Kickstarting Aussie Startups - Stock Options

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!

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Why NOT study an MBA

Image by Vela

Recently, a senior engineer at Google asked me for a reference to support his application to an MBA program.  It was not the first time I’ve written such a reference, but it got me thinking about the pros and cons of engineers trundling off to business school. There’s certainly lots out there on why you should study for an MBA, but not much on why you should not study for an MBA. So, at the risk of offending my friends and colleagues with MBAs, let me give you some reasons.

I’ve never attended a business school, but this has not stopped me from starting and running companies. In my opinion, most smart, experienced engineers probably already possess the acumen they need to be successful in business. Further, there is the opportunity cost of pursuing an MBA, and finally there is the financial cost. After all, the time and money spent on an MBA could be spent building your business.

I asked my colleague why he wanted to pursue an MBA. First, he thought it would be valuable for the professional networks he would forge. He admitted that the business knowledge he thought we would gain was a secondary consideration. Second, the MBA would give him greater credibility with potential investors to secure funding to start a company.

There is no question that in business the old adage “it’s not what you know, but who you know” rings as true as ever. But is an MBA really the most efficient way to build your network? I would argue, “no”.  For someone reasonably adept at plugging into social networks, both online and offline, there are countless networking alternatives to an MBA. From online social networking sites, such as LinkedIn and Google+, to offline networking events, such as your local Mobile Monday or the local Silicon Beach/Alley/Forest/etc. entrepreneurs group.

So what about credibility with investors? There’s a perception that one always needs to raise capital in order to start a company.  In reality, chasing funding is often the last thing entrepreneurs should be worrying about. Capital-light businesses, such as online businesses, can often be bootstrapped using a credit card (or two).

If you’re an engineer, consider building a proof of concept to validate the idea first, and getting some real users or customers. Then, and only then, seek capital, by which time, with any luck, your business might even command a non-zero valuation. And if you're not an engineer, team up with an engineer.

Finally, ask yourself "why do you really want an MBA?" It might be because you feel that somehow you’re not ready to start a business and the MBA will prepare you. If so, my advice is, don’t procrastinate further, just do it! If you fail, just fail quickly, learn from your mistakes, and try again. The experience you gain will be worth a thousand lectures. And if you succeed, I look forward to hearing from you.

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