The taxation of employee share schemes explained

Building a technology company isn’t easy; a huge range of specialist skill sets are needed – software developers, data scientists, designers, product managers and engineers to name a few.

However in the Western world we have a crisis in education with declining enrolments in science, technology, engineering, and mathematics (or STEM for short). This is remarkable given we are in one of the greatest economic gold rushes of all time, thanks to the internet and software eating the world.

So startups and technology companies everywhere are scrambling for talent and they increasingly need to offer a variety of incentives to attract and retain that talent; the most powerful of those incentives is giving employees the chance to earn a part of the company and become owners themselves.

To understand how this works let’s step back and consider how shares are divided up in a company from the very beginning.

Companies are started by founders, who are the people who originally come up with a great idea to start a business. Typically, this group numbers somewhere between two and four people. Even though one person might originally come up with that idea, they will still need a founding team around them with complementary skill sets to turn this idea into a real company. Two people in a founding team is ideal. Greater than four people founding a company starts to become unwieldy in figuring out who is in charge. So founding teams will usually be between two and four.

The founders are the people who take all the risk in a venture, they are the people that put everything on the line. They quit their jobs, work for no pay, and have to risk being thought of as a fool. In fact, the bigger the potential opportunity, the bigger the fool you can look as a founder, because the biggest potential ideas are ones that no one has thought of yet, that go against the prevailing wisdom.

The vast majority of startups will fail miserably, and these founding teams might spend years with no income toiling away for no result. But if the idea works out and becomes a huge success, they receive the lion’s share of the reward. They took the biggest risk, and therefore they share the biggest reward.

So let’s say we have a startup with four founders: Alice, Bob, Carol and Dave. If we look at the equity pie, the easiest way to start a business is to divide all the shares equally between the four founders, so they each get 25%.

Vesting

A huge number of complications can occur in early stage businesses. Alice might lose interest in the business and quit after only a few weeks, Bob and Carol might have a fight and one of them walks out, or Dave might not pull his weight and the three others might want to replace him. Well if you just gave the shares out without some sort of agreement to deal with these situations then you might have someone who leaves after a few weeks, doesn’t put any effort in, who still keeps their 25% years down the track. That wouldn’t be fair on the others, so startups usually put in place an agreement between each other to deal with what happens when something goes wrong. This agreement is called a vesting agreement, and it is designed to deal with all the tricky situations startups get themselves into when something goes wrong. And believe me, with early stage companies a lot of things can go wrong.

A typical Silicon Valley-style vesting agreement lasts for four years with what is called a one-year cliff. Under a vesting agreement, instead of automatically being granted all your shares where you can do whatever you like with them straight away, a vesting agreement instead restricts your shares so you are granted them over time, in this case over four years. At time zero, all the shares are unvested, and nobody can do anything with them if they leave the company.

With a four-year vesting agreement with a one-year cliff, nothing happens for a year. This is what they call the cliff. If you leave the company before a year, you get nothing. This is fair because if you are meaningfully going to contribute to a company you should be at the company for at least a year. If for some reason you quit or are asked to leave, the company can still continue without an unworkable share structure where all the people left working hard are resentful that a large shareholding is owned by someone who isn’t doing any work.

On the anniversary of the original grant date, 25% of the shares will vest. At this point you own them and can do whatever you want with them, even if you leave the company for whatever reason – the shares have been earned. After the first year, vesting typically proceeds, so that every month 1/36th of the remaining unvested stock vests. So after two years, 50% of your stock will have vested; three years, 75%; and after four years, your stock is fully vested.

Vesting is not just a good idea; it solves a whole bunch of messy problems for when things go wrong. And believe me, a lot of things go wrong in startups! So if you’re going to start a company, it’s really important you put a vesting agreement in place.

So let’s look at what happens to the capital structure when investors start to come in. Let’s say along the way our startup finds an early stage angel investor who is willing to invest $500,000 for 20% of the company. This means he thinks the company is worth $2.5m after he invests, because his $500k is worth 20%. We call this the post-money valuation of the company, because it is the valuation after the money is invested.

The pre-money valuation of the company is the valuation before the money goes in. Since $500k was invested this means that the pre-money valuation of the business was $2 million. Everyone, all four of the founders and the new investor in the company, now owns 20%.

