(Based on an Office Hours with an Angel)
“The rules of capitalization are so unfair to words in the middle of a sentence.”
– John Green, Paper Towns
“Are you planning to follow a career in Magical Law, Miss Granger?” asked Scrimgeour.
“No, I’m not,” retorted Hermione. “I’m hoping to do some good in the world!”
– J.K. Rowling, Harry Potter and the Deathly Hallows
I never understood exactly what people were talking about when they mention the problems of stock options in Australia and why it’s a big deal. Reading up on it, I still can’t quite get a sound explanation. But we are looking to bring on co-founders and are about to face this head on.
To narrow in on what people are talking about, is the Income Tax Assessment Act of 1997. Specifically, Division 83A which was new legislation approved by parliament on December 2, 2009 . What this change means is that tax must be paid on stock options and shares in the same year they are issued.
This might sound like a small change but the entire upside of stock is that it builds the value of time into the equation. As in for a startup, the difference in salary is amortized into the value of the stock. It’s deferring the benefit until later.
What it means is when you issue stock to someone, The Australian Government taxes it like income as if you’d just given the person X amount of dollars in salary where X is equal to the value of the stock.
This is of course totally ridiculous. Because for a startup, giving a person stock is akin to giving them a lottery ticket – nobody knows if the startup will even succeed, but they are taxed as if they already won the lottery. 90% of startups fail and their stock ends up being worthless anyway. In a lot of cases it is paying cash in taxes for stock that ends up worthless.
So what this did was remove the incentive for choosing stock over a salary as a means of compensation. The reason it affects startups disproportionately is because salaries are rarely present in the early days since the founders choose to give it up and instead use the money to grow the company.
When the founder takes a salary it directly comes out of money that could be used for growth. And they feel safe in the knowledge that a bigger company means their stock is worth more so they’ll make up the difference later when they sell that stock. When you hear on the news about the wealth of founders of a company, what they are usually referring to is the value of the stock they own.
An interesting question is what happens if value of the stock goes down instead of up? You’ve already been taxed at the higher stock price so theoretically you would then get a tax refund. But so often founders don’t realise that and miss out.
To better understand the math behind these two differences is an excerpt from a talk delivered by Charles Munger of Berkshire Hathaway.
“If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum.
In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15%–or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.
Even with a 10% per annum investment, paying a 35% tax at the end gives you 8.3% after taxes as an annual compounded result after 30 years. In contrast, if you pay the 35% each year instead of at the end, your annual result goes down to 6.5%. So you add nearly 2% of after-tax return per annum if you only achieve an average return by historical standards from common stock investments in companies with tiny dividend payout ratios.”
It might seem a bit confusing but basically what it means is you get bulldozed by your income tax bill. And for a startup without any cash, you have to pay tax with money you don’t have, on shares you haven’t sold yet. And if you did sell them, you’d be hit with a capital gains tax again.
Summed up. It’s like paying for the same thing over and over again. This hurts innovation because founders are less likely to start great companies as a result. And the company is less likely to succeed because the founders spend all their money paying taxes instead of growing the company.
For a standard founder vesting agreement of 4 years, it means the founder will be taxed on their stock 4 times while it is being issued and then a 5th time when they cash it in, instead of just once. You start to see why it creates a problem.
It also means that a successful startup is less likely to give stock to employees since the employee will be taxed when they do. So companies circumnavigate giving stock to employees and as a result aggregate wealth drops and the ecosystem is damaged.
Because the early Paypal employees were issued stock along with a salary, when Paypal was acquired it minted an entire syndicate of angel investors who would later go on to invest and produce more startups and thus more big companies ad infinitum.
It’s probably worth understanding why this legislation was introduced in the first place.
It was introduced in 2009 to combat big corporate executives who were using stock options as a means to avoid paying income tax. By deferring a salary and issuing options in big stable companies with little risk, they were able to still receive their salary and bonuses on paper without having to pay the 45% nominal income tax rate, instead only a one off 30% capital gains tax once the stock options were exercised.
