20th August, 2023
Fair go, mate! 🤑
Two weeks ago I published a long response to the Government’s Startup Council UpStart Nation report.
In case you missed it:
This is now the most viewed post ever on this Substack.
When I publish things like this I’m always interested how many private messages of support I get. Unfortunately, far fewer people are prepared to say they agree in public. I suspect that's part of the reason why I'm still considered "contrarian" and so easily ignored as an outlier.
Thank you to everybody who took the time to get in touch and special thanks to those brave enough to say it out loud.
A surprising number of the comments and questions I got related to employee share option plans (ESOP). I also saw a lot of reckons on this topic published on various social media platforms.
These complaints can be broadly summarised into two groups:
It’s not fair that startup employees have to pay tax on stock options when they are exercised; and
It’s not fair that startup employees have to pay tax on stock options, full stop.
Currently employees pay income tax (39% for most employees) on any gains on options. Meanwhile investors pay capital gains tax (0% for nearly all investors) on any gains on shares.
As I said in my post, referencing some even earlier writing:
There are two ways to close that percentage gap - by reducing the income tax rate that employees pay (as the report suggests) or by increasing the capital gains rate that investors pay (curiously, this isn’t mentioned at all). The smartest solution would be a mixture of those two things.
I thought it would be interesting to go even deeper on ESOP this week.
But first we need to talk about how startups are valued, and specifically the common confusion about the difference between cost and value, because I think this explains nearly all of the angst…
Cost vs Value
People working on and investing in startups spend a lot of time worrying about valuations.
This is rational. The valuation literally defines how much of the company existing shareholders need to give to new investors when raising capital. But there is a lot of confusion about the difference between cost and value.
The cost is how much you have to pay to buy a share.
The value, at any given point in time, is how much you would receive from selling the share.
For liquid shares, like those listed on share markets, this is usually the same amount. You can buy a share today and sell it immediately, if you choose to, for more or less the same price.
For illiquid shares, like a private startup, the reality is quite different. You can buy a share today but it might be years, if ever, before you can sell it at any price. In a practical sense the value immediately after you have paid to buy the share is $0. It may never be worth more than that again, unless things go well.
This causes specific problems for employees who receive options as part of their compensation.
Let’s use some concrete examples to help unpick these questions…
Acme Ltd, <beep beep>
Imagine you are an employee of a startup called Acme Ltd. As a benefit of your employment in this exciting fast-growing company you have received stock options which, as the name suggests, give you the option to purchase 1,000 shares in the company for $5 per share (the “strike” price) at any time, as long as you are employed by the company or for 90 days after you leave.
When you convert that option into shares we say your options have been “exercised”. The most likely trigger for that is you have decided to leave Acme to go and work somewhere else, meaning you have 90 days before the options expire.
Let’s further imagine that today is that day and because of the efforts of yourself and your teammates while you worked there, the current value of a share in Acme has increased to $20. The valuation of an illiquid company like a startup is always subjective - but in this case perhaps that is the price per share paid by the most recent new investor in the company.
When you exercise your options you need to pay the company $5,000 and in return you receive 1,000 shares currently valued at $20,000. That sounds like a good deal. But it’s complicated.
The $15,000 difference between the price you paid for the shares and the current value of the shares is treated as income and, like any other income, you have to pay tax on that amount at your marginal rate (if you’re already in the top tax bracket then that rate would be 39% currently).
To better understand what’s happening here we can break the transaction down into its component parts: Effectively you received a cash bonus payment of $15,000 from Acme, which is taxable, and then immediately used that cash to purchase shares in Acme, handing the money straight back to the company. The good news, if you want a positive spin, is that those shares you just bought are now a capital investment, and so any future gains on those are tax free under current rules.
The problem you have is the extra $11,000 you need to pay for the shares (the $5,000 strike price, plus ~$6,000 of tax). This needs to be paid using real cash, meanwhile the $20,000 “value” of the shares is just a number in a spreadsheet.
Remember the cost is how much you have to pay to buy a share. But the value is how much you would receive from selling the share.
In this example the cost is $20 per share.1 The real value is actually $0, because the shares are illiquid and you can’t sell, so there is no way to realise the “value” of those shares until much later.
To complete our example, let’s fast forward 5 or 10 years and consider two possible outcomes for you now that you are a shareholder:
Acme Ltd becomes a huge success and Mega Corporation offers to acquire the company and pay you $100 per share in cash; or
Acme stops growing, isn’t able to secure more investment to continue to fund the salaries of employees and so is forced to shut down, meaning your shares are worthless.
Those are obviously the two extremes. There are many possible outcomes in between. But they illustrate the width of the range.
In the first case, your shares which cost you a paltry $11,000 are worth $100,000, and there is no further tax to pay. That’s pretty close to the mythical 10x return startup investors often dream of.
In the second case, your shares which cost you a staggering $11,000 are now worth nothing. This is the practical reality for many startup investors.
Are either of those outcomes fair?
