t waste their time with you and (2) if you’re going to pass on a deal, you want to do so as quickly as possible. The later in the process you pass, the higher the cost to you and the startup. If you fail a high percentage of deals near the finish line, you’re doing it wrong.

When we analyzed and observed other investors, it seemed like two large sources of rejection frequently occurred at the very end of the process: outside of scope and disagreement on valuation. Investors would spend an enormous amount of time learning about a startup’s technology, business, and team, only to say, “No,” because they didn’t feel the investment ultimately matched their thesis or the founders wanted too high of a valuation.

Ideal Profile

To address the first category of failure, we made a list that defined our ideal profile and stuck to it. That may sound simple in theory, but it turns out to be extremely difficult in practice due to “fear of missing out”. Our goal was to come up with a set of criteria so crisp that we would never invest outside its boundaries and would invest in anything within its boundaries at the right price. Obviously, such perfection is impossible, but we are far closer to this ideal than everyone else.

Our list is not very long:

  1. Must be a “technology startup”.
  2. Must be “capital efficient”.
  3. Must be looking for an investment of no more than our maximum round size.
  4. Must be looking for a valuation of no more than our maximum valuation.
  5. Must be located within our investment geography.
  6. Must not be in one of our excluded business areas.
  7. Must meet our minimum traction bar.
  8. Must have a minimum number of FT founders..


Obviously, the parameters of each requirement can evolve. But it’s easy to declare them at any point in time, at least for (3)-(8).

Defining a “technology startup” is more subtle. For example, Internet auction sites and bookselling sites were “technology” in 1995. In the 2020s, not so much. What about a company that makes clothing from advanced materials manufactured by someone else and then sells it on Amazon? We would look at this business and conclude that their value add is the design of the clothing, so it’s fashion not technology. A similar analysis applies to resellers, who may sell extremely technical products, but their specific value-add is not the technology in those products.

Then there’s the issue of “technology-enabled” businesses–ones that apply technology internally to deliver a non-technology product such as car repair or temporary workers. In these cases, we consider how much technical advancement the startup has achieved and whether its business is likely to scale dramatically better than it would without the technology enablement. For example, if the technology enablement were superficial and easy to imitate, we would be a no. If the business required building or customizing specialty facilities at scale, also a no. If the differentiation were branding or fashion, no.

In general, we try to predict whether the business would scale rapidly due to its technological advantage and whether the exit market would treat the business as technology, with its associated high valuation multiples. Obviously, these touchstones are imprecise, but at least they provide a framework for making a determination.

The definition for “capital efficient” is also fuzzy. The underlying issue is that, the more capital a company needs to prove out its business, the more vulnerable it is. Also, when you’re an early investor that doesn't follow on, there can be structural challenges with large subsequent rounds that occur before a company has achieved product-market fit. The question we ask ourselves is, “Could this business reasonably get to breakeven, if necessary, with only $1M to $2M in total investment?” That doesn’t mean we don’t want companies to take more money; we just want them to have the choice and negotiating power of not needing large future rounds.

Valuation Up Front

Addressing the second challenge of avoiding mismatched valuation expectations is trickier. Any solution requires calculating at least a narrow range for the acceptable valuation up-front and at low cost. Initially, we developed a basic algorithm using parameters like founder experience and stage of technical development. This algorithm worked well enough to make us far more nimble than other investors, but required substantial qualitative judgment to determine the input value for each parameter. 

Then, a few years after we started investing, startups in our price range started routinely having initial revenues. We quickly realized that we could key valuations off these revenues. While more objective than our first algorithm, this path presented two sub-challenges.

The first sub-challenge was determining whether focusing on revenues would produce “negative selection”. It’s theoretically possible that the startups with the most potential to have very high returns are those working on groundbreaking products that take longer to reach a salable stage. In fact, there was also some conventional wisdom to this effect. However, there was also conventional wisdom from the “Lean Startup” movement that advocated getting some version of the product into the hands of customers as soon as possible.

When we analyzed our portfolio up to that point, we determined that several factors argued strongly for early revenues being a net positive:

  • Burn. Startups at our stage seemed to typically burn $10K to $20K per month. Revenues of even $5K per month could extend runway 33% to 100%. Because we fundamentally believe that the earliest startups represent option value, revenue that extended runway should increase this value.
  • Business. Having some customers willing to pay something is a positive sign that the startup is in a general area that might be a good business. Also, founders that are able to convince people to pay now is some indication that they’ll be able to convince people to pay more in the future. Finally, achieving initial revenue quickly and at relatively low cost is a signal of capital efficiency.
  • Innovation. Having customers to test new features on and ask about broader needs is a valuable source of insight. People who pay money are a more reliable source of opinion because they have skin in the game.

The second sub-challenge was how to deal with different revenue models. Obviously, a company that sells a piece of hardware at 50% margin and then a bunch of professional services is quite different from a SaaS company with customers on annual contracts at 90% margin. After reviewing our portfolio to that point, we were able to construct a set of rules that accounted for these differences:

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  1. Only revenues from the technology product or service count. No professional services revenues.
  1. Only gross margins count. 
  2. Growth path matters. A startup that reaches $10K/month in three months since launch is more attractive than one who took a year to grow from $1K to $10K.
  3. Recurring matters. Customers on annual contracts are better than ones on month to month contracts, which in turn are better than those who pay once. Generating revenues from a spot market, such as an ad or affiliate network, is the least attractive.
  4. Price point matters. At low price points, the sales channel must be very scalable and the acquisition costs pretty low. At higher price points, there is more room for error.
  5. Sales channel matters. The lower cost and more scalable the channel, the better.
  6. Acquisition cost matters. The less it costs to acquire a given amount of revenue, the better.
  7. Revenue concentration matters. Having more than one enterprise customer or customer segment is more attractive.