Taxation

At this stage our company probably wants to start hiring its first employees. It finally has some money in the bank and can afford to pay some salaries, but it’s not a lot of money. The market for hiring staff is tough and it’s a very competitive and global market. The company has to compete with very well-funded companies who can offer much more than what our startup can afford, and this is in addition to all the other perks big companies are offering like free food, a great office and free gym membership. Not only that but Silicon Valley is even more desperate for talent, and companies like Google and Facebook are paying even more and have even better perks. On top of all that our startup is very risky and based on statistics, more likely than not is going to fail. So the only way it can attract staff to join such a risky and low paying endeavour is through stock; it’s something that the startup can hand out today, and even though it might not be worth a lot right now, it could be worth a fortune later on if the company is successful down the track. This is why equity is the primary means in which startups attract and retain talent, and this is why it is so important.

So our company wants to make its first hire, and given it’s such a risky proposition, the cost in terms of equity will be high, maybe a few percent. As time goes on and the company gains traction, the risk involved with the business will become lower, and as such, the equity compensation decreases. At the same time, the company becomes more and more valuable, so the dollar value of the equity already granted will increase.

Typically, an early stage startup might reserve 10% or 15% of its stock in a special pool for employees. So let’s carve out this pool in our capital structure; 15% is reserved for the staff, and each of the four founders and investors each end up with 17%.

At this point you might think it’s all very straight forward. But if only it was! The big problem we’ve neglected so far is the issue of taxation. While these shares are actually worth real money – we’re giving out 15%, and remember our seed investor paid $500k for 17% of the business. So they’re worth a little under half a million dollars right now. If you gave out the shares directly as stock grants, that means the staff in total would have to treat those shares as income, and pay income tax on almost half a million dollars in this financial year!

Can you see the problem here? You’re trying to attract people to join your company by handing out shares because you can’t afford to provide a good salary, but by doing so you’re burdening them with a huge tax bill! Not just that, but those shares you are handing out won’t be worth anything if the company isn’t a success. On top of that there’s no active market in which they can be sold because it’s a private company – a market won’t exist until the company goes public or gets bought out in a trade sale. Who in their right mind would want to be given stock then?

Stock options

Fortunately there’s a way in which this problem can be solved, and that’s by handing out a stock option rather than the stock directly. An option is a contract which gives the owner the right, but not the obligation, to buy or sell an underlying asset, which might be a share, at a specified strike (or exercise) price on or before a specified date. A stock option is what’s known as a derivative, which means that it derives its price from something else, in this case the value of the stock. As the value of the stock goes up, the value of the stock option goes up as well. As the price of the stock goes down, the value of the stock option goes down as well. But for the option to have any value at all, the underlying share must be worth more than the strike price, because this is the amount of money someone has to pay to exercise the option, which grants them the underlying shares.

So our payoff diagram looks a little like this: if I buy an option while the stock is trading below the strike price I’m down the purchase price of that option, but once the underlying stock reaches the exercise price, the value of the option steadily rises in a straight line. Once the underlying stock reaches the value of the strike price plus what I paid to purchase it, I’m making money – and my ability to make money is limitless, if the stock keeps rising, I keep making money. This means that by owning an option I share in the upside of the company. If things go really well, I make money as fast as all the shareholders do, but if the stock doesn’t rise or it drops then not only do I not make any money but I’m only out of pocket what I paid to buy the option.

The reason why giving options to staff works out better than giving out shares is because if I grant options that only provide upside from today then basically the value of that option today is pretty much zero. This means if we hand out options then we don’t have a big income tax problem because the value of the options are pretty close to zero. The way this is achieved is by the company setting the exercise price of the option to be the same as the fair market value of the shares as of the date of grant. So if for argument’s sake each share is currently worth $1, then the company would set the strike price of those options to also be $1. This means that effectively the options are worth zero today because I would need to pay a dollar to exercise the option into a share which would also be worth $1. The great thing about having the options worth zero is I can give them away to staff without having them receive a big tax bill, because there’s no value in the options today. The staff share in the upside success in the company as much per share as shareholders do, but the value of the company has to improve for them to become valuable. This is a great mechanism for attracting new staff – if the company does well, then they do well, but they don’t get burdened with a tax bill upfront.

However, it’s a little more complicated than that. Options actually have two components of value in them. They have what is known as intrinsic value as well as time value. Intrinsic value is the value you would normally think would be in an option – it’s the difference between the market value of the underlying share and the strike price of the option. So let’s say our share is worth $1 today and the strike or exercise price of the option is also $1. When the stock trades below $1, then the option is also zero. If the stock was worth $2 and the strike price $1 then the option would be worth $1, and if the stock rose to $3 for the same strike price, then the value of the option would be worth $2.