This doesn’t even take into account the accumulation. A yearly 45% income tax works out to a lot more over say 10 years than one big 30% capital gains tax right at the end. This was the weapon of choice for unscrupulous corporate executives to avoid their taxes. So the government fought back by changing the law so that any stock options or share issuances get treated like income for tax purposes.
It worked. The unscrupulous corporate executives went back to earning big salaries and paid their taxes as normal. The whip of the Australian government was flexed and it brought corporate Australia into line.
But there’s no such thing as a free lunch and in what can only be described as a Pyrrhic victory, nearly every startup founded in Australia post 2009 has been caught in the crossfire and are collateral damage.
This has led to the widely held proclamation that it has crippled innovation because many, perhaps mistakenly, believe that innovation only comes from startups. What results reminds me of a quote by Jonathan Swift: “Laws are like cobwebs, which may catch small flies, but let wasps and hornets break through.”
One sane suggestion is to include a cap whereby this type of stock treatment should not occur for companies with under 2 million in revenue. But this seems a lot like a band-aid fix. What happens when the company crosses 2 million revenue?
This doesn’t just affect founders but every employee from then on. Some of the most affluent early employees at big tech companies like Google and Facebook joined the company well after the 2 million dollar revenue mark. Even the maseusse was well compensated joining Google early.
So we’ve illustrated the extent of the problem and what it is. Now one might ask how do you get around this?
Since it is an otherwise insurmountable hurdle and a crude warning – not something you want to fuck up. It is the Australian equivalent of forgetting to file an 83(b) tax election form when incorporating in Delaware in the USA and being fucked forever. A tripwire that when crossed means you don’t pass Go, likely ever, and go straight to jail and can’t ever get out and not buy any more properties and just lose.
It’s well understood how awful and destructive the legislation has been so you would assume it is just a matter of time until it is repealed or new legislation is proposed to remedy the situation. In which case startups may have to resort to one of a half dozen workarounds.
You can incorporate elsewhere, in the US for example, usually as a C corporation. This is what a lot of Australian companies do, usually in one state, Delaware which is lenient towards young corporations. Indeed some up and coming accelerators even encourage this. But it means when those startups become big companies, they will be paying taxes in the US and will probably end up moving there too because that’s where their company is. When that happens there’s no real incentive to come back.
Or maybe set up an Employee Share Options Scheme in such a way where the company gives an employee a bonus which they then use to purchase the stock options at market rate thus it is not considered as compensation. I don’t really understand how this works but they are typically expensive to create and implement.
The most technically complex method which might appeal to many engineers and finance types is instead of issuing stock directly, to issue stock options. Then to decide the strike price of the options using an algorithm such as the Black-Sholes Formula. A wise angel investor suggested it since it means delaying the exercising of it.
A strike price and stock price are not the same thing. The stock price is the current value of shares. The strike price is the future value of a stock option which converts to stock when exercised. One supercedes the other. There is a huge difference between owning stock and owning a stock option. One is owning it now, the other is having the option to own it at some price in the future.
Normally when pricing a stock option you are “In The Money” on an asset. To figure out what this means, we’ll go to Investopedia.
You are “In The Money” if 1) for a call option, when the option’s strike price is below the market price of the underlying asset or 2) for a put option, when the strike price is above the market price of the underlying asset. When you are “In The Money” it means an option is worth exercising and you will profit if you do. This is because the stock price is justified by the value of the company.
So for this method to work, you have to intentionally make your option not worth exercising. What this entails is intentionally going “Out Of The Money.” To figure out what this means, we’ll go back to our old friend Investopedia.
You are “Out Of The Money” if 1) for a call option, when the strike price is higher than the market price of the underlying asset, or 2) for a put option, when the strike price is lower than the market price of the underlying asset. When you are “Out Of The Money” it means an option is not worth exercising so you will not make any profit.
An “Out of the Money” option has no intrinsic value since the strike price of the stock option is out of sync with the value of the underlying asset which is the company. It’s why when you are “Out Of The Money” your options are effectively worthless at present moment but can change based on time. So you build the time which it will take to divest the shares into the strike price.
