A startup that goes well can be very rewarding. How do we ensure that everybody involved gets their fair share?
Let’s go deep into the weeds of startup compensation, options, capital gains and tax…
There are multiple different ways to get paid when we work on or invest in startups. We should always stop and think about which of these to optimise for in the short-term and long-term.
We can get paid directly as employees. This could either be a fixed salary, or an hourly rate.
Advantage: The amounts are agreed and documented in advance and we always get paid (at least as long as the startup stays in business and we continue to work on it).
Disadvantage: The amounts are fixed, so there is no upside if things go really well.
We can get paid a percentage of revenues.
Sales people are often paid commissions, calculated based on sales made. There are many possible structures, depending on how easy it is to attribute sales and revenues to a specific person or team.
A variation of this is where everybody on the team is paid a percentage of total revenues - e.g. as an end of year bonus. This is also how partnerships work.
Advantage: If we’re successful we can earn more, and we get paid immediately (notably before shareholders).
Disadvantage: There is no guarantee we’ll make as many sales as we need - especially in the early stages things are often slower than we’d hope.
Last but not least…
We can own shares in the company.
The one (and only) way to acquire shares in a company is to buy them.
When a new company is incorporated shares are issued to everybody who invests the initial capital. These are typically very small amounts. At the very beginning a startup is only worth as much as that capital invested by first believers. Later other investors can buy shares, either from the company when new shares are issued in an investment round or from an existing shareholder who is willing to sell them.
However or whenever we acquire shares, it always involves an investment of cash.1
The two (and only) ways to get a return on that investment are: (a) When the company pays dividends to shareholders from profits, which is exceptionally rare for startups, because they are often take many years to become profitable and even then usually prefer to re-invest those profits in further growth rather than make payments to shareholders; or (b) When the shares can be sold to somebody else.
Advantage: If the startup we invest in becomes a high-growth company the value of the shares can increase significantly over time.
Disadvantage: We have to invest cash up-front. It can be many many years before we get a return on that investment. And there is no guarantee of any return at all - in fact the average startup returns nothing.
Perhaps it seems like something is missing from this list. It’s true there is one thing, which I’ll discuss soon, but it’s probably not the one you’re thinking of…
It’s common to hear people working on startups talk about “sweat equity” or “options”, as a way of becoming shareholders without investing cash up-front.
Are they though?
Both of these things are widely misunderstood by employees, founders and investors.
(I’m not an accountant and definitely not your accountant, so if you have been given “free” shares or options in return for work on a startup stop reading this and instead get good advice from somebody who is. Ask them how much tax you will pay and when.)
In simple terms, “sweat equity” is when we are paid for the work we do in shares rather than cash. That’s possible, but doesn’t make them free, because the IRD treats the value of those shares as income, just like a salary, and expects tax to be paid on that amount immediately.
The obvious downside is that, as we discussed, it could be a long time before the shares generate any cash returns.
A better way to think about this type of transaction is to imagine we are paid cash (and pay tax on that amount) then immediately investing that cash to buy shares at the current price.
On the other hand, an “option” is a contract that gives us the ability to purchase shares in the company in the future, for a price that is agreed up-front.
There is a lot of jargon to learn in order to understand options:
Typically options have a “vesting” period. This is the time between when the options are issued by the company and when they become unconditional for the employee. Departing employees usually forfeit any unvested options.
Sometimes there are additional performance criteria attached to vesting. For example, sometimes options vest based on milestones rather than time.
Once options are vested employees can choose to “exercise” them at any point before the “expiry” date. That means, paying the company the agreed price (the “strike” price) in return for the agreed number of shares.
Remember, shares always cost money.
In the case of options the IRD treats the difference between the price you pay (usually a small amount) and the value of the shares you get as income, just like a salary, and expects tax to be paid on that amount. The advantage of options compared to basic sweat equity is that they allow the tax bill to be deferred until the point where shares can be converted into cash. But that comes with not insignificant complexity.2
To answer my own question: Sweat equity and options are not a way to give employees shares without payment, they are just salary disguised as shares, with corresponding tax treatments that apply.
