Share option scheme

The Australian government is modifying the tax laws on startup options, after much pressure from interest groups

The issue that they, the ATO and Treasury, have is that every time they create a favourable option tax scheme for startups, the big 4 consulting firms figure or how to game the scheme for their larger clients, closely followed by all the small consultants and their clients.

It looks like they have over cooked this new scheme to avoid this issue but by doing so made it less useful than it could have been.

My personal opinion is that the scheme could be very simple, as follows:

1. A company is eligible if

(a) more than 25% of the fully diluted stock, including options, are at least 1x liquidation preferred stock with a threshold of board and shareholder control rights, including drag-along rights for exit.

Note, they don’t need to grant options until someone invests, and with the proposed zero valuation (below) the timing of option grants becomes less critical. For example a company can accrue promises (by letter) to grant options and grant them later on when they hit the 25% threshold.

(b) the holders of at least 80% of liquidated preferred stock do not own any common stock or options.

Together these features would exclude the unworthy small businesses, corporations, listed leeches and SME’s, so long as beneficial interests were carefully excluded. And also the companies would need an annual external audit of their capital structure.

2. All options are deemed to have zero value at the time of grant with no income declarable, no matter what the price per share of the preferred stock. Keep it simple. This also avoids all the silly valuation methodologies, the dumb timing issues, etc. Note that the zero valuation for options does not imply any valuation of the common stock for tax purposes.

3. Options are only over common stock, must vest over at least two years, and the board must have power of attorney rights over them.

4. Options must be between 10% and 25% of the fully diluted stock after each option grant.

5. Profits from options are taxed at the same rate as capital gains as if the stock was held from the time of grant, independent of the mechanism used by an acquirer to buy out the options, or the time the stock is held between conversion and sale.

It is useful to remember that the mean return on genuine startups in Australia is quite negative over the last 40 years, so such a tax scheme isn’t giving anything away as such. Just so long as it can’t be gamed by the unworthy.

This scheme is also structured to force all this incubators and angels into sensible investment structures. It’s a two-fer that addresses the question as to “what is a startup?” from a capital structure point of view.