Now here’s where the complication is – options also have a time value. The time value of an option is the discounted expected value of the difference between the exercise price and the stock price at expiration. In layman’s terms, even though the intrinsic value of an option today might be zero, there is a probability that by expiration of the option that the stock might have risen. So even though the intrinsic value might be zero, the value of that option isn’t exactly zero, it’s instead worth a small amount, which is a reflection of the probability that at some time in the future it might be worth something.

It’s fairly complicated to calculate the time value of an option. Companies usually use either one of two ways: the binomial method or the Black-Scholes method, although there are other methods, but all the methods use a lot of complicated maths (if you want to know the difference between the two, here’s a great video). The main way is the Black-Scholes model. The development of this model by Stanford academics was so fundamental to the creation of modern financial markets that the economists that developed it won a Nobel Prize in Economics for it. The model takes into account something known as the volatility of the stock, which is a statistical measure of the variation of price of the stock over time. The more volatile the stock is, or the more it moves up and down, the higher the time value is of the option. This makes a lot of sense intuitively, because the more it moves up and down the greater than chance it might actually be above the strike price at the time of option expiry.

So it’s important to remember that even though the company is giving out stock options to staff that has the strike price equal to the market price of the stock, even though the intrinsic value of the option is zero, the time value of the option will still be worth something, and as such the option will have some value which the staff will receive as income and have to pay tax on in the current financial year.

So let’s now talk about taxation of employee stock and why it’s so important to get this right. We know so far that when you’re granted either a share, or an option, that you’re going to have to pay income tax on the fair market value of that grant in the financial year in which you receive that grant unless the grant is subject to deferred taxation, that is, among other things, subject to vesting conditions.

Not all shares in startups are the same

Now the first thing to remember is that not all shares in a company are the same. Investors rarely buy common (or ordinary) stock in a company – they buy instead a class of stock known as preferred stock. The stock is called preferred because it comes with a number of special rights and privileges. A common right is something known as senior liquidation preference. Liquidation preference was originally designed to provide downside protection to investors that put hard cash into the business, as opposed to just the hard work that founders and staff put in. We call that hard work “sweat equity”, because the equity is paid for in sweat, rather than hard cash.

Financial investors in startups like venture capitalists are not just smart, they are in a powerful position; there’s a rule in startups called the golden rule – he who has the gold rules. These financial investors invented senior liquidation preference to ensure that if the company goes belly up that in a liquidation scenario that they get their money back before any of the people who earned sweat equity get anything. This is why it is called “senior” in a liquidation. So if a venture capitalist invests $2 million dollars in a company with a 1x liquidation preference, then if the company doesn’t go very well and winds up, that the venture capitalist will take the first $2m out of what’s left before any of the people with sweat equity see a cent.

Now this was originally supposed to only provide downside protection, so that if a company didn’t set the world on fire that the investor could get first claim on the assets, but if the company did well that in a distribution of returns in a sale of the business for a lot of money they would have to convert their preferred stock to common (or ordinary) stock and share like everyone else. So in a trade sale there are two options – you either chose to be paid out as a preferred stockholder, who only gets back their money up to the terms of the liquidation preference in the case of a wipeout, or you could convert to common and share with everyone else if the company did well. This is called a non-participating liquidation preference.

However, over time, and because of the golden rule, venture capitalists twisted liquidation preference to become participating preferred stock. What this means is that in a sale of the business they got both the liquidation preference and after that they get to share with everyone else.

So let’s say our venture capitalist invests $2m in a company giving it a $6m pre-money valuation, so that they take 25% of the stock, but their stock is preferred stock with a 1x participating liquidation preference. This means that if the company sells for $8m, they first get their $2m liquidation preference and then they get 25% of the remaining $6m, for a total of $3.5 million! So you can see that even though the venture capitalist owns only 25% of the company, they get almost 50% of the returns in a sale of the business!

So you should be able to see right away that the taxation of the common stock on par with the preferred stock in the case of liquidation preference is quite unfair because the returns are not equally distributed between the two classes of stock.

It can get much, much worse than this. Sometimes the multiple on the liquidation preference for participating preferred is more than 1x, sometimes it’s 2x or 3x, or more. If we go back to our VC’s $2m investment in a company at a pre-money valuation of $6m to get 25% of the shares outstanding, that if the multiple is 3x then the VC would get $6m off the top before anyone else got anything. So if the company sells for $8m, then the VC takes $6m and then they share in 25% of the remaining $2m so they end up with $6.5m of the $8m which is over 80% of the returns even though they only had 25% of the shares outstanding.

