Almost a decade and a half ago, we had our first child. Around the same time my parents adopted a grandparenting style that echoed the ethos of Silicon Valley entrepreneurs.
[For the record, it was not Facebook's popular guiding principle of Move fast and break things. Between arthritis, artificial joints and gait instability on downsloping surfaces, they only ever developed proficiency in the break things department.]What they had in common with the dotcom innovators was a shared belief: It's better to ask forgiveness than permission. This elasticity when it came to boundaries or barriers served their interests well:
You mean to tell us more than one dessert per meal is not what you meant by "reasonable amount" of sweets?
Our interests, not so much.
Which is why I was so completely engrossed in a recent article from Propublica that described how Peter Thiel accumulated a Roth IRA valued at over $5 billion. (Thanks to physician finance blogger and friend Dr. McFrugal for putting the article on my radar).
Thiel and a couple of his co-founders at Paypal pulled this off by exploiting legal loopholes that took both ingenuity and chutzpah.
They took three simple steps:
Oops, wrong steps. Let's try that again:
- Make a legal contribution to a Roth IRA.
- Undervalue shares of a privately held company and purchase those shares using the funds in the Roth IRA.
- Enjoy the substantially increased value of the Roth IRA when the privately held shares are taken public during an IPO.
What Thiel did, with the assistance of a firm that had a sophisticated understanding of the new retirement account parameters, was to contribute less than the $2000 limit to a Roth.
He then used that contribution to purchase a million founder's shares of the privately held Paypal, valuing each share at 1/10 of a cent. When Paypal had an IPO in 2002, those shares became incredibly valuable.
When ebay purchased Paypal later that same year, those shares exploded in value.
When Thiel heard about a new social media company seeking investors, he made a $500,000 investment in the nascent Facebook, purchasing a 10% stake in the company...all within his Roth IRA.
Obviously there was a great deal of luck, skill and risk involved in placing a bet on what would turn out to be a unicorn investment. The genius of purchasing it within his Roth IRA means that under current law, his profits and the growth of any future investments in the account will remain tax free forever.
Mitt Romney, whose $30 million Roth IRA would come back to haunt him during his presidential run, used similar tactics by purchasing shares of privately held companies in his Roth IRA before they went public.
This is a playbook that, while not exclusively limited to entrepreneurs, would tend to favor those who both understand corporate valuations and have comfort with elastic concepts in valuing privately held companies.
Hence the moniker Trapdoor Roth - a secret entry few are familiar with, and fewer still are in a position to use effectively.
New laws never fail to tempt the clever and outrageous among us.
Or as the grandparents might say, better to ask forgiveness than permission.
Comments 4
I don’t perceive this as “outrageous” or somehow stretching the rules at all. It’s in fact the “feature” of the Roth vehicle. The taxes were paid on the original investment same as with any Roth account.
Author
Outrageous? Brilliant application of existing law? An example of unintended consequences. And since a very select few can purchase an item which they get to value at the time of purchase, there’s an element of unfairness in that particular aspect of the process. The entrepreneur could argue that their company is worth nothing until the time of a sale or IPO, and most would be right. And because Thiel has been so successful (only in retrospect; he could easily have failed or lost to competition at any step of the way), his case is one that highlights extreme success. How envious do we grow of neighbors who hit the megamillions jackpot 4 times in a row?
But the envy strictly belongs to you, because you don’t have the ability to perform and rather than admit your lack you want to indict their luck as if “that’s not fair”. In fact it’s completely fair. The only difference between Roth treatment of that structured deal and non Roth treatment is the way the taxes are handled. The “evaluation” at IPO would be same. Martha Stewart and Zuckerberg issued a different class of shares to themselves than the common stock and became instant billionaires.
Author
It’s certainly possible that there’s an element of that.