4 Ideas for Improving Employee Stock Compensation

Summary:

  • Stock compensation increasingly matters if a country wants successful startups
  • Stock compensation is partly a tax problem
  • Stock compensation is complicated by having different shares for investors and employees/founders
  • Simpler tax deferral laws for stock compensation would help
  • Other ideas include extending stock option expiry, using a single class of stock, or sharing upside via tokens.

Stock compensation increasingly matters if a country wants successful startups

An increasing portion of jobs in the world are software developer jobs. The financial return you can get from money is now more limited than the financial return from being able to write high quality code.

We are seeing this play out in a few ways:

  1. Software companies like Google and Facebook are highly profitable, so profitable that they could double or triple employee salaries (which are well into six figures) and still be highly profitable. This is putting huge upward pressure on salaries.
  2. Demand for software engineers is so high that high hourly rates are paid for software in countries with very low GDP. For example, I’m now seeing hourly rates of up to $50/hr in countries with less than $5,000 per capita. Slowly, software salaries seem to be globalising.
  3. 50 years ago compared to now, money was of more relative value than founders/coders. Back then, investment terms skewed towards investors. Now, terms (and valuations) skew towards founders. Founders and ideas have become more scarce relative to capital.

As a corollary, software is pulling talent from non-software jobs. This is reducing supply in non-software jobs and putting upward pressure those salaries too. (Why would a mechanical engineer accept $50k if they can get a software job that will train them and pay them $80k [numbers do still depend on geography, but less and less]).

This is where stock compensation comes in for early stage founders. When you run an early stage company, you can’t pay salaries like Google. Stock compensation is your way to compete for employees. A stock compensation framework that is simple to understand and taxed fairly is highly valuable to founders.

The tax problem with stock compensation

Why (deferred) stock compensation should be taxed at a lower rate than income

When employees receive stock, they receive this in return for their work. On the surface, it seems stock compensation should be treated as income and taxed as income tax.

However, the benefit of stock to an employee is typically delayed (if they receive any benefit at all). They can’t cash in on their gains until the stock becomes liquid (which means an acquisition or the company going public). So, there is an inflation aspect to stock compensation that isn’t there for a monthly salary.

This inflation argument also applies to the case of why capital gains should be taxed at a lower rate than income tax. For example, if there is an annual rate of inflation of 2%, the associated tax on stock compensation over a period of 10 years of almost 22%.

There is a separate argument for having a lower tax rate on stock compensation, which is to incentivise entrepreneurship and/or employee ownership. I won’t get into that here and don’t have strong views either way.

Lastly, given capital gains is taxed at a lower rate in most countries, it seems unfair to startup employees to have to pay ordinary income tax on all of their gains, when investors who buy the shares get capital gains treatment. For reasons I’ll outline below, non-investor stockholders in startups that are not yet public often end up paying income tax on stock gains rather than capital gains.

What happens in practise with taxation of employee stock compensation

One specific problem with giving employees stock in a startup is that the shares are not liquid (they cannot easily be sold). If you simply grant shares to an employee, they have to pay income tax when they receive those shares today, even if those shares end up being worthless (in which case they could claim a capital gains loss, but not a write off on their income tax).

To avoid this issue, companies that are not yet public (and whose shares are not trade-able) often give employees stock options. This solves the problem of the employee paying tax when they get the shares, but introduces the problem that they will have to pay tax if and when they elect to exercise those stock options (assuming the value of the company goes up when they elect to exercise them). Further, the rate of tax paid on any paper gain made upon purchase of their shares is the income tax rate, not the lower capital gains rate.

Technically there are ways for employees to avoid paying this income tax on execution if strict rules around holding periods are followed. In the US, it is also possible to get capital gains treatment from the time of share purchase until the point of sale. The strict requirements include holding periods and sometimes that employees be still be employed at the same company when the exercise their options. In short, strict rules mean that most employee stock options end up being taxed in large part as ordinary income.

The 409a valuation and the giraffe

One of the big bureacracies of stock compensation in the US revolves around how to value stock options (or stocks) given to employees – particularly for companies that are not public. This process is determined by tax law, is called a 409A valuation, and – in practise – is well exemplified by this conversation my founder friend had with a company that can do the 409A valuation for you:

My friend to 409A advisor: “Ok, so here’s how you’re saying the 409A valuation works… You walk into a room with a giraffe and the giraffe asks you for your financial statements and all of your previous fundraising information. The giraffe takes a week and comes back with some more questions on your fundraising records. The next week, the giraffe comes back again but this time simply takes the price investors paid for shares in the last round of funding, divides by four, and uses that as the price at which you grant employee stock options… Is that how it works?

409A Advisor: “Yeah, that’s basically right, but it’s not a giraffe, it’s an elephant.”

my founder friend

Note that I’m not proposing a solution here (yet). I also want to be clear that this isn’t an easy problem. Valuing the shares in a company that is not yet liquid/traded is not easy – hence why I later suggest we should think about making it easier for companies to let their stock be tradeable.

What the above story illustrates is that rules around stock compensation – in their bid to provide a lower effective tax rate – have created enormous bureaucracy (and costs) for companies, as well as lots of confusion for employees.

One further point around the factor of four in the story above. The reason employee stock options are valued lower than investor stock is because investors typically have preference shares, which means they get their money back before employees and founders get anything. There is a good rationale to this (that I’ll dive into later), but it adds to the confusion for employees around how to value their options – and – the more confusion for employees, the less they will value the stock compensation, and the weaker the stock compensation becomes as a useful tool for founders.