What is the other common way of getting “paid” to work on a startup?
It’s actually the reverse: it’s volunteering time or even paying to work on a startup.
This might sound incredible,3 but it happens all the time.
For example, whenever a potential investor meets with founders to give their perspective and advice, without receiving (or expecting) any payment.
Or, following investment, when an investor becomes an unpaid director or advisor to the founders during the early stages. They have effectively paid the company to hire them!
Immediately following investment the biggest constraint is forward momentum, so the best option for investors is to focus on increasing the value of their shareholding rather than on their hourly rate.
This is also common in the non-profit sector - e.g. where we might donate both time and money to an organisation to help them with their work.
This is what I mean when I say the best founders choose their investors.
Smart investors are prepared to invest handsomely in the opportunity to work with the best founders: generally a little bit of money and a lot of time. And it’s the time that makes the biggest difference.
Unfortunately most founders optimise for money. This creates a race to the bottom for investors (especially those running venture funds) as everybody competes to offer founders more and more cash on more and more generous terms. What gets squeezed are the potential returns and, more importantly, the time that investors can put into helping to make the outcomes great for everybody.
If you write a song that’s recorded umpteen times, the income will last your lifetime plus copyright, which is 70 years.
But if the songs take shape in the studio, over late nights and conceivably the odd spliff, how do you decide who has written what?
How do we align incentives in a startup between team members - who are being paid a salary and/or commissions - and shareholders?
This seems like such a simple question, but if I could get back all the days I’ve spent wrestling with possible answers I’d be much younger.
Despite that, I still think it’s important. When startups go well they can go really well.
For example, when Xero listed in 2007 the whole company was valued at $55 million (and there were a small group of us who invested prior to that at even lower valuations). Today it’s worth billions.
Ideally, the team who do the hard grind day-to-day to grow the company should share in the upside, rather than having that value captured entirely by shareholders who contributed capital.
While it might, on the surface, seem contrary to their own interests, smart investors understand that getting this right is often a key that can help to unlock that upside in the first place. For example, it’s common for venture investors to insist on 10% or more of the company to be set aside for allocation to employees via an Employee Share Ownership Plan (ESOP).
The question then is just how to manage that allocation. But the details get devilish very quickly. Often because of tax.
The first problem, as we saw above, is that shares have a cost and we can’t just gift them to anybody without creating an immediate tax liability. Meanwhile the payback could be many years in the future, if at all. Generally people are not happy to pay tax on income that may never actually be paid.
When I first started investing in startups it was common to solve this using an employee trust structure, which effectively gave employees the benefits of shareholders without requiring them to invest cash up front. However, there is no such thing as a free lunch - these schemes were very expensive for the company (which is another way of saying “for those who did invest cash”) because of the tax that was paid up-front on behalf of employees; because of the cost and complexity of administering them; and because of the large amount of time spent explaining these schemes to employees. I personally spent a significant amount of time on this at Vend and Timely, which would have been better spent growing those businesses.
For all these reasons simple options schemes are now more popular.
An alternative, which we used at Timely, is called “phantom equity”. This is just a fancy name for a cash bonus which is paid in pre-agreed circumstances - e.g. when a startup is floated on a stock exchange or sold outright. The tax position on these is cleaner, or at least more easily explained: employees pay tax on the bonus when it’s paid, just as they would on any other salary amount. Perhaps as an indication that I’ve completed a full lap, this is a throwback to the exact pattern we used at Trade Me following the sale to Fairfax.
However, as we’ve seen, neither of these solve the real problem: investors who pay cash up-front for their shares pay no tax on their gains when those shares are sold (because in New Zealand there is no capital gains tax on investments4), meanwhile employees who receive options or bonuses that are paid on exit as part of their compensation are taxed at normal income tax rates.
Investors and founders both want employees to be shareholders, to align incentives. But it’s impossible to do this in practice. Employees don’t and can’t benefit from the gains like investors do unless they invest cash up front like investors do.