The solution that is often proposed (and was proposed again in the UpStart Nation report) is to allow employees to defer the tax payment until the value of the shares is realised.
In our examples above this would mean the ~$6,000 tax payment wouldn’t be due until the shares are sold, and if the shares are never sold would never be due.
I agree that would be preferable. However, it does create some complicated boundary conditions. Does “realised” mean when the shares are sold? Or when there is an opportunity to sell (which is one definition of “liquid”). For example, sometimes you can sell illiquid shares to other investors ahead of an acquisition - e.g. a new venture capital fund investing in the company might offer to mop up smaller shareholders when they invest (this is called “secondary”). Are the shares liquid then? Would that offer trigger the tax payments, even for those shareholders who don’t sell? Likewise, what if the eventual acquisition offer, rather than a clean $100 per share cash payment is a mixture of cash and stock and earn-out bonus payments conditional on other results. What portion is considered liquid in that case? When is tax due on the remainder? How would the shareholders involved and Inland Revenue keep track of all of this?
It might be easier to define what is considered a fresh fruit or vegetable!
And if we’re doing this in the name of fairness, is it fair to other tax payers that you are able to defer your income tax payment but meanwhile enjoy all of the other benefits of ownership, including the tax free capital gains that accumulate?
Buy now, pay later
As I said in my original post, I think this is a straw man argument, because there are better solutions to these issues if the people who set up ESOP schemes actually want to solve them.
It’s important to realise, if Acme Ltd wants to give you options where the tax is deferred until an acquisition this is already possible under the existing tax rules.
For example, rather than $5 per share the company could choose to set the strike price at 1c per share. This would mean you only need to pay $10 rather than $5,000 when you exercise your options.
And rather than having options expire 90 days after you leave, the company could choose to make the expiry far into the future - say 10 years or longer - which means you can simply hold the options until they are liquid, rather than being forced to exercise them when you leave.
A scheme with these settings means you pay a bit more tax, but that tax is only due after you have received the windfall gains from the options.
This is more-or-less exactly the parameters of the options scheme used by Vend, for example. The sale to Lightspeed in 2021 saw many employees exercise their options on the day of the sale. That created a tax liability, but they got the cash from the sale first.
However there are valid reasons why other companies might make different choices.
Some startups might think that the value of an options scheme is to ensure that everybody who contributed over the years gets a small share of the gains, if and when an acquisition happens. So they prefer to set a long expiry on options and make options available to the whole team.
Others might think that the value of an options scheme is to incentivise key employees to stick around and help to grow the company. So they prefer to set a short expiry on options and target options at the most critical team members.
I’m not sure there is an obvious right or wrong answer.
These are all choices companies make when founders and investors set up an options scheme for their employees. And like any choice there is a trade-off.
It doesn’t seem smart to me to have the government mandate one or the other.
Any startup that puts a short expiry on their options is choosing to make tax painful for their employees (most specifically their former employees). I don’t recommend that, but I can understand why some companies make that choice. Messing with tax settings to try and get around this situation doesn’t seem like the solution to me.
The elephant in the room
None of this really closes the gap between investors, who pay cash up-front for their shares and currently pay no tax on any capital gains that result, and employees, who (assuming the options scheme is configured to be employee friendly, as explained above) pay nothing up-front for their shares but pay income tax on any gains that result.
As long as we have a 0% capital gains tax rate, there is no easy solution to this.
Because of the complications with defining when an illiquid stock becomes liquid, as described above, there are even some people who suggest there should be no tax at all on stock options.
I expect most business owners would love to be able to offer their employees tax free benefits like this. The question I like to ask anybody who proposes this sort of special treatment for their own sector is: which other sectors should have to pay more tax to counterbalance that?
It seems a stretch to argue that startups should be able to compensate their employees without that compensation attracting income tax (although some people in the ecosystem do argue this point - perhaps without really thinking about what they are suggesting).
The question then is just when tax should be paid.
If those who promote startups think that this sort of special tax treatment will result in better outcomes for everybody in the country, not just for them as individual investors and employees then I’d love to hear those arguments. Otherwise, it all seems like a very self-serving set of suggestions.
It’s preferable for startups to offer employees stock options on friendly terms that don’t leave them with up-front tax bills before the gains are liquid. But that is already possible and is a choice that startups make when they set up their schemes.
I’m not convinced it is useful to have the government mandate that all ESOP schemes must be employee friendly, as there are valid reasons why some companies might choose different settings.
It would be better if investors and employees all paid the same amount of tax on their respective gains. The obvious way to achieve this is to impose a capital gains tax rather than race to the bottom on income tax.
But I don’t hear many of the people complaining about tax on ESOP advocating for a capital gains tax.
Everybody just wants to pay less tax.
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Maybe it seems like this should be $11 per share, but we need to consider the components of the cost price: $5 per share, paid by the employee; plus $15 per share, paid by the company (which incurs a ~$6 per share tax cost). Tax might be love, but love is complicated!