Occasionally the sponsor will buy back the technology in cash. the payout to the partners in after-tax dollars is often calculated on the basis of a 50% return compounded annually. In many cases, Section 1235 of the Revenue Code -- a special provision that applies primarily to R&D partnerships -- can be utilized. This section allows the inventor (i.e., the partnership) to get long-term capital gain treatment on the sale of a patentable invention even if the inventor has held it for as short a time as one day and no patent has been applied for. Typically a patent attorney will furnish an opinion that the device is patentable before the project is undertaken.
But if such heady rewards seem out of line with usual returns, John J. Hentrich, a Los Angeles attorney whose firm, Riordan, Caps, Carbone & McKinzie, has been actively putting together both sides of R&D deals, points out that "the partnership is assuming the risk that the purchase option won't be exercised." And even if a sponsor pays out in equity, it still can be mutually advantageous. Says Peter F. Zinsli, vice-president of private Rexon Business Machines Corp. of Culver City, Calif., which recently closed a $1-million R&D deal to finance the development of an expandable business computer: "We would continue with our development program even if we hadn't funded it with an R&D partnership. The value of the R&D deal comes when we can finance at a lower price than we could with venture capital. We think we've done that. We're offering to sell [the partnership] stock at a fixed price that is beneficial to us. We hold the cash without interest for two years, and stock dilution is two years out as well."
But an eventual dollar-convertible buy-out such as Rexon's is not necessarily the goal of all successful R&D projects. Partnership tacticians are now taking advantage of Revenue Code Section 351, by which the taxable event of the buy-back can be postponed. Section 351 provides for a reorganization under which it is possible for the partnership to incorporate itself. "If properly structured, the partners may not be obliged to recognize the gain until they ultimately sell the stock of the sponsor company," advises attorney Hentrich.
At least one venture capital concern, Crosspoint Financial Corp. of Palo Alto, Calif., is pushing this situation to a logical conclusion by using it to found a business from scratch complete with top management and marketing experts. Last year Crosspoint forged what its president, John Mumford, claims to be the first financing of a prenatal-stage business that melded a partnership with straight venture capital. In September 1981, a $125,000 partnership was devised specifically to develop a digital voice data switch for the telecommunications industry. The partners were high-level executives and engineers who had been wooed into the formative dealings by the promise of shares in the business once it was set up. Within nine months, the $125,000 had been absorbed in defining the product.
At that juncture, partnership shares were converted into corporate shares and the key employees had their corporation. To fund the development of the product line, Crosspoint arranged a second R&D partnership together with ordinary venture capital. The amounts this time were considerably heftier: $3.5 million came from the partners, and another $1.5 million in working capital from venture investors. The infant Irvine, Calif., corporation was named CXC. Within its first quarter of existence it was employing 50 people -- solid testimony to the efficacy of Tax Code Section 174 as broadened by the Snow decision.
The partner-venture capitalist combination, which many underwriters see as the new wave in R&D deals, gives venture capitalists, Mumford explains, "tremendous leverage provided by Uncle Sam." Otherwise, venture capital would shy away from so unformed a situation. And the corporate owners are left with a substantially greater proportion of stock -- up to 2 1/2 times as much, according to Mumford -- than if a typical venture capital deal had been struck. Furthermore, as a raw start-up device, some CPAs consider an R&D partnership to be a more effective tax set-up than Subchapter S. In a Sub S, tax advantages are proportioned to shareholdings. If, for example, only half the shareholders put up all the capital, they will be able to deduct only their half of the losses.
When it comes to selling the R&D deals to investors, most legitimate partnership creators do not view the technique as a tax shelter so much as a business investment structure that happens to use before-tax dollars.Thus, they tend not to leverage the deals. One CPA -- Nicholas G. Moore, a Coopers & Lybrand managing partner who co-authored the definitive paper on the subject -- says, "The only thing I'm worried about is charlatans in the marketplace. There are some bad deals coming out, particularly in highly leveraged packages. I'd be in favor of eliminating the ability to leverage altogether." And the brief history of R&D limited partnerships already shows that the IRS is looking very closely at leveraged arrangements.
Like any specialized financing evolving from the complex meshing of disparate tax and investment provisions, research and development vehicles will require a number of years before all their ramifications -- positive or negative -- become clear. Right now, they seem mostly good. Extols Ronald Moskowitz, president of Ferrofluidics Corp. of Nashua, N.H., which recently has been investigating partnership financing of new products based on magnetic fluid and crystal-growing technologies, "We considered a variety of sources. My feeling is you match different sources of capital with different purposes. We had several exciting projects in basic technology and development, and the R&D partnership seemed like a super concept. If oil and gas can do it, why not research and development? It's a terrific opportunity because it allows us to expand early without pushing us into a possible loss."