That doesn’t seem fair. There are two possible solutions if we want to close that gap: remove the tax on employee gains, or impose a tax on investor gains.
Occasionally startup founders or investors, or other people in the ecosystem, agitate for special tax treatment for startup employees, but they are always curiously quiet about capital gains tax for startup investors.
I’ve also yet to see any proposal that doesn’t just simplify to “we’ll just pay less tax, kthxbai”. There is always a frustrating lack of detail about how this would be justified and explained to other taxpayers, who would be left covering the difference.
Remember Hugh the forklift driver from Timaru? How would tax breaks for startup employees benefit him and his whānau?
Perhaps we think these incentives would create more highly paid jobs or more profitable startups that contribute income tax back to the economy. Or perhaps they would increase productivity, because employees working on startups would be more motivated.
If we believe those things are real then let’s spell them out. And quantify them, rather than just putting our hand out. I’m not convinced they are real.
On motivation, specifically, I don’t believe that employee share ownership is a useful way to motivate a team. I’ve never seen that happen in any of the schemes I’ve helped to implement. In fact the opposite - many employees discounted the value of the shares they were given to zero because they weren’t sure they would ever be valuable, and in some cases were still frustrated to get a big tax bill on exit. So the shareholders were left with the worst of both worlds: an expensive scheme that didn’t really change behaviour.
The thing that really motivates people is a company with a purpose they believe in, work that they find meaningful and colleagues who support and encourage and challenge them to be better.
The reason to implement a scheme is so that everybody who contributed gets to share in the success if and when it happens.
So, is a capital gains tax the solution…?
What would it take to convince more people to invest in startups rather than real estate?
A common answer to that question is: a capital gains tax. I’m skeptical. Let me try to explain why…
The fundamental problem with the housing market is that generally nobody believes that prices will fall. The issue is not that capital gains on property are tax free. It’s that everybody believes that capital gains on property are almost certain.5
This explains why people are not so enthusiastic about other types of capital gains, which are also tax free - e.g. gains on investments in businesses.
In those cases the capital gains - and indeed the capital itself - are at risk.
So, it’s difficult to see how a capital gains tax would make much difference to how capital is allocated. Especially if it also applied to other types of investment. Especially especially if there are exclusions related to housing - e.g. family home is excluded.6
If we want to shift investment preferences - e.g. less into property, more into productive businesses - then we need to make those things we want to encourage either less risky or more rewarding.
If we want to make housing more affordable then we need a solution that causes prices to fall.
But nobody wants their property value to fall, so any solution that would cause that to happen is considered politically impossible.7
Which takes us back to the beginning of this logical loop…
The fundamental problem with the housing market is that currently nobody believes that prices will fall in the long term.
The issue is not that capital gains are tax free. It’s that everybody believes that capital gains on property are almost certain.
Maybe we inherited startup shares or won them in a late-night poker game, but even in those contrived cases somebody bought them before gifting them to us. ↩︎
Typically options that have a very low (i.e. nominal) strike price and a long-dated expiry (i.e. 10 years), so once options have vested employees can wait until there is a transaction, then exercise them and sell them immediately. The tax bill in this case is on the difference between the strike amount and the sale price, which can be substantial. But at least employees have cash on hand at that point to cover that expense. ↩︎
Or as we might say in NZ: fairly interesting. ↩︎
Everywhere else in the world investors expect to pay tax on capital gains. And that just gets priced into valuations and stock option calculations. ↩︎
Historically people ranked good deeds based on what was considered most likely to get them into heaven when they died. Now we rank property purchases based on estimated capital gains. Same logic, I suppose. ↩︎
↩︎A capital gains tax on property, exempting the family home, pool house, in-ground swimming pool, tennis/basketball court and grounds.
— Rowan Simpson (@rowansimpson) September 8, 2017
Westpac chief economist Dominick Stephens hit the nail on the head:
People want everyone to be able to buy a house and the financial system to be safe and they don’t want to see house prices fall, and they don’t want to see infill in their suburb.
↩︎Well something has got to give. The resolution is going to involve someone experiencing some disappointment relative to what they’d hoped for.
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