Prepaid Variable Forward (PVF)

A Prepaid Variable Forward (PVF) is a financial contract that helps large shareholders monetize stock holdings, hedge risk, and defer capital gains taxes, all while maintaining some exposure to potential stock appreciation.

This instrument combines elements of forward contracts, options, and equity collars.

Though complex, PVFs are favored by company founders, executives, and high-net-worth individuals managing concentrated equity positions.

Key Takeaways – Prepaid Variable Forward (PVF)

• PVFs let shareholders monetize large stock holdings, hedge downside, and defer capital gains taxes while retaining some upside.
• The investor receives 75-90% of current value upfront, pledging shares for future variable delivery.
• Final shares delivered depend on stock price relative to a floor (downside protection) and cap (upside limited) at settlement.
• Tax is usually deferred until settlement, avoiding immediate recognition if structured properly.
• PVFs support diversification, liquidity, and estate planning, with optional cash settlement and voting rights retained.
• Risks include capped upside, counterparty default, regulatory scrutiny, and high legal/structuring costs.
• Used by founders, executives, and high-net-worth individuals for concentrated equity positions.

What Is a Prepaid Variable Forward?

A PVF is an agreement where a shareholder receives a substantial upfront cash payment by pledging shares of stock to a financial institution (usually an investment bank).

In return, the shareholder commits to deliver a variable number of shares, or their cash equivalent, at a predetermined future date.

The number of shares ultimately delivered depends on the stock’s market price relative to preset floor and cap levels at settlement.

Core Mechanics and Structure

The Initial Transaction

The shareholder and financial institution agree on:

• The number of shares pledged
  
• The contract duration (usually 2-5 years)
  
• The floor price (minimum value protected)
  
• The cap price (maximum value for upside participation)
  
• The upfront cash payment percentage (typically 75%-90% of current market value)
  

The upfront payment is not considered a taxable sale if the PVF is structured correctly, due to the variable delivery feature and continued voting rights.

Variable Delivery Mechanism

• Below Floor – The investor delivers the full, original number of shares.
  
• Between Floor and Cap – The investor delivers a proportional number of shares, calculated so the bank receives a value matching the initial payment.
  
• Above Cap – The investor delivers the minimum number of shares defined in the contract, retaining any appreciation above the cap.
  

Cash Settlement Option

Many PVFs allow cash settlement rather than physical share delivery.

This offers flexibility, especially if the investor wishes to retain full ownership for voting or governance reasons.

Tax, Estate, and Wealth Planning Angles

Capital Gains Deferral

PVFs are valued for their ability to delay taxable events.

The IRS typically doesn’t treat the upfront payment as a taxable sale, provided variable delivery and voting rights are retained.

This allows capital gains tax to be deferred until contract maturity, potentially several years in the future.

Avoiding Constructive Sale

US tax code (IRC Section 1259) penalizes “constructive sales,” which lock in gain without transferring stock.

PVFs avoid this by allowing variable delivery and not fixing the number of shares in advance, thus preserving the tax deferral benefit.

Estate Planning Considerations

If the contract holder passes away before settlement, heirs may receive a step-up in cost basis for the pledged shares.

This can dramatically reduce capital gains tax, making PVFs a valuable estate planning instrument.

Strategic Benefits and Practical Uses

Diversification With Tax Efficiency

Executives and entrepreneurs often have most of their wealth tied up in company stock/business equity.

PVFs let them access liquidity to diversify, invest in other assets, or fund major purchases without triggering immediate capital gains tax.

Downside Protection

The floor price functions like a built-in put option.

It protects the investor from the full downside if the stock drops dramatically, providing a safety net while still allowing for some appreciation.

Retention of Voting Rights

Since shares are pledged, not sold, the investor often retains voting rights until settlement.

This can be important for those wishing to maintain influence in the company.

Financing and Flexibility

The upfront payment can be used for any purpose: portfolio diversification, purchasing real estate, paying off debts, or seeding new ventures.

Because the transaction isn’t an outright sale, it often attracts less market attention.

Risks and Considerations

Capped Upside

The contract’s cap price limits the investor’s participation in future stock gains.

