QSBS Due Diligence: What VCs and Acquirers Actually Check

Qualified Small Business Stock (QSBS) is a key benefit for both individuals and startups. For individuals, it can potentially exclude up to 100 percent of capital gains from federal tax. From a startup’s perspective, QSBS eligibility makes stock more appealing to investors and can encourage them to provide funding for growth.

Given this, you shouldn’t be surprised to learn that investors will be doing their homework during the due diligence process to ensure that QSBS qualifications are met. In fact, this has become a standard due diligence item for venture capitalists and acquirers, and a failure to provide thorough documentation proving QSBS status could reduce purchase prices or kill deals entirely. This underscores the importance of having a tax planning strategy in place or working with a financial professional who can ensure your startup stays compliant.

Why QSBS Verification Matters in Fundraising and Acquisitions

QSBS status offers significant tax advantages that increase a startup’s investment appeal and can significantly improve after-tax returns in a future sale. The biggest draw for investors is the federal tax exclusion on capital gains from the sale of qualifying stock. For eligible QSBS, investors can exclude gains up to $15 million for stock issued after July 4, 2025, or 10 times the original investment.

Acquirers care about QSBS status because it influences deal structure and attractiveness, ensuring a more tax-efficient exit for founders and investors and more favorable deal structures that reflect the company’s financial health and financial projections.

The QSBS Documentation Package Investors Expect

Investors are regularly including this in their due diligence process to ensure QSBS status. They expect to see a thorough documentation package that can help them verify it. A complete QSBS documentation package includes company-level and shareholder-level records, which help verify:

• Proof of C-corporation status, which may include articles of incorporation, corporate bylaws and any board resolutions approving the stock issuance.
• Gross asset test documentation, which may include annual financial statements and balance sheets, and tax basis records for assets.
• Active business requirement records, such as records of business activity and records confirming the business is not among the excluded categories.
• Shareholder-level documents, such as subscription or purchase documents, evidence of original issuance, holding period records and QSBS attestation letters.

QSBS Attestation Letters: The Gold Standard

QSBS attestation letters are formal documents that confirm a startup’s stock meets the eligibility requirements for QSBS status per Section 1202 of the Internal Revenue Code. They were once considered optional, as they are not a legal requirement for claiming tax benefits. However, they’re becoming increasingly popular as a critical documentation piece to prove QSBS status in the event of an IRS audit and for due diligence during a liquidity event.

More specifically, QSBS letters confirm corporate status, gross assets, active business requirements and original stock insurance shareholder documentation including taxpayer’s holding period evidence. Beyond IRS audit support and for due diligence during a liquidity event, they’re also important to attracting investors looking for tax-efficient investments and for streamlining tax preparation for venture capital firms and their portfolio companies.

QSBS attestation letters can’t just be issued by anyone. They’re typically provided by financial services firms or tax professionals.

What Investors Verify About Your Corporate Structure

There are several startup-level requirements that investors will likely scrutinize during QSBS diligence. These include:

• Domestic C-corporation status: Your startup must be a C-corporation at the time that stock is issued.
• Qualified business: Your startup must also qualify. Disqualified categories include professional services, financial or brokerage services, farming, hospitality, and mining or extraction.
• Gross asset test: Investors will verify that your startup did not exceed the maximum aggregate gross assets immediately before or after any stock issuance. For stock issued before July 4, 2025, the limit is $50 million. For stock issued on or after July 4, 2025, the limit is $75 million and will be adjusted for inflation after 2026.

Investors will also look at equity issuance history and ongoing compliance throughout due diligence.

The $50M Gross Assets Test: What Gets Scrutinized

The $50 million gross assets test is the biggest QSBS disqualification trigger.

Investors will look to verify that your startup did not exceed $50 million in aggregate gross assets immediately before or after any stock issuance for stock issued before July 4, 2025. To do so, they’ll likely request balance sheets before each equity financing round to verify that assets were under the threshold. Keep in mind that gross assets involve cash, property and FMV of all assets, not just deployed capital or book value and will be benchmarked to fair market value including intangible assets such as intellectual property licenses.

They’ll also look at timing to verify that stock issuance occurred when assets were below the limit (even if your startup later exceeded the limit).

Verifying the 80% Active Business Requirement

One requirement for QSBS eligibility is meeting the ongoing business test throughout the holding periods. To qualify, a startup must have at least 80 percent of its assets used in the active conduct of one or more qualified businesses during the shareholder’s holding period. Qualifying activities include research and development, commercial activities and more. Assets that are held for reasonably required working capital can be treated as active. So can assets held for investment that are expected to be used within two years to finance research and development or other working capital needs as documented in your business plan and financial projections.

Investors will also look to make sure that real estate, passive investments and non-qualifying assets don’t exceed the 20 percent threshold.

Stock Issuance Verification and Redemption History

Investors also check stock issuance verification and redemption history. These help identify risks and evaluate a startup’s overall financial health and how the management team governs capitalization decisions.

Key investor checks on share issuance are done by analyzing the startup’s cap table to understand how past share issuance impacted ownership and to determine if the new investment will result in dilution. They assess total shares outstanding, valuation history, past investors and the option pool.