So to do this in a startup context is when you set the strike price of the stock above the valuation of your company. It is based on the assumption that by overvaluing the stock options at the beginning, the value created by the company over time will meet up with this valuation.
The financial way of saying this is that the strike price of the option will erode in proportion to the growth of the company and they will meet in equilibrium. When this happens the value of the company has reached the strike price and it becomes “In The Money” so you exercise the stock option.
The reason you don’t get taxed on it is because you can’t. While you are “Out Of The Money” your stock is explicitly worthless. It would be beyond unreasonable for the government to tax you on worthless stock. But built into this worthless stock is time. Over time, the worthless stock becomes worth something once it becomes “In The Money” and the value is conferred. When that happens, that is when you get taxed.
But here’s the catch. You have to look everyone in the eye and say the stock is worth X more than the valuation of the company at the present point in time. And it ends up being a sort of high speed game of chicken whereby if you don’t exercise the option before it expires the stock ends up being worthless.
The astute might point out that if you did this you wouldn’t participate on the capital gain of the company going from the lower valuation to the higher one. So why not just issue the stock immediately and get taxed on it. This is not entirely correct because you are participating but the participation is already built into the strike price because it is already set much higher than the current valuation. What you are saying is that the stock will be worth much more later than it is now therefore we’ll just issue the strike price at the later value.
This also avoids both being taxed at the issuance and again on any capital gains on it. Plus you can get a discount for owning the asset for longer than a year.
It’s basically intentionally overvaluing the company and is more common than someone might think which sounds sinister but is actually completely innocent. This is because so much of the value of an early stage startup’s stock is defined by what other investors are willing to pay for it. Because the stock price meets in the middle of what the founder thinks the stock is worth and what the investor thinks it is worth, you end up nearly always overvaluing a company.
How else might you value the stock of a company with no assets, no revenue and no product but just a few 28 year olds with laptops? Frequently these end up being the next Twitters. Indeed Twitter, Facebook, Pinterest, Instagram, Whatsapp, Snapchat were all precisely this but it doesn’t make them any less valuable as companies. If you invested in Twitter at the beginning and you didn’t overvalue the stock, you would own the entire company because they had no assets.
There is a corollary to this esoteric to the tech world. When a company has no assets, how might you price the value of it? This is the equivalent of asking how you would price the value of an idea and the execution of the idea. It’s an interesting thought experiment. Moving on.
A method that is highly recommended is to incorporate earlier. To incorporate now even when you don’t really know what the company does with a generic company name. By incorporating early the startup has a low valuation so the value of the stock is not enough to trigger tax implications when issued. You can then operate this company indefinitely without being hit with tax liabilities until you sell the company. This method is best used by companies that intend to bootstrap.
It is perhaps the simplest and most effective method but comes with signalling problems because on paper the company has existed for much longer than the founders have been working on it. The company may not even have the same name as what the brand eventually ends up being. Famous examples of this are Freshbooks which was originally incorporated as 2nd Site.
When we incorporated the Simple Technology Corporation, we hadn’t done anything yet and issued shares representing the total valuation of the company to be only $10k dollars. Granted, I was also the only shareholder so it was easier to negotiate.
Now if you need to raise money and issue stock to employees, you’ll have to wait to do this all in one go. Basically, you refrain from issuing shares altogether but keep everything in contract form. So there is a contract with each employee saying they are entitled to a certain amount of shares. But you don’t actually issue any shares yet. You rack up as many of these share issuances via contract as you need to. It’s important to always include a clause that if the company is to be acquired, all shares are issued immediately.
You then negotiate with the investors and come to a term sheet for the financing. You then incorporate a new company and begin trading as that one. Usually, if you raise an institutional round of funding, they will make you reincorporate the company anyway to make sure nothing has gone wrong with the paperwork.
