A Tax Tweak for Silicon Valley Workers Awaiting IPOs

(Bloomberg View) -- The Senate's tax proposal would disrupt the disrupters: By taxing stock options at the time of vesting, rather than when they're exercised, the change would push startups toward cash compensation. Venture capitalists say that would be expensive and harmful to innovation. But the reality is that changes in Silicon Valley financing culture over the last decade have made equity compensation a bad deal for startup employees, as I can personally attest, so this policy change would probably be good for workers.

The idea of stock option compensation for startup employees is sound: allow risk-taking employees the opportunity to get paid less in cash, in exchange for upside if a company does well. This reduces cash pressure on early-stage companies, and it aligns workers' priorities with the companies'. If the company succeeds, everybody wins -- what could be more American than that?

The problem is how it works in practice. As venture capital firm Andreessen Horowitz said in a blog post earlier this year, it's taking longer for companies to reach the IPO stage, when employees could start to cash in on their stock options. The average age of companies at their time of IPO has increased from 6.5 years to 10.5 years. The annual number of IPOs has decreased by more than half. The post lists a number of culprits for the change, including regulatory changes, the pain and scrutiny involved in being a public company, and perhaps the biggest factor, the increasing availability of late-stage venture capital.

It's the latter factor that has turned the tables on stock option compensation. It used to be that the interests of investors, management and employees were somewhat aligned. A company would be founded, hire some people and grow, and eventually it would either mature enough to go public or would hit a point where it needed the capital available only in public markets. Then it would have an initial public offering. Employees at successful startups need liquidity events eventually to make their risk worth their while -- living in startup communities like the Bay Area is expensive, and it's tough to make a real living there without an IPO payday eventually. Startup salaries alone won't cover the mortgage of a house in Palo Alto.

But with the availability of late-stage venture capital, that's changed. Now, if things are going well, there's almost always a pot of money available in the private markets, either from VC firms like Andreessen Horowitz or other players like Softbank, which just finalized a large investment in Uber. Employees awaiting an IPO to get their payday? Out of luck.

This is particularly pernicious because of the way the scales are tilted against employees. Typically employees are granted a quantity of stock options without being given any information about what percentage of the company that entails. They have very little insight into what those options are worth, nor whether other investors have special clauses that protect them in case things go bad for the startup. If they leave the startup and have to decide whether to purchase their vested options, they have no way of knowing if or when they'll ever get an IPO and be able to sell those options.

I should know, because this happened to me. I spent 20 months at a startup earlier this decade, and at the time of my departure had some vested options with a decent amount of value. My stay was roughly in line with the average employee tenure at tech companies. I had 90 days to decide whether to purchase my options, after which point I'd lose them forever. Under current law, you're forced to pay the embedded capital gains taxes on those options at the time of purchase, even though you don't know if or when you'll ever be able to sell them. Doing this would have cost me tens of thousands of dollars, which I was not in a position to do. I chose not to purchase the equity, which, on paper at least, has continued to increase in value even though five years later the company still has not had a public offering.

Worst of all for employees, this situation is what's good for management and outside investors. If employees aren't in a position to buy their options, those shares disappear, increasing the ownership percentage of everyone else.

The loudest whiners about this proposed legislative change are venture capital firms and tech entrepreneurs, which should tell you something. If cash becomes king and stock compensation dwindles … well, good riddance.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Conor Sen is a Bloomberg View columnist. He is a portfolio manager for New River Investments in Atlanta and has been a contributor to the Atlantic and Business Insider.

To contact the author of this story: Conor Sen at csen9@bloomberg.net.

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