Investors will also look for disqualifying redemptions. For instance, if a startup buys back its own stock, it may nullify QSBS tax exemptions. They’ll also look to assess significant redemption, which are those done in a two-year window (one year before and the other after stock issuance) and involve buying back stock with a value exceeding 5 percent of the aggregate value of the startup’s total stock.

Red Flags That Kill Deals or Reduce Valuations

QSBS eligibility can be complicated to understand. Noting this, it shouldn’t surprise you that various mistakes can kill deals or force more combative price renegotiation. Some of the common red flags that kill deals include:

• Lack of proper documentation: If your startup lacks attestation letters, has incomplete cap tables or is missing asset schedules from funding dates, that could be a big problem.
• Discovered disqualification: Several things can revoke QSBS eligibility. Perhaps the most common is your startup exceeding $50 million gross assets at issuance, but never disclosing this to stakeholders.
• Unclear qualifications: Gray area industries or the accumulation of passive assets can derail deals, especially in tightly regulated sectors subject to industry specific regulations.

Acquisition-Specific QSBS Diligence

If QSBS preservation impacts deal structure, additional verifications may be necessary. This due diligence may include planning stock-for-stock deals to verify their own QSBS status to preserve shareholder benefits. Investors will also assess transaction structure analysis and whether a reorganization qualifies under Section 1202 for QSBS rollover. Finally, investors may also analyze state tax analysis in non-conforming states to see how it impacts deal economics.

Multi-State Considerations in QSBS Diligence

Multi-state operations introduce various complexities for QSBS verification. Specifically, verification involves satisfying federal and individual state rules, which may not conform to each other. Therefore, it is important to document compliance with the active business requirement and navigate divergent state tax treatments. States such as California, Alabama, Pennsylvania and Mississippi, for instance, do not recognize the federal QSBS tax benefit.

Investors will also assess state tax impact based on their own residency and verify that interstate operations don’t threaten the 80 percent active business test.

How to Prepare for QSBS Due Diligence

So what’s the best way your startup can prepare for investor or acquirer QSBS verification during due diligence?

• Attain annual QSBS attestation letters before fundraising or the sales process. While not required, they strengthen your case by providing key documentation.
• Organize chronological asset schedules that show compliance at each historical issuance date.
• Prepare a written analysis explaining any gray areas or close calls on qualification. This helps explain things that could otherwise be perceived negatively.

Your Fractional CFO’s Role in QSBS Diligence Preparation

A good Fractional CFO partner can help your startup prepare for QSBS verification by maintaining documentation that passes investor scrutiny, coordinating with legal to acquire QSBS attestations annually, and preparing and organizing your asset schedules, cap tables and other key compliance documentation.

A good Fractional CFO will also help prepare your startup for investor presentations, enabling you to strive for more successful fundraising rounds with clear financial projections that reflect the competitive landscape.

Don’t Let QSBS Documentation Gaps Derail Your Next Round

Worried that QSBS documentation gaps will sink fundraising rounds? Contact Graphite and work with a Fractional CFO today to set yourself up for fundraising success. A good Fractional CFO knows how to manage key QSBS documentation to pass investor scrutiny as part of the due diligence process. Contact us today for more information and to get started.

FAQs

What QSBS documentation do VCs typically request during due diligence?

VCs typically focus on verifying your startup’s C-corporation status. They also assess its gross asset history and overall business operations. Noting this, they’ll tend to want to see articles of incorporation, stock purchase agreements and subscription documents, cap tables and stock ledgers, financial statements, gross assets test documentation, subsidiary financials and debt instruments, among others.

How do investors verify compliance with the $50M gross assets test?

Verifying compliance is primarily done by assessing financial documents and formal attestations from the startup. The investor bears the burden of proof, making the due diligence process all the more important.

What happens if QSBS qualification cannot be verified during diligence?

If investors cannot verify QSBS qualification during due diligence, they can’t rely on the tax benefits that come with it. This can create a serious tax risk for both parties during any future transaction and give the investor pause in proceeding with the investment. If an investor is unable to verify QSBS qualification during the due diligence period, it often reflects poorly on your startup’s record-keeping.

Do acquirers care about QSBS status in acquisitions?

Yes, they care a great deal about QSBS status, largely thanks to the tax exclusion that sellers are privy to. QSBS status can significantly impact the deal structure, negotiation process and the after-tax proceeds for selling shareholders.

When should we obtain QSBS attestation letters?

QSBS attestation letters should be obtained annually or during significant financial events (e.g., fundraising, a merger or acquisition, when needed by investors or auditors, etc.). It’s also a good idea to obtain these letters before exercising any stock options. Attestation letters aren’t legally required to claim the tax benefit, but they represent key documentation to prove QSBS eligibility.

How far back do investors review QSBS compliance during diligence?

Investors typically want to see QSBS compliance from a startup’s incorporation date through the present day. This helps them confirm that all requirements for the tax benefits have been met. Diligence is most important and most intense around events such as funding rounds, stock issuance and acquisitions.