This is the fourth post in a series on kickstarting Aussie startups. The first post is here.
In my previous posts I focused on how the government can encourage investors to back startups through some relatively straightforward taxation and policy changes. In this post, I'm switching tacks and focusing on ways of incentivizing employees in startups.
Traditionally, incentive stock options have been the most flexible and tax-efficient way to incentivize employees. Options give employees “skin in the game” without incurring tax liabilities until they are exercised and (presumably) worth something. At least, that is the way they are supposed work. Unfortunately, Australia’s tax treatment of stock options is now amongst the most backward and punitive in the world. Since the tax changes that came into effect on 1 July 2009, Australia taxes options at the time of their granting. Given that options typically come with restrictions, for example, vest over several years and cannot be traded until exercised, this means employees are being taxed for gains that they may never even realize! Suffice to say, this removes a key incentive for employees to join startups.
That said, private (unlisted) companies can find legal workarounds around these restrictions, but quoting Scott Farquhar, the co-founder of Atlassian:
"It's very difficult; just the legal and the tax structures that you have to set up in Australia took us hundreds of thousands of dollars in legal fees and tax advice and so forth ... whereas if you go to the States it's a relatively simple document that's pretty standard that everyone signs and it might cost you two or three grand in legal fees.”This is definitely not the kind of financial outlay that your average startup can afford!
Further, public companies have no such recourse and, as a result, have stopped issuing stock options to Australian employees. Instead, restricted stock has become the chief means of incentivizing employees in public companies. Unfortunately, restricted stock lacks the flexibility of options since, under the current tax regime, employees incur a tax liability at the time of vesting. Invariably this forces employees to sell shares to cover their tax liabilities. Everyone loses in this model. The employee loses “skin in the game” and the Australian Tax Office (ATO) loses tax receipts on future capital gains. In addition, 3 years and counting and there is still no clear guidance from the ATO to confirm whether it is even permissible to allow vesting of restricted stock with time frames of less than one year, e.g., quarterly vesting.
Proposal 4: Tax stock options upon exercise
Defer taxation of stock options until the point of exercise and mandate that employers withhold the income tax. This simple approach, which works well in the US and the UK, requires minimal administration by the employer and minimal risk to the employee. There are no loop holes and no potential for rorting, and it preserves maximum revenues for the government (albeit deferred). Finally, it works for startups and multinationals alike.
Let's put the incentive back into incentive stock options!