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Delete option: tax changes slamming the brakes on start-up incentives

Published 02 April 2013 09:54, Updated 10 April 2013 07:42

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Delete option: tax changes slamming the brakes on start-up incentives

Bugherd’s Alan Downie and Matt Milosavljevic spent two years finding a way to give staff equity. Photo: James Morgan

In early 2011, the two co-founders of tech start-up Bugherd, Alan Downie and Matt Milosavljevic, decided to hire their first employee. Without the cash flow to offer a competitive wage, they wanted to offer an equity stake in the company to attract and incentivise the best talent.

What followed was almost two years of research into complex accounting structures to avoid paying an up-front tax bill that neither Bugherd or its prospective employees could accept. After budget-saving measures introduced by the federal Treasurer, Wayne Swan, in 2009, employee share options are treated the same as income, the receiver of the shares being taxed on a notional valuation.

Entrepreneurs like Alan Downie say the changes put a dampener on a remuneration method that is widely used in innovation hubs around the world such as Silicon Valley, where the tax comes later when the options are cashed in. The move in Australia to slap a tax burden on aspiring entrepreneurs is likely to have pushed talent overseas at a time a number of countries are actively welcoming it. The United States, for example, is hotly debating proposed law reforms such as the Startup Visa, hoping to tap the new jobs companies produce and the new entrepreneurs who move to the US.

“The issue in a start-up is my company is worth nothing at the moment,” Downie says. “The shares are not worth anything to the employee until the shares become liquid, and they have the money in the bank. Then everyone is happy to pay tax. But if we give one of our guys $100,000 in equity, and he pays $50,000 in tax, and then we go broke, he doesn’t get his $100,000 but he has still paid his tax.”

In fact, that’s the most likely outcome in the entrepreneur community, he says, given the high failure rate of start-up companies.

The changes to the Income Tax Assessment Act 1997 came about because Swan believed the system was being “rorted and exploited so much so that it plunders the public revenue by tens of millions of dollars”.

The main culprits were large established companies that were paying their staff in options instead of income. There remains some controversy in business circles over whether this constitutes a tax rort because the options still attracted tax when exercised, and capital gains tax was paid on the gains.

No options for options

But the result in the community of emerging companies is that many founders have simply stopped using share options. Those that are using them are using complex structures to do so, giving thousands to accounting firms instead of to the public purse.

A March report by Deloitte Australia and legal practice Norton Rose surveyed 104 large and small businesses and found only a third had issued share options, despite 94 per cent believing they were a valuable way to incentivise employees. Tax was the reason 81 per cent of companies not issuing employee shares chose not to.

Downie has taken the route of offering a non-recourse loan to employees to pay for the share options, after speaking to a range of accounting firms and international companies.

This structure avoids the up-front tax hit but it has its drawbacks. Firstly, there is the time and money it takes to put it together. Bugherd got a bulk discount with three other companies to put the structure in place, but still paid $5500 to do it. Some companies pay tens of thousands of dollars.

Secondly, a loan legally has to be repaid. If the company fails, it would be expected to simply write off the loan, but the employee can be held to ransom in the case of an acrimonious dispute. Or not even an acrimonious dispute, Downie says.

“As a company becomes more successful and you get more people on the board, the original founders become minority share holders. If an early employee has a very generous share offer, [the employee] could be forced to pay back the loan or lose their shares.”

Thirdly, even if company relationships are smooth, the tax office could simply change its rules, or apply existing rules in an unexpected way, he says.

“If we sell the company for $10 million next month and pay back the loan, was there a fringe benefit applied by doing that loan?” Downie ponders. “There are tricky bits that haven’t been tested.

“It cost us $5500 to do it. In the scheme of things it’s not that bad. But you still have an instrument that is complicated working through loopholes that the ATO could close at any time. The legislation is built in a way to stop people doing what we’re doing. It’s not an ideal scenario.”

The mention of Australia’s rules around employee shares invariably makes visiting entrepreneurs choke on their lunch. Like Ben Huh, Seattle-based co-founder and chief executive of the Cheezburger Network who was in town last month. His company receives 375 million page views a month across its popular sites like I Can Has Cheezburger and FAIL Blog, and grew with the help of employee shares.

“That’s terrible,” he says when asked about the tax rules around share schemes. “What you’re doing is the government is forcing employees to incur a significant amount of risk prior to seeing the reward. The government is not participating in the risk-reward process, the government is basically saying ‘I’m going to offload my revenue risk onto you prior to you being successful’. They’re imposing a very risk-averse mentality on a population that’s willing to take risks. They’re taxing the willingness of people to take an honourable adventure.”

Grow bigger, pay more

The companies that really get walloped by the employee shares tax rules are the fast-growing ones that are rapidly expanding their workforce.

Eddie Machaalani, co-founder and joint CEO with Mitchell Harper of BigCommerce, says they took a different avenue to give Australian employees shares in the business.

Big Commerce’s Mitchell Harper and Eddie Machaalani wore a significant cost to get their employee share scheme up and running.Photo: Nic Walker

BigCommerce paid a set amount of cash to all its team members to fund their purchase of options in its stock at market rate. This avoided immediate tax implications, ensured favourable capital gains treatment, and meant the team members wouldn’t be taxed at each vesting period because their options had already been fully exercised. The scheme came at “significant cost to us”, he says, but he hopes other start-ups take the same route to make employee stock ownership plans (ESOP) as common in Australia as they are in the US.

“We obviously didn’t want our Australian employees to have to cough up a large amount of cash up-front to be part of our ESOP,” Machaalani tells BRW. “It wouldn’t have been fair.”

A spokeswoman for Swan says the government has a range of schemes to support small businesses. “The government is supporting small businesses through the instant asset write-off, simpler depreciation arrangements and a new loss carry-back to promote innovation and sensible risk-taking,” she says. “Employee share schemes are being considered as part of the digital economy white paper, and the government welcomes industry views.”

Niki Scevak, the founder of start-up incubator Startmate and managing director of venture capital fund Blackbird Ventures, supports change to the rules but says the impact to early-stage companies has been overstated. They can get around the problem by issuing options early when they’re worth very littlehe recently told The Australian Financial Review .

“It’s not a problem for start-ups. It’s a problem for valuable companies like Atlassian and BigCommerce that decide to retrofit options plans when they are valuable,” he says. “Should [the government] change it? Yes. Is it the most painful problem in the start-up ecosystem? I don’t agree with that.”

Malcolm Thornton, investment director at venture capital firm Starfish Ventures, says the entrepreneur community is “incredibly grateful” for generous R&D tax incentives, and the work done by Commercialisation Australia to support start-ups. “But we are competing globally,” he says.“One of the key legs of the stool is how you recruit and retain talent. In California it’s a standard part of the employment process to talk about an option program.”

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