What new tech founders need to know when it comes to offering Stock options.
Granting stock options has become a key component to attracting and rewarding people in start up and growing companies in Ireland. There are 3 key components that should be understood before considering offering stock options to your employees.
1. The tax consequences
2. The various ways to reduce or eliminate taxes and
3. Why you might want to issue options in the first place.
I’ve rounded off the blog with some of the TOP 10 GOLDEN RULES Ireland’s leading start up founders shared with me after presenting this topic at a recent techpreneures meeting.
1. The Tax consequences of the various stock option schemes to the employees
There are a number of share option schemes in practice and they fall into Approved and Unapproved schemes – ( revenue jargon )
Approved Schemes Are suited to public companies, require entire employee involvement and avoid any income tax being levied on the grant or exercise of the share options. These schemes (typically Save as you earn and Profit sharing schemes) are not applicable to start-up technology companies, so ignore them unless you’re newly IPO’ed employer offers them to you.
Unapproved schemes, Are typical in private and start up companies, can be targeted at key employees or new employees you may want to attract, however employees can get caught for income tax on the grant (in certain circumstances) and the exercise of the options and this provides an unwelcome entry cost. In most cases these taxes are incurred prior to any sale so they represent outlays for employees at a time when Founders are trying to reward them for their sweat equity contributions. The employee not only has to come up with the cost price of the shares if they are being charged for the shares but also the income taxes in relation to the different between the exercised market value and the cost price.
So in most situations the employee only exercises the options when a liquidity event occurs, i.e. a company sale.
There are 3 events in relation to share options
Grant – When you have an option to acquire the shares – You shouldn’t have to pay taxes on grant.
In order to avoid any taxes on the granting of the options the options should be open for not greater than 7 years, and or they should be granted at the market value ( not below ) at the time of grant. Nobody ( with a bit of planning ) should have to pay taxes at the grant stage. Company has yearly filing requirements with revenue when options are granted / exercised – Form RSS1 – to be filed by 31st March in the following year.
Exercise – When you actually Acquire the shares – You will pay taxes at exercise – Income taxes !!
Exercise is when the majority of taxes are incurred. Taxes Payable – The difference between the market value at the exercise date ( not the option date ) and the exercise price is assessed to income taxes ( IT 41%, prsi-ee4% and USC 7% (+3% if income >100K ) Possible Total 55%) These taxes must be filed and paid on a RTSO1 form within 30 days of exercise and a Form 11 income tax return must be filed for the tax yr also. If the Exercise date is long before any eventual sale date the Employee will have a tax payment long before any capital return. If the date is close to the sale date, the employee will still be taking execution risk.
Sell
If the Employee exercised and sold at the same time then no CGT applies, only Income tax applicable to the Exercise. If the employee didn’t exercise and sell the shares at the same time then the market value on sale may be different from the market value on exercise, in which case a CGT liability will arise on the difference ( assuming you sell for a higher value ) Rate 33%. CGT only applies to the difference between the Market Value at Exercise and the Eventual Sale Price. So the only time CGT is going to come into play is when the share options are exercised and retained for a period of time prior to sale. The cost basis for CGT purposes is the market value on the date you exercise.
What all of this means is that for unapproved schemes the primary tax will be income tax not capital gains but Income Tax, which leads us to point No 2
2. The various ways to mitigate against income tax payable as a result of exercising stock options. ( To the Employees )
I’ve grouped the tactics into thee categories.
Devaluation
1. Offer shares with NO current value – upward only share option schemes. – Growth / Flowering Schemes – The employee would not participate is anything below the exercised market value when the shares are sold. This would enable employee stock ownership without creating taxable events until the time of sale of the stock.
2. Encourage them to exercise their options immediately but include retention provisions whereby they cannot sell them for anything from 1 to 5 years. “The Clog Period”. Revenue allow you to reduce the IT exposure by up to 60% for 5 yr restrictions.
3. Issue a separate class of highly restrictive shares with little or no rights, Revenue will apply a far lower minority interest valuation to these shares.
Delaying the Event
4. Don’t exercise until sale. Keep the options open for less than 7 years and let them exercise on the occurrence of an event ( typically a sale of takeover ) Income Taxes are paid on the gains.
5. Allow them to forfeit the shares if they wish – this will allow them to get the IT back in the future. This does not reduce the initial exposure, but can enable a refund on forfeiture.
Assistance
6. Offer a BES ( or Employee Investment Incentive Scheme – EIIS – ) to soften the blow of income taxes if there are paying for the shares exercised. ( slightly more complicated )
7. Offer a “Put option” to sell the shares back to the company within a certain time frame in order to reduce the risk to the employee. ( issue – requires retained earnings if for value )
8. Loan the funds to acquire the shares now ! issues here re BIK.
9. Award additional salary in order to cover the net tax cost of the share exercise.
3. Commercial considerations
Too many companies give away too much Equity to employees who are not present for the entire life cycle. The contribution of the employee should be assessed in the context of the life cycle. What is the expected life Cycle of your company ( up to an event ) – 7 yrs – 9 yrs ?
What is the company trying to achieve
- To offer benefits ?
- To encourage retention ?
- Will this be achieved via options ?
- Do the employees accept that Options = a sweat equity challenge ?
What is the employee trying to achieve
- Do the employees value the options ( Does the employee need help with something else and would they value this far above being granted options )
- Do the options change behaviour ?
- In at lot of cases employees don’t care how many options they are being granted, the fact that they are being granted any signals an inclusive Company approach.
TECHPRENEURES PRESENTATION
I’ve set out the Golden rules from numerous conversations with technology company CEO’s who have gone down this path before.
Top 10 Golden Rules from the Techpreneures
- Simplicity over complexity
- Offer Options only to Key employees who will be present for the majority of the company life cycle.
- Don’t exercise until Company sold. Exercise happens at the same time the purchase agreement is executed. – Avoids Losses !!
- Always have buy-back clauses
- Avoid share price risk if possible
- Always have a power of attorney or alternatively a nominee company set-up.
- Don’t issue shares until employees sign the power of attorney
- Never have to round up signatures or risk losing a sale due to inability to execute
- Avoid entering into irrevocable agreements when sales may not go through – messy.
- Avoid taking on Employee tax risks. – Are they buying in or not ? – Tax hurdles or issues should be secondary issues.
