In this third post in my series covering the budget recommendations that I coordinated at StartupIreland, I’m republishing our rundown on the current problems encountered by Irish startups that want to give their employees a stake in the success of the company.

This is post number 3 in the series “#StartupIreland Pre-Budget Submissions 2015”

The TL;DR version is that in Ireland, exercising an option to buy shares is deemed to create a benefit-in-kind that is taxed at income tax (up to 54%). This means that when a startup exits, employees get taxed a lot more on their gains than investors or founders, which runs counter to the intended goal of incentivising employee performance. Elaborate alternatives can be set up, but they are expensive and discourage international venture capitalists from getting involved.

We discussed this at the Techpreneurs meetup in August (which was possibly the best techpreneurs event yet – kudos to Peter Cahill, who is organising it now). After a full room of fairly seasoned entrepreneurs chewed on the topic for three hours, the overall conclusions were:

In practice most employees aren’t too concerned about these details so long as they don’t have to put cash down upfront As a matter of principle, fair is fair. Employees deserve to be taxed at a fair rate like everyone else.

Background

The success of a startup depends on its ability to attract, retain and motivate highly skilled workers. Due to the IDA’s success at attracting high levels of Foreign Direct Investment, most startups are now competing against international technology giants to hire local talented staff. Startups cannot offer salaries or benefits to compare with those larger companies, but there is one thing they can offer that the larger companies cannot: ownership by way of equity participation.

Not only can share ownership plans help startups attract the key staff that they could not otherwise afford, but it also promotes strong team dynamics and staff loyalty. In the United States it is typical for startups to allocate up to 20% of equity to an employee ownership plan upon their first major investment. This allows startups to incentivise extraordinary performance from its key employees during the critical transition through the startup and growth phases.

Unfortunately, there is currently no good way for an Irish startup to offer an employee ownership scheme without triggering unfair taxes for the employee along the way. The three major approaches in current use are outlined below, along with the associated drawbacks.

Approach A: Ordinary Shares

If a startup simply grants ordinary shares to a new employee as part of an incentivisation plan, then the employee immediately faces a taxable benefit-in-kind event. As the shares are not liquid, the employee must spend her savings to pay the extra income tax. Therefore, a grant that was intended to incentivise the employee instead has the effect of costing her money.

Approach B: Growth Shares and Flowering Shares

Some companies are creating new share classes that offer little or no present day value to their holders, but provide the ability to benefit in future increases in share value. These shares can be granted to employees before they have a taxable value. However, when they are disposed of (e.g., when the startup is acquired), the rise in share value is taxed as a capital gain.

One approach is known as “growth shares”, which only pays its holder the disposal price minus the share price when it was issued. Another approach is “flowering shares”, which define commercial targets that must be hit before they can be disposed of (thus allowing the present-day taxable value to be discounted).

Although growth shares and flowering shares can technically achieve the goal of incentivising employees without triggering income tax, they suffer from some serious issues that make them impractical for most startups:

They are complicated to implement, and can easily generate legal costs to the startup in the €10,000 – €20,000 range. Their complexity can deter both Irish and international venture capital investors from investing in the company during the growth phase. Growth-stage investors may simply require that the extra complexity of this share class be removed before they invest, which results in employee resentment.

Approach C: Share Options

An alternative strategy is for a company to grant share options to employees under an unapproved share option scheme. These options trigger income taxation when they are exercised. This poses several problems for the employees:

If employees exercise their options during the startup and growth phases of the company, the rise in share price creates a large income tax burden that they must pay from their savings. If all goes well and the startup is acquired, then the employees simultaneously exercise their options and sell the resulting shares. Unfortunately, the employees face income tax on the exercise of the options, instead of CGT on the disposal of the shares. The employees therefore pay over half their gain in tax, while the other shareholders face only CGT.

In both of the above scenarios, the intended purpose of the share options ⎼ to incentivise the employees ⎼ is subverted. Instead of feeling rewarded by the business, they feel punished. In case (1) the employees are faced with a large tax bill without receiving any cash to pay it with. In case (2) the employee is faced with paying much higher taxes than other shareholders participating in the transaction.

Recommendation

We recommend that exercising an share option to purchase shares in a startup company should not be a taxable event. The taxable event will then become the disposal of the purchased shares, which will be a capital gain.

This single measure resolves all the difficulties with share option incentive schemes, while still ensuring that all parties pay their taxes.

Coming in Part 4: R&D Tax Credits

In the final part of this series I’ll post our recommendation on making R&D tax credits work for startups. This is a tax incentive that is designed to encourage high-value-add job creation in Ireland. Startup companies are R&D wunderkind, but they are avoiding this tax break due to the cost and uncertainty of accessing it. In effect, this means that scaled up tech companies (e.g., international IDA clients) are benefiting from this tax break, whereas younger home-grown tech companies (Enterprise Ireland clients) are not. We should level this playing field.

You can stay tuned by following me and StartupIreland on Twitter.