These egregious terms are more common than you think. The US law firm Fenwick & West publishes a quarterly survey on financing terms in venture deals and for example in Q1 of 2013, 23% of senior liquidation preferences were multiple liquidation preferences, and of those 29% were between 2x and 3x and 14% were over 3x. Right before I floated Freelancer.com, one of the term sheets I received from a US late stage venture capitalist had a 3x liquidation preference.

To make matters even worse, liquidation preference stacks; later investors will always want at least the multiple that the earlier investors got. So if the company takes in $2m at a $6m pre-money with a 2x liquidation preference, then $5m at a $20m pre-money and finally $50m on a $200m pre-money, all with a 2x multiple, then the total amount of liquidation preference in the company is $114 million dollars. That’s right, in a sale of the business, the investors take $114 million right off the top, and if the company sells for less than that, the founder and staff get nothing at all. If it’s participating preferred, then on top of this they get to share in the rest.

Sometimes there might be a cap on the total amount of liquidation preference that can be received, but in the latest Fenwick & West survey for Q3 2014, 63% of participating liquidation preferences were not capped. Participating preferred liquidation preference, senior multiples and uncapped liquidation preferences are common tricks of the trade that venture capitalists and other financial investors use to bridge valuation gaps between what the valuation that founders place on their business and what investors are willing to pay.

Taxation of grants

So again you can see it’s grossly unfair to tax grants to founders and staff as if the value of the common and preferred stock are the same. The problem is that when your startup is still a private company that there is no active market price for your stock, in fact, the only price you’ll typically have is the last price that an investor bought preferred stock at. That’s why in the US it is common in the treatment of taxation of common stock to discount the market price of the preferred by 90%. It’s illiquid, it’s subordinated, there might be a tonne of liquidation preference on top, and I’m not going to even get into all the other rights and privileges that VCs will have as a result of owning preferred stock – including the ability to pretty much fire you at will.

Now let’s look at how the taxation of grants works with respect to vesting. Let’s say for arguments sake that an early employee is granted 200,000 shares which at the beginning of the life of the company, when there is no value in it, are worth 1 cent per share. Let’s say these shares vest with our standard Silicon Valley-style vesting agreement, which is over four years with a one-year cliff. On the one-year anniversary of the grant, 25% or 50,000 shares vest, and after that each month, 1/36th of the remaining or 4,166 shares vest until the four years are up and the grant is fully vested. Let’s say that after the first round of investment in the company, or the Series A, happens sometime in the first year and that the shares are now worth 20 cents each. On the one-year anniversary 50,000 shares vest which is worth $10,000 at 20 cents a share. On that date, the early employee would have to pay income tax on $10,000 in that financial year. Let’s say the company then goes through another round of funding and the shares are now worth $1 each. Each and every month now, the employee would have additional income of $4166 that they would have to pay tax on – and there are 12 taxable events in that financial year! Let’s say the company does really well and the shares end up being worth $20 each – that would be 12 taxable events per year on income of $83,320 each! Granting options where the strike price of the option is equal to the fair market value of the stock at the time of grant might be slightly better, but remember that the value of this option will never be zero due to the time value of the option.

If the company does really well, this rapidly becomes a nightmare from a taxation standpoint! If the company is still privately held, the staff member might not be able to sell any stock to cover their tax bill because there is no active market for the shares. The company might not even be generating any revenue – just think of how Snapchat is valued at over $10 billion and not making any money yet.

26 U.S.C. § 83(b)

In the US, luckily the IRS has realised the problem of vesting of employee stock, and has created a special exemption called an 83(b) election. 83(b) allows founders and employees to decide at the start of your vesting agreement to be taxed for the entire amount that will eventually vest at the present value. Rather than paying tax each year then, you pay all the tax up front based on the value of the stock or options as and when it is granted to you. The two important conditions of 83(b) is that the stock or options granted to you need to be at risk, that is to say be subject to a vesting agreement, and that you have to file a 83(b) election within 30 days of receiving the grant.

If we go back to our example of the early employee receiving 200,000 shares at 1 cent each under a standard Silicon Valley vesting agreement, then under 83(b) the employee could just elect to pay income tax on the total value at the start, which is $2,000. This is significantly better than the nightmare scenario I talked about before, when you have to pay tax as and when each share vests. Of course, if the company ends up being valuable, the employee will still pay capital gains tax when they sell the shares down the track on the difference between what the stock is worth then and now. If they’ve held for more than a year they’ll pay long term capital gains rather than short term, which is a bonus. At the end of the day, the tax department still gets their tax, it just gets their tax when the stock has crystallised real value and the employee can actually sell the stock to pay for the tax bill.

Click here to read part two.

This story originally appeared on SmartCompany.