The startup community is seriously sweating a stock option provision of the Senate tax bill

A measure in the Senate tax bill has the tech industry spooked. (Bigstock Photo)

A section of the tax overhaul proposed by Senate Republicans is making waves through the startup community, with reactions that range from head-scratching to full-blown outrage.

The provision would tax stock options and restricted stock units at the time of vesting rather than when they are exercised, as is the case now. Startups often use those types of compensation units to compete with bigger companies that can offer higher cash salaries. Experts tell GeekWire that the Senate tax bill, as it is currently proposed, would force many startups to dramatically reconsider their compensation structure.

Here’s how the change would play out in practical terms:

  • Imagine a startup hires an engineer for a lower salary than a big fish like Microsoft can afford but offsets that with $50 worth of stock options that will vest (become available to the employee) in two years.
  • Over those two years, the value of the stock increases to $70.
  • On the day the stock options vest, the employee will owe the IRS taxes on the $20 increase in value, even if she is not able to exercise the stock and actually receive the taxable income.

“There’s a real risk — and it’s not unusual in startups — that the value can go down,” said Craig Sherman, a partner at Wilson Sonsini Goodrich & Rosati focused on corporate law and venture capital. “There are natural cycles and in many tech companies, the value of the stock goes up and down just like it does with public companies. So if you’re taxing people on a theoretical, paper gain that could evaporate the next day, you’re actually punishing people for working at startups.”

Small startups could be hit particularly hard, as their stock isn’t as easy to unload as shares of big companies like Uber or Airbnb. If stock options are no longer as attractive to potential hires, it could also hamstring startups’ recruiting efforts.

“The only way they can compete now is by offering the possibility of big upside from the equity and if that is taken away, the only way a startup is going to be able to recruit people is by matching cash compensation, which I’m not sure how that’s possible,” Sherman said. “This would have a devastating impact on the startup ecosystem.”

Despite impacts on the startup community, the measure could be a significant revenue source for the federal government, offsetting some of the other tax cuts in the broader plan.

Silicon Valley is mobilizing to fight the vesting provision; more than 500 tech companies signed a letter urging Senate to eliminate it, Recode reports .

The National Venture Capital Association is also aggressively pushing to have the measure removed from the Senate bill.

In Seattle, entrepreneurs and tech leaders are also sounding off on the measure and warning of its implication on the startup ecosystem. Continue reading for some of their reactions.

Aaron Bird, CEO of Bizible

Aaron Bird, CEO of Bizible at GeekWire HQ. (GeekWire Photo / Todd Bishop)

“If you value the stock on the classic statement ‘it’s worth what someone will pay for it’ — the ‘value’ of privately held stock at the time of vesting is, in the vast majority of cases, zero. Because it can’t be sold. It would be more fair to tax homeowners when their Zillow’s value went up than taxing startup employees on vested stock. Presumably, your house is marketable (i.e. you can sell it). With very few exceptions (less than 0.1 percent of startups), you can’t sell your stock in a privately held company. So, you would be taxing an employee on an asset they can’t sell and may never be able to. There are many cases, where an employee could literally go bankrupt paying taxes on vested stock or options. Additionally, those options/stock could turn out to be worthless, either because the company doesn’t exit for high enough valuation or the employee simply doesn’t exercise the options when they leave — which then would make the options worth nothing despite the fact that the employee paid taxes on the previous ‘value’ of the options.”

Chris DeVore, General Partner at Founders Co-op

Founders Co-Op Partner Chris Devore. (GeekWire Photo)

“It’s hard to see it as anything other than red-state resentment of the tech industry written into tax policy; there’s no even halfway-reasonable economic or behavioral argument for it, it’s pure spite and politics as far as I can tell.”

Craig McLuckie, Founder and CEO at Heptio

Heptio CEO Craig McLuckie. (GeekWire Photo)

“The proposed changes, as I understand them, are troubling. It is challenging for startups today to compete with late-stage technology companies on cash compensation. Stock options are a key tool for startups to reward entrepeneurial employees for their commitment to creating something new. The changes proposed aggressively favor established tech companies. Ultimately they will hamper the U.S. tech communities’ ability to innovate in an increasingly competitive global ecosystem.”

Nishant Singh, CEO of Peach

Peach CEO Nishant Singh. (Peach Photo)

“The proposed Senate tax bill is a short-term thinking by lawmakers. All the multi-billion dollar companies that currently employ thousands of people and boost the local economy were in fact, a small startup when they started. They became big not just because their idea was good, a big part of their success were the employees who took a leap of faith and joined these companies when they were still small. These employees took a hit on their cash compensation by taking in less money up front in return of stocks.

In essence, the Senate bill is killing this leap of faith by taxing stocks even before they vest. People won’t join startups and if startups are unable to hire talent, less money will be poured by venture capitalist, the whole ecosystem of startups will stagnant.”

Douglas Sirotta, Senior Tax Partner at Ernst & Young

Ernst & Young Partner Douglas Sirotta. (LinkedIn Photo)

“Equity instruments such as stock options currently are taxed upon exercise, which can mirror the ability for liquidity. However, a provision in the proposed Senate tax plan would tax upon vesting, whether you can liquefy or not.

This could be problematic for those that don’t have the wealth or wherewithal to pay taxes on vesting. The consequences could be significant, as stock compensation is the vehicle that startups have used to stay competitive in compensation with equity versus cash and bonuses, which require more of a cash outlay that is not within reach for many startups.

This could be an effort to try and offset the other tax cuts or it may be excluded in final legislation, as it was not included in the House bill. While it still remains to be seen how this will all play out, if provisions do come forth and change how equity compensation is taxed, these companies can explore alternative compensation strategies and this could very well lead to big changes in how employees of startups are compensated.”

Tom Seery, CEO of RealSelf

RealSelf CEO Tom Seery. (RealSelf Photo)

“Taxing stock options on vest, versus on exercise, would have a terrible impact on entrepreneurship, and would further weaken the ability of startups to compete for talent with the increasingly dominant tech platforms of Google, Facebook, Amazon and Apple.

I’ve been fortunate enough to work with incredibly talented people, many of whom left great jobs to take a risk on RealSelf. Offering stock options has not only been crucial to attracting and keeping top talent, but also to building a great workplace culture — employees see the impact they have on the company and know that they will share in future success.”

Matt Oppenheimer, CEO of Remitly

Remitly CEO Matt Oppenheimer. (Remitly Photo)

“By fundamentally changing how equity compensation works for employees at startups like mine, growing companies across the country would face an uphill battle to recruit and retain the talent necessary to build competitive, disruptive businesses. Mortgaging the primary source of job creation and innovation in our economy in exchange for a short term tax bump is short-sighted and irresponsible. I think this is unlikely to pass because I believe cooler minds in Congress will take a step back and see how harmful this tax could be.”

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