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Unlocking the Unicorn Handcuffs

Posted by Dan Eyman | September 30th, 2016 | No responses

New legislation was introduced in July and passed the house last week called the Empowering Employees Through Stock Ownership Act (EESO) and it is aimed at providing employees of privately held company employees the flexibility in handling the tax obligations with exercising stock options for a period of up to seven years.

Background

Startups typically grant employees ownership in the company they are working for in the form of stock options, incentive stock options (ISOs). Awesome right? Sometimes. If you work for a fast growing startup with a lot of traction, perhaps a unicorn, maybe your options are worth a lot. Do you think unicorns make any noises like a horse would? Except I imagine it would be more magical sounding. I digress…..

The problem arises if and when you want to leave the company. Employees typically have 90 days to exercise their options or lose them. Ninety days after an employee’s separation from the company, the ISOs (incentive stock options) automatically convert to what are called non-qualified options (NSOs), which wind up resulting in even more taxable income. Private company employees often cannot or do not have the ability to liquidate shares to cover the tax liability like a public company employee would. So in a sense you are handcuffed to the company.  Let’s look at an example.

Let’s say you are an early employee at a Unicorn startup and you were given 0.5 percent of the company when you started five years ago. At this time the company was valued at $50 million, then your ownership position would have been valued at $250,000 ($50 million x 0.05%). Fast forward and the company is now valued at $10 billion. Now your ownership stake is worth $50 million. Whoa….we are paper rich yall! Holla! That is a paper gain of $49,750,000.

But there is bad news if you would like to leave. Of course there is. Mo money mo problems. So if you decide to leave you will face a short-term gains tax of 40 percent, $19.9 million, plus the $250,000 needed to exercise the options. You would have only 90 days to come up with the $250,000 and then the remaining tax would be due by the next tax deadline of April 15.

Some companies like Pinterest and Quora tried to ease the burnden by giving them years to exercise. However the truth is that many companies with these employee dilemmas choose not to do anything about it, because they believe “locking people in” is good for business. Any stock that is not exercised can be returned to the option pool and granted to other employees.

 

The Problem is Exacerbated by Two Main Factors :
1) Companies Are Staying Private Longer; and
2) The Option Plan Structure Startups Use Make it Hard for Employees to Leave.

Companies Are Staying Private Longer

The US Jumpstart our Business Startups (JOBS) act passed in 2012 increased the number of shareholders a private company can have before having to register its common stock with SEC and become a publicly reporting company.  The threshold is reached only if the company has 500 “unaccredited” shareholders, or 2,000 total shareholders, including both accredited and unaccredited shareholders. This means a company can stay private much longer if it has the capital to do so.

Additionally, private capital available to start-ups has dramatically increased in recent years. This acceleration in the amount of capital invested in private companies—an increase that originated with an influx of later-stage capital from nontraditional sources chasing venturelike returns—eventually trickled down to earlier stages. In just the past two years, the capital invested in private companies almost doubled, to about $81 billion in 2015, from around $47 billion in 2013, and $24 billion on 2005 (See chart below).

Total Capital over time | amCharts

Source: Pitchbook Data, Inc.

Finally, these two factors are coupled with a lackluster IPO market and have kept unicorns away from the public market. So what we have is a culmination of the ability to have an increased number of shareholders prior to going public, the available capital to sustain operations from private capital sources, and a lackluster IPO market ( I will blog on this next).

The Option Plan Structure

Start-ups grant stock options and/or restricted stock units (RSUs) to employees as part of their compensation. Stock options come with a vesting period over time, typically four years. Once the option vests you have a set period of time to exercise before the option expires, which comes with its own set of problems.  Scott Kupor from a16z has a good post on recommendations for startup employee option plans here. Upon exercise of the option, or vesting of an RSU,  you are required to immediately pay income and social security taxes on the difference between the strike price and current fair market value.

The Empowering Employees through Stock Ownership Act 

Extends the time period required to pay tax upon exercise of stock options or RSUs up to seven years (unless the company goes public)

To qaulify for the deferral of income tax:

  • The company is required to grant options to 80 percent or more of its employees on an annual basis
  • Must offer employees stock options on similar terms
  • Cannot be traded on an established market
  • Legislation is not intended to benefit anyone with more than 1.0% ownership

This is an amendment to Section 83 of the Internal Revenue Code.

 

Here is What the Legislation Will Do:

Reduce the Barrier to Exercise Stock Options:
  • The legislation extends the time period in which employees are required to pay tax upon exercise of stock options or RSUs that are settled for stock up to seven years. The amount of tax the employee can elect to defer is calculated in the same manner as under current law: the excess of the fair market value of the stock, over the amount the employee pays for the stock.
Promote Broad-Based Employee Ownership:
  • To qualify for the deferral of income tax, the company is required to grant options to 80 percent or more of its employees on an annual basis; must offer employees stock options on similar terms; and cannot be traded on an established market. The legislation is not intended to benefit the most compensated employees or the largest owners of a company. Individuals who own 1 percent or more of the company and those who control the company, such as the Chief Operating Officer, the Chief Financial Officer, and the four most highly compensated officers, are not eligible.
Require Employees to be Fully Informed: 
  • There may be instances where the stock price of the company declines after the employee elects to defer income tax liability. It is critical that employers provide employees with information, through a written notice, on the tax consequences of this election, and failure of the company to provide a notice to an employee will result in a penalty.
Use Existing Administrative Tax Rules and Provide Worker Flexibility:
  • Similar to other tax elections in the stock options space, the employer will be required to report the future tax liability on the employee’s Form W-2. Once the employee has the cash to pay the stock, a tax deferral is no longer permitted. In other words, if stock of the company becomes readily tradable on an established market, or the employee decides to sell or transfer part or all shares to another individual before the seven-year time period ends, the employee will have to pay tax. The employee can also decide to revoke the deferral and pay his or her income tax at any point.

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