Ideas for better systems:

  1. Government level: A simple rule allowing for tax deferral until sale

I provide this as an illustrative example because the problem isn’t a simple one, and deeper thought is needed from others that understand taxes and politics better than I.

One simple approach might be to forego all of the current benefits around stock options and instead allow recipients of stock to defer the tax on any stock (or options) received until they sell that stock. When the stock is sold, they pay income tax on any proceeds up to and including the value when they received the stock, and capital gains for anything above.

At the time of issuance, the stock could be valued with current bureaucratic process for valuing employee shares (often common stock), or, ideally some laws are passed that employe some simple rules of thumb for companies at various stages.

2. Founder level: Long expiry dates on employee options

In this article, I’m trying to look holistically at how founders can make their shares more valuable as a tool to incentivise to employees. Tax laws are outside of a founder’s control, so this idea and the next two focus on things a founder could do.

This first idea is something that is already happening with reasonable frequency. The idea is to provide employees with a very long (10 year) expiry period on their stock options, and allow them to keep any vested stock options even if they leave the company. Traditionally, startup employees have been forced to exercise (pay to buy) their stock options within a few months of leaving [both by tax law, and by companies]. Given employees move jobs a lot, and given the high demand for employees, it makes sense to me to make stock option terms more friendly [even if the tax laws in the US still force employees to buy their stocks when they leave to gain the tax benefit].

3. Founder level: All common stock

I mentioned above that investors often have a different type (known as class) of shares than founders and employees. Investors typically have preferred shares which get their money back before excess proceeds are shared around. For example, if investors put in $20M and the company sells for $15M, then investors get $15M back and founders/employees don’t get anything. (In practise, this may differ because there may be an incentive to keep founders/employees on board).

There is a good logic to having investor-specific stock because it protects investors. It means that if a founder raises $20M and then sells the company for $10M in the next twelve months, the founder and employees don’t get a share of that $10M. However, it also means that in a scenario where a company sells for an amount that is close to the total money raised to date, then employees don’t have any assurance of a payoff (of course, management could structure something for employees near the time of sale – but certainly employees have no leverage in the stock agreements). Further – and more importantly – it makes it very complicated (and generally impossible) for employees to to value their shares. Employees don’t have access or knowledge to understand the detailed payout structures with two classes of shares.

So, while having a preferred class of shares for investors does protect investors, it makes the common stock (which is what founders and employees receive) less valuable economically. More critically, two classes of shares makes employee stock much more confusing (which additionally makes it less valuable). Therefore, in a market that is shifting towards founders/employees, founders might consider moving to having just one class of shares for everyone (favouring employees/founders and disfavouring investors).

There are companies that do this, although they are currently largely limited to second time founders with a good track record. Pillar.vc are one VC firm that invests on this basis, and I think this will become more common.

In short, by giving everyone common stock (including employees), one takes out the complexity of employees trying to understand what return they will get in the case of the company being sold.

4. Tokenisation of upside

This is where you roll your eyes, and roll your eyes you should, but I think there is some value in thinking about tokenisation of upside as a way to provide employee compensation. I wouldn’t do it myself right now because I don’t see a very clean way to do it (that is compliant and sensible), but I would consider it in future.

It’s best to understand tokenisation through an example. Uniswap is an exchange for crypto currencies. 0.05% of all trades made on the platform accrue to the owners of Uniswap tokens*, and there is a fixed maximum supply of Uniswap tokens. So, by buying uniswap tokens, you are buying upside (revenue potential) in Uniswap’s protocol. Uniswap dishes out these tokens to platform contributors for the work they do.

So, by creating tokens and attaching revenue streams to them, you can create a separate way to share upside (tokens) with employees/founders. [Side note: The difference between employees and contractors is shrinking, so I see that laws, including stock compensation laws, will need to adapt to this.]

Now, you might say “Aren’t those tokens just unregulated shares?”. The answer to the spirit of that question is “yes”. Token based approaches are largely doing what usually is done via a public stock listing, but in a much simpler way, albeit unregulated. One specific near term regulated path I see for founders is creating tokens that only accredited investors (people with minimum net worth) can buy**. This kind of approach might lend itself to liquidity while potentially being compliant with securities laws.

This brings us back to a deeper point about early stage startup shares – which is that they are not liquid/tradable. All else being equal, something illiquid is less valuable as a form of compensation, and raises the question of why startups can’t be publicly traded earlier.

The reason startups don’t go public earlier is because:

  1. It’s too expensive. The documentation and filing requirements and ongoing cost of listing on an exchange are at a level that it doesn’t typically make sense to go public until your company is worth billions.
  2. They don’t want to. A lot of founders and investors would say they don’t want to go public because they don’t want the pressure of having to provide quarterly reports as well as public scrutiny. Largely, this is associated with the expense and bureaucracy of the current laws for public companies.

The current tokenisation we are seeing in crypto should make us realise that we can come up with cheaper and simpler regulated processes for companies to go public. Afirst step would be to create a new class of simple laws for small companies (worth less than $1 billion market cap) to go public and allow them to trade their tokens on open source exchanges that comply with standards.

*Technically, there is currently an option for the community to turn on this fee, so it’s not there right now.

**I have mixed feelings on current US laws that restrict startup investing to people with a minimum net worth or income. It may protect some people from bad investments but it seems exclusionary. It’s hard to weigh these two factors but I would lean towards removing income and net worth requirements.

Stock Compensation Increasingly Matters

In summary, people remain important in building successful startups. The value of what people can offer is – largely thanks to software – increasing, so workers (especially coders) have more leverage. Stock compensation is one of a founder’s most valuable assets for recruitment.

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