If the stock price soars far above the cap, most of that extra gain goes to the financial institution.

Counterparty Risk

PVFs are private, over-the-counter agreements.

If the financial institution defaults, the investor may struggle to recover pledged shares or their equivalent value.

Regulatory and Tax Complexity

Regulatory scrutiny is increasing, and IRS interpretations can change.

Proper legal and tax structuring are key.

Mistakes can result in the upfront payment being deemed a taxable sale or constructive sale.

High Transaction Costs

PVFs can be expensive to set up, with substantial legal, financial advisory, and implicit financing costs (reflected in the discount to current market value).

Numerical Example: PVF in Practice

Let’s work through a realistic example to show how a PVF contract functions from start to finish.

Scenario

• Shareholder: Tech founder holds 100,000 shares of Company X, trading at $60/share ($6,000,000 total).
  
• Needs: Wants liquidity for diversification and real estate, but wants to avoid selling outright and triggering $3 million in capital gains.
  
• PVF Structure:
  
  • Term: 3 years
    
  • Floor price: $50/share
    
  • Cap price: $75/share
    
  • Upfront payment: 85% of current value ($5,100,000)
    
  • Variable delivery: Shares to be delivered depends on Company X’s price at settlement.
    

At Settlement: 3 Potential Outcomes

1. Stock Price Falls Below Floor: $45/share

• The stock has dropped to $45/share.
  
• Shareholder delivers the maximum: 100,000 shares.
  
• Value delivered: 100,000 × $45 = $4,500,000.
  
• The shareholder already received $5,100,000 upfront, well above the value of the shares now. The “put” protection feature of the floor price creates a net gain over a simple sale at the bottom.
  
• Taxation: Capital gain recognized now on the difference between original cost basis and settlement value.
  

2. Stock Price Lands Between Floor and Cap: $65/share

• Stock finishes at $65/share.
  
• Formula for shares delivered: Upfront payment / settlement price = 5,100,000 / 65 ≈ 78,462 shares (rounded per contract terms).
  
• Shareholder delivers 78,462 shares (keeping the rest).
  
• Shares kept: 100,000 – 78,462 = 21,538 shares (worth $1,400,000).
  
• The shareholder monetized most of the position up front, participated in moderate upside, and now owns fewer but more valuable shares.
  
• Taxation: Gain recognized at settlement, potentially optimized due to spread over time.
  

3. Stock Price Rises Above Cap: $80/share

• Stock closes at $80/share.
  
• Minimum delivery: Contract may set this at 63,750 shares (cap = $75/share; 5,100,000 / 80 ≈ 63,750).
  
• Shareholder delivers only 63,750 shares (keeps 36,250).
  
• Shares retained: 100,000 – 63,750 = 36,250 shares (worth $2,900,000).
  
• Even though upside is capped at $75/share, the investor may keep more shares or cash, depending on contract terms. Appreciation above the cap isn’t fully captured, but the contract may allow some limited participation beyond the cap (if structured that way).
  
• Taxation: Gain recognized on shares delivered; the rest are still held or can be sold as desired.
  

Cash Settlement Option

If the contract allows, instead of delivering shares, the shareholder can pay the cash equivalent – helpful if they prefer to maintain their holding, or if market conditions have changed.

Trends and Market Evolution

• Broader Use – Originally the province of C-suite insiders, PVFs are now common among family offices and high-net-worth individuals with large, illiquid stock positions.
  
• Customization – Banks offer structures with multiple observation dates, knock-in/knock-out clauses, and add-ons using options or swaps.
  
• Regulatory Oversight – SEC filings (Form 4 for insiders) and clear disclosures are required. Ongoing tax law changes mean expert guidance is a must.
  

Conclusion

Prepaid Variable Forwards are among the most nuanced instruments for sophisticated wealth management.

They offer an elegant way to access cash, defer taxes, reduce concentration risk, and retain partial upside, while introducing a new set of costs and risks that demand careful planning.

When used appropriately, with sound legal and financial advice, PVFs can help investors solve the perennial challenge of managing large single-stock exposures in a tax-optimized and flexible way.