Equity compensation, often in the form of stock options, is a critical tool used by startups to attract, retain, and incentivize quality employees. But stock options have a downside: current tax law requires that employees pay an immediate tax when they exercise their options, usually long before they can sell those stocks to realize their full economic value. Fortunately, a bill being considered today by the House Ways and Means Committee could remedy this problem.
Stock options often make up a significant portion of compensation packages for startup employees. According to one study, 73 percent of venture-backed firms grant options to all of their employees. This is a win-win for startups and their employees—young, high-growth companies can hire talent without breaking the bank while employees can directly benefit from helping their company grow.
While stock options are in theory a great tool for startups and their employees, in practice, the tax treatment of stock options grants often makes it impossible for employees to realize the value of their options. Under the current tax code, employees who exercise stock options are required to pay an immediate tax on the difference between the fair market value of the underlying stock and the amount paid for the stock. This means if you’re an employee at a startup that has grown in value, you may be on the hook for a significant tax burden upon exercising your options. This is problematic for employees at private companies, since there is no liquid market on which to sell some of the newly acquired shares to help pay the tax. Unless an employee has enough cash on hand to exercise the options and pay the associated tax, she simply cannot realize the value of her stock options and acquire an ownership stake in the company.
This creates several problems for startups and their employees. First, costly options make it difficult for startups to compete with established companies for top talent. When faced with a choice between a large tech company that can offer higher salaries and more attractive benefits and a startup that can offer compensation that may require an high out-of-pocket tax payment, few potential employees can afford to choose the startup.
Second, the stock option tax limits employee mobility. Consider this: an employee has been working at a startup for six years. She’s lucky—the company has grown steadily and its valuation has increased commensurately since she joined. She’s offered an exciting opportunity at a smaller startup where she would be able to play a more integral role in shaping the company and helping it to grow. But, the majority of her net worth is tied up with her current employer in the form of stock options, and in order to leave the company and exercise those options, she’d have to pay upwards of $100,000 in taxes. If she doesn’t already have significant personal assets on hand, it may be economically impossible to leave her current job and forfeit the equity compensation she’s accrued.
But there’s some good news: this afternoon, the House Ways and Means Committee will consider a bill that would make it easier for employees at private companies to exercise their stock options. The Empowering Employees through Stock Ownership (EESO) Act (H.R.5719) would allow employees to choose to defer their tax liability for up to seven years, or until the underlying share is sold (whichever happens first).
Yesterday, Engine led a letter signed by over 50 startups expressing support for the bipartisan bill, which represents a simple, commonsense fix that will go a long way towards growing our economy, empower employees, and fostering startup growth. As the letter notes, the bill “will make it possible for more employees to obtain an ownership stake in the companies they help build and make it easier for startups and private companies to attract the talent necessary to grow the economy.” We hope that the Ways & Means Committee will approve the bill today and that House leadership will move it to the floor as expeditiously as possible. Startups and their employees across the country are depending on it.
Read more on the issue: One Way Stock Options Are Hurting Businesses — and How to Fix It