Employee Share Schemes and Start up Companies

Transcription

1 Level Harris St Ultimo, NSW Employee Share Schemes and Start up Companies Submission (7 February 2014) Manager Individuals Tax Unit The Treasury Langton Crescent PARKES ACT 2600 by @treasury.gov.au Dear Manager, Employee Share Schemes and Start up Companies: Administrative and Taxation Arrangements : Discussion Paper August 2013 StartupAUS welcomes the opportunity to make this submission to contribute to the regulatory review of the Government into Employee Share Schemes addressing the very real difficulties being faced by start up companies under the current scheme. As a non for profit organisation with the mission of fostering and building a community of technology entrepreneurship in Australia, StartupAUS is in broad contact with the wider and emerging Startup industry throughout Australia and is well placed to contribute to the discussion with a highly relevant response reflecting the direct concerns of Australian Startups. We were pleased to have the opportunity in the stakeholder consultation 4 February to confer on the issues for the startup sector. StartupAUS StartupAUS is a non for profit organisation with the mission of fostering and building a community of technology entrepreneurship in Australia and being able to reflect and communicate the issues and exigencies needed to grow the sector: StartupAUS was formed in March 2013, when more than 50 of the key players in the startup ecosystem tech CEOs and entrepreneurs, incubators, coworking spaces, investors and government came together to work out a joint plan to grow and support Australian startups. 1

2 StartupAUS is itself a startup, relying on passionate locals representing the tech community. The StartupAUS board is currently comprised of Alan Noble of Google Australia, Bill Bartee of Southern Cross Ventures, Peter Bradd of Fishburners, Stephen Baxter of River City Labs and Dr Jana Matthews, of ANZ Innovyz Accelerator. StartupAUS has Advocates in every state. Advocates are volunteers responsible for organising grassroots efforts and coordinating community activities. EXECUTIVE SUMMARY Startups have a significant role to play in invigorating and growing the Australian economy and workforce but that potential is being significantly and materially thwarted by the current taxation legislation on Employee Share Schemes. StartupAUS recommends the Government adopt a policy that removes the current obstacles to potential economic growth and supports the adoption of the successful, simple and facilitative system with tax payable upon disposal of the shares. StartupAUS proposes a broader, more realistic definition of "Startup" based upon concerns expressed to StartupAUS by its own members and identified in various reports and inquiries referred to in this Submission. It is acknowledged that any such definition requires a degree of objectivity for it to operate. StartupAUS notes that ASIC are presently reviewing the content of ASIC Class Order 03/184 and Regulatory Guide 49 which will serve to facilitate the reforms to Employee Share Scheme. Without a complementary and suitably flexible reform package StartupAUS submits Australia will be left behind the rest of the world and its economy and workforce denied the opportunity to participate and prosper in the global technology and digital economy. ECONOMIC IMPORTANCE OF STARTUPS We understand and were pleased to gather from the Stakeholder Consultation that the Government recognises that the startup sector is valuable to the Australian economy and there is a desire in Government for it to grow and that Government understands the need to address issues around ESS for that growth to reach its potential. As stated in the Discussion Paper Start ups positively impact economic growth and development and have the potential to generate new markets and significant employment growth, facilitate trade and exports and generate strong future productivity growth. Start ups also create prosperity and jobs in a much shorter timeframe when compared to other 2

3 small businesses. Australia s transition to a digital economy is helping remove the constraints of geographical distance and time and driving innovation more rapidly than we have witnessed before (Discussion Paper p2.1 8.) We further refer to the Background part at the end of this Submission. TREASURY S FOCUS OF DISCUSSION In Treasury's Invitation to comment on Employee Share Schemes and Startups (21 January 2014 ) we note Treasury wishes to focus on a. The 2009 changes and their effects on businesses b. What are the barriers to offering an employee share scheme? c. What steps should be implemented to overcome these barriers? d. What would be the broader economic benefits in implementing these steps? e. What is a startup? f. Any other costs or issues associated with the implementation of an employee share scheme. a. THE 2009 CHANGES AND THEIR EFFECTS ON BUSINESS If you were a startup prior to , did you change your ESS arrangements following the Budget changes? If so, how? Prior to the 2009 changes startups were able to utilise the ESS because tax was not payable until such time as the employee shareholder sold the shares. Tech startups are entirely speculative high risk rolls of the dice for their founding directors and shareholders and for the employees who invariably work for minimal or no salary and whose incentive is that with hard work and some luck one day they may be able to sell some shares to reap a reward. It is not until the startup company is successful that anyone makes any money. As soon as the 2009 changes were introduced the reforms shut down any such incentive. The 2009 reforms were aimed at deriving additional tax revenue and improved reporting from the big end of town companies whose share values were ascertainable by valuation or by market. As noted by Treasury in our stakeholder consultation startups could not use the revised scheme and those with enough money to hire lawyers drafted share schemes and employee share agreements to find a way around it. Also as noted by Treasury in our stakeholder consultation, startups interests and assets are not liquid they are valueless shares that cannot be sold to pay tax. The costs of carrying out a valuation to verify that the shares were worth nothing is prohibitive and the complexity of administration of a compliant post 2009 ESS required retaining expensive legal and accounting services. What were the compliance impacts on your business of the new withholding 3

