A proposal by the U.S. Senate to change the way shares in startup companies are taxed incited panic and dread in Silicon Valley on Monday, with startup founders and investors warning of nothing less than the demise of their industry should the proposal become law.
The provision in the Senate’s tax reform plan, which appeared to catch the industry by surprise, involves the treatment of employee stock options. These options give the holder the right to purchase shares in the future at a set price and can be very valuable if a company does well and the share price increases.
Options are often a major portion of the compensation for startup employees and founders, who take lower salaries in anticipation of a big payout if their startup takes off. Options typically vest over a four-year period.
Senate Republicans have now proposed taxing those stock options as they vest and before startup employees have the opportunity to cash them in, resulting in annual tax bills that could easily climb into the tens of thousands of dollars, say startup founders and venture capitalists.
“If there were a single piece of legislation to adversely affect startups, it would be this,” said Venky Ganesan, managing director at venture capital firm Menlo Ventures. “Everyone is freaked out.”
Justin Field, vice president of government affairs at the National Venture Capital Association, said that the Senate’s proposed tax change would be “crippling” to the startup industry.
How far the provision gets remains to be seen. The National Venture Capital Association was successful in getting a similar proposal removed from the House tax bill, although it “didn’t fully appreciate” the Senate’s intention to add the tax provision, Field said.
The association also helped to steer lawmakers away from a proposal discussed late last year to tax venture capitalists’ profits on investments at a higher rate.
Republican Senator Rob Portman of Ohio, a member of the Senate Committee on Finance, has filed an amendment to repeal the provision in the tax bill, according to his spokesman.
A new proposal
Under current tax code, employees are taxed only when they exercise their options. Options are exercised when the price they were granted at–known as the strike price–is lower than the share price, and some shares can then be sold to pay the taxes.
But the Senate proposal would require startup employees to pay regular income tax on the value gain of their stock options even before they are exercised. These options are illiquid assets, and cannot be spent or saved.
“What this would mean is every month, when your equity compensation vests a little bit, you will owe taxes on it even though you can’t do anything with that equity compensation,” Fred Wilson, a venture capitalist with Union Square Ventures, wrote on his blog Monday.
For instance, if a startup employee receives stock options at a dollar per share, and the shares increase in value by $1 every year during the four-year vesting period, the employee would have to pay income tax on $1 per share after the first year, pay again on the $1 increase in value after the second year, and so on.
When that employee owns hundreds of thousands and even millions of shares, that is a hefty bill to pay. And there is always the risk the startup will eventually fail.
“This reform will force the average employee to pay taxes on that bet well before they even know if it’s a winning ticket,” said Amanda Kahlow, founder and executive chairman of marketing data startup 6sense.
For startup founders in particular, such a tax bill could be ruinous.
“It would mean that I would have to sell the company,” said Shoaib Makani, founder and chief executive of long-haul trucking startup KeepTruckin. “I have zero net worth aside from the common stock I hold in the company. It would be impossible. I would be in default.”
Some executives in the startup industry, however, have pushed for companies to move toward bigger salaries so employees are not so dependent on options to buy a house or pay for other large expenses. And when startups suffer valuation cuts, employees can end up with worthless options.
The Senate’s proposal came as a revenue-generating measure to help offset tax breaks in the bill. A spokesman for Senator Orrin Hatch, a Republican and chairman of the Senate Committee on Finance, did not respond to requests for comment and other Republicans on the committee were not immediately available.
A spokeswoman for Senator Ron Wyden, the committee’s ranking member and a Democrat, said he was aware of concerns that the provision would limit startups’ ability to attract talent.