Just at incorporation, you fulfill all of the contracts and issue shares to everyone in the new company. No tax liabilities are triggered because this is a brand new company with a low market cap. You then issue the investors shares last, which they’ve bought with their investment. This raises the price of all of the shares. You are now a new company and proceed with business as normal.
Another method is by using an augmented Employee Stock Options Program. Where a company can vest the shares but hold them in a trust. The trust is specifically written to match the dates of the vesting agreement. Then once the agreed vesting date has been reached, the shares are released from the trust and the employee gets hit once with a capital gains tax. The founder or employee doesn’t actually own the shares yet, the trust does and they are a beneficiary of the trust until the date they are released.
But then you face the additional costs and complexity of managing and running the trust and having this program drawn up and executed in a way that is fair and equal for everyone. Some companies create very large trusts of which all of their employees are beneficiaries in certain ratios representing their would be stock ownership.
The method I think is the most creative that I’ve heard is by creating two companies with a forced acquisition agreement and a heavy discount. So one company acts as the conduit for the other. The founders own shares in the small company which doesn’t appreciate at all. They also issue new employees stock in this company which are effectively worthless since the company has no valuation.
Now the other company, the larger one owns all of the IP, assets and userbase thus it does appreciate. This company only has a small amount of shares issued to one shareholder. Now when the bigger company gets to a size a liquidity event can occur. Just prior to this event, the forced acquisition agreement triggers and the larger company with the huge valuation must then acquire the smaller one and all of the shares transfer over. Because of the huge discount the shares transfer over in the same rate and the single shareholder gets diluted to all hell. It can be done with a simple contract and seems like the corporate equivalent of a sleight of hand magic trick.
A method I don’t personally like but is effective, is you incorporate two companies and create a trust. One company contains all of the shareholders and shares can be issued safely in this one without triggering tax liabilities. The other company contains the business, assets and IP. The second company then issues all of its stock to a trust. The trust is managed by the first company which contains all of the shareholders.
If the business is acquired, all of the money flows into the trust and the windfall is distributed to all of the shareholders based on how many shares they own. So the second company is sold, all the money goes into the trust. The trust is managed by the first company which pays out the trust to all of their shareholders. A variation of this is done where instead of having a company as the trustee of the trust, you just have an individual.
A modicum of goodwill is needed to do this that all parties aren’t going to turn around and screw each other. And nothing makes people want to screw each other more than a lot of money. Because nothing enforces the trustee to distribute the profits of the trust. They can just change their mind and keep it all themselves. It’s very common. Families turn on each other. Parents end up suing their children. A husband makes his wife the trustee and she runs off with the gardener.
In fact one of the most famous Australian examples is with the Rinehart family trust. The children are suing the mother who is the trustee. The trust says it is meant to be given to them. But the trustee changed her mind and kept it all.
Whichever path is chosen, it is unnecessarily complicated. You end up in the same bizarre situation – having to deal with a problem that really shouldn’t even be a problem. It almost becomes comical the lengths founders have to go to avoid the red tape. One wonders and is left stunned how it even got to this point. It was likely just a mistake at the Governmental level.
I think nearly every investor and entrepreneur seems to have found their own way around it. And there is promising legislation to remove it entirely. I think since almost unanimously the industry has said it is a bad thing speaks volumes. It doesn’t occur often where nearly an entire industry is in agreement on something.
As a founder, you’re left just wanting to get on with running a company, and to be able to get the best people possible to build the best company you can, in the way you want to.
Im told this essay was actually used in a report to treasury and referenced heavily by and read by a lot of Government ministers when starting a review of the policy. Apparently it captured a perspective that many people wanted but few had actually written.
That of simplified unbiased unjudgemental fact devoid of hysteria. It’s as laymen an explanation of the problem and how people are going about solving the problem as anyone has been able to find, for people who themselves don’t understand the problem but are in charge of legislating to fix it.
These same government ministers, who didn’t really understand what the problem was, have implemented a number of changes to the policy which are either in the process of or have already entered into legislation.
So, this essay actually helped change the law. And whoever said blogs couldn’t be influential?