The Law of Equity Compensation Is Not Great
I got into a friendly Twitter banter last night with a friend.
I was pushing my argument that we should repeal the taxes on transfers of stock to workers.
My friend Nick Ambrose (@nick_a_ambrose) was arguing that existing equity incentives were fine, especially incentive stock options. At least, I think this is what he was saying. Here is the start of our conversation:
— Joe Wallin (@joewallin) November 5, 2014
Nick and I went back and forth a little more. I was pointing out that options are what companies do because they can’t do stock awards, because of the tax problems. He was arguing options or other currently available mechanisms are fine, or work just fine.
I pointed out that I think Fred Wilson agrees with me. Here is what Fred said:
I do not believe there is an optimal way to issue employee equity at this time. Each of the three choices; options, restricted stock, and RSUs, has benefits and detriments. I believe that options are the best understood, most tested, and most benign of the choices and thus are the most popular in our portfolio and in startupland right now.
Nick still didn’t agree with my idea, I don’t think. I finally told Nick I just disagreed with him, and smiled at him through Twitter.
I don’t think options are as good as stock awards. Here are my reasons:
- Options have to be exercised; if not, they terminate.
- I have seen companies with large groups of option holders see the option holders get quite anxious when the option termination dates start rolling in. The workers basically want the management of the company to create a liquidity event–go public or sell the company–so the workers can get liquidity for their options before they expire. I don’t believe this would happen in the same way if the workers held stock. Stock doesn’t have an expiration date.
- Frequently workers quit when they are vested but before a company liquidity event. In these situations, workers frequently can’t exercise their options in full because the tax consequences are too severe. These workers miss out on some potential big gains. This is really unfortunate for the worker.
- ISOs don’t solve these problems. Even though there is no ordinary income tax on an ISO exercise, there is an AMT adjustment. Sometimes the AMT adjustment results in the worker paying a lot of tax. More tax than the worker can afford to pay.
We need to fix worker equity compensation tax laws. We need to make the law better. The way the law works currently is not good enough.
The fundamental problem I would like to see addressed is this:
If a company wants to issue stock to a worker, the worker has to pay tax as if she received cash. This despite the fact that the stock is illiquid and can’t be sold. This causes company to issue stock options rather than issue stock to workers. But options are not as good as stock awards. The reason? Options expire. And once they are in the money exercising them triggers taxes that workers frequently can’t pay. This frequently robs workers of much of the value of the equity incentive. A sad result for workers.
Let’s repeal the tax on transfers of stock to workers. This would directly address the problem described above. It could also help ameliorate wealth concentration by helping to spread the wealth around. This could ultimately help create more angel investors. These are all good things.
The fundamental question is: Do we try to make the law better, or do we leave it the way it is?