With these rules, we can look at a startup’s revenues in the context of our historical deal flow and determine our valuation tolerance. Obviously, if we happen to have several recent deals with identical revenue characteristics, we can determine the valuation easily. But the above rules also allow us to make tradeoffs versus recent deals with different characteristics. For example, a company that is otherwise similar at half the price point would be worth a modest amount less. But if it had achieved revenue more quickly then grown much faster, that could make up the difference. In practice, we seem to be able to make these tradeoffs for most startups we encounter.

Importantly, we distinguish between the “market” price and the price we are willing to pay. While we may determine that the market price for a startup is X, that price is based on the startup going through the much lengthier, haphazard, and opaque process other investors use. So we typically ask for a price that is 20-30% below market. Conversely, we acknowledge that startups can likely get a 20-30% higher price if they are willing to go through that longer haphazard process. Note that this position makes us a more competitive choice for startups that don’t have a lead investor or a substantial fraction of the round closed. Startups that already have a chunk of working capital coming in obviously don’t get as much benefit from us moving quickly.

Logical Process

These two innovations, sticking to an ideal profile and aligning valuation expectations up front, lead to a straightforward, efficient investment process. We simply apply the concept of failing as fast as possible.

  1. Receive request. We funnel all funding requests through our Web site to ensure we get a relatively consistent set of information that we can process quickly. Sometimes, we receive an electronic or verbal inquiry where we can “look ahead” to identify an obvious mismatch and save a founder the trouble of going to the site.
  2. Screen for profile fit. Based on a company’s description, Web site, and deck, we try to determine if a company fits our ideal profile. Occasionally, making this determination may require a few emails.
  3. Screen for valuation fit. Based on a company’s revenue model, current revenue level (including firm contracts going active soon), and capitalization structure, we calculate our valuation tolerance. Sometimes, making this determination may require a few emails. 
  4. Make an estimated offer. If a company’s valuation expectations are far outside our tolerance, we often reject the deal out of hand. If there’s potentially some room for overlap, we will provide our estimated offer to the company. Sometimes, exploring whether there is overlap may require a few emails.
  5. Review initial diligence documents. If there’s a profile fit and valuation alignment, we’ll review an initial set of diligence documents. We usually want to see a capitalization table, current balance sheet, monthly P&L spreadsheet, and some breakdown of customers.
  6. Phone call. If the documents don’t present any red flags, we schedule a phone call to review the business in general and dig down on specific issues. Often we proactively schedule a phone call for a few days after the company’s estimated date for delivering the documents.
  7. Make confirmed offer. Within 2 business days of the phone call, we make a confirmed offer or final rejection. We almost always make our offer based on a YC post-money SAFE with a cap set to our pre-money valuation plus the round size and a discount of 20%. In cases where there is a specific reason to use a different type of instrument, we can be flexible.
  8. Final diligence. If the company accepts our offer, we proceed to final diligence. Unlike some investors, final diligence is not about figuring out whether there’s a good fit. Rather, it’s about verifying the information previously provided, as well as generally making sure the company is legally and financially squared away.
  9. Execute investment. Once final diligence is complete, we generate investment documents, execute them, and then wire.

Typically, steps 1-4 take hours to days. The whole process requires 3-4 weeks from first contact to wire–if the company is responsive, has the necessary documents at hand, and there are no scheduling issues. 2 weeks is sometimes possible. The most common causes of delays are the company not having all the necessary initial and final diligence documents or there being some sort of circumstance that needs correction before we can proceed, such as converting to a C corporation. 

We often see other investors taking 3-4 months, sometimes longer, even in the good case. Moreover, we often see those investors saying, “No,” several months in. 

Internally, because our process always has a well-defined next step with a well-defined decision making scope, we rarely find ourselves getting bogged down. If we do, or if we end up having to say, “No,” late, we try to identify the underlying cause and fix it if possible.

Given this approach, we’ve found that it helps for founders to keep the following in mind:

  • Meetings are late in our process. Just because we don’t take a meeting early, doesn’t mean we’re not seriously evaluating an opportunity. Scheduling introduces calendar delays and limits the number of startups we can work with at any one time. Luckily, we can collect the vast majority of information we need for a decision without a meeting. When we take a meeting (usually by Zoom), you have already checked off many of our boxes and we have concluded a fit is likely. 
  • We care about the details of your revenues and unit economics. Because revenue is our number one metric, we tend to dig pretty deeply into the details of each revenue stream and its associated economics. We’re essentially trying to build a model of how your business generates gross margin.
  • We care less directly about your vision and team. Other investors will often spend a lot of time trying to assess your vision and entrepreneurial spirit over several meetings. While we do care about vision and team, we are humble about our ability to assess them just by talking to you, so let the early results mostly speak for themselves.
  • The more organized you are, the faster the process will go. However, we are patient. If, for whatever reason, you don’t have everything nicely organized, it usually won’t stop the deal. With a well-defined process, we can hold an investment at any stage while issues get resolved. In fact, we often help companies overcome obstacles during the process. But we would sincerely prefer to complete the process as quickly as possible so founders can start putting our investment to work in their businesses!
  • We care about speed. We want to be fast so you can be fast. First, we want to get you back to the business of building your business. Then, once we’ve invested, we want you to have the resources for faster sales, marketing, and future fundraising.

In general, we see ourselves as less judgemental and more process driven than other investors. The goal is not to holistically assess each company and pronounce it a “good deal” or not. Rather, the goal is to systematically build a large portfolio of companies in a very specific area of the market. Just because a company isn’t in our target area doesn’t mean we don’t think it will succeed.