4 and reporting requirements introduced in ? As per the above the impact was not to use the ESS as compliance was prohibitive. Are there other impacts on your business from the changes in ? As per the above the impact was not to use the ESS as compliance was prohibitive. b. WHAT ARE THE BARRIERS TO OFFERING AN EMPLOYEE SHARE SCHEME? If you are a startup, do you offer shares or options through an ESS to your employees? What other benefits do you offer your employees? Are these sufficient to retain or attract the necessary employees? If you do not offer an ESS, what are the major reasons why not? As per the above the impact was not to use the ESS as compliance was prohibitive. c. WHAT STEPS SHOULD BE IMPLEMENTED TO OVERCOME THESE BARRIERS? StartupAUS proposes: STEP 1: STEP 2: STEP 3: Impose the tax upon and at the time of sale of the employee share, i.e., during or after a liquidity event. Define Startup suitably clearly and broadly with appropriate metrics to achieve certainty of the ESS and with sufficient flexibility to be beneficial to the appropriately eligible startups. Deploy clear simply drafted and standardised Employee Share Option Programs and Employee Share Schemes and reporting system for startups. d. WHAT WOULD BE THE BROADER ECONOMIC BENEFITS IN IMPLEMENTING THESE STEPS? Step 1 means that tax is paid when the value of the employee shares are realised. This recognises the fact that employee shares in startups are an incentive not a salary bonus. By enabling the employee to have so called skin in the game local and overseas skilled and experienced professionals will be attracted to work for Australian startups and increase the chances of success thereby the prospects of a higher percentage of profitable new businesses adding to Australia s GDP and tax revenue for Government. As set out in the Background a successful startup eco system requires a culture where failure is allowed to occur. The costs of failure therefore need to be minimised. Removing the current up front tax on the issue of employee shares or exercise of options means that if a company fails to become viable there is that much less expense in trying, thereby encouraging the risk taking necessary in entrepreneurship and developing the startup sector. 4

5 Step 2 would make the Employee Share Scheme targeted to the relevant sector giving confidence and certainty to startups to readily deploy Employee Share Schemes without apprehension of breaching any tax or company laws. Administrative, legal and accounting costs would be reduced and more of the early seed and later venture capital investment will be available for expenditure on the core business and technology development. Step 3 similarly to Step 2 a standardised ESS, Employee Share Option Plan (ESOP) and reporting system would substantially reduce legal and accounting and administrative costs making more of the early seed and later venture capital investment available for expenditure on the core business and technology development. As set out in the Background overall these steps will foster the requisite culture and optimism of entrepreneurship and remove the current barriers to enable the startup sector to rapidly grow and reach its potential contribution to the national GDP. e. WHAT IS A STARTUP? What are the key characteristics of the type of startup that is most likely to make use of an ESS? The experience of StartupAUS is that the key characteristics of a startup are new emerging high growth companies using technology and innovation to tackle a global market. In the Stakeholder consultation Treasury indicated that this sort of definition does not work in the Tax Act and that, by way of example, Facebook would meet that definition and that it is a better to have a simple metric to make administration easier for the startup company. On the other hand StartupAUS submits that if the definition comprises nothing but metrics then it ends up applying to any company operating any sort of business including say a local grocery store. Leaving the definition entirely metric will not achieve the aim of putting a ring around the concessions being afforded to foster the startup sector. StartupAUS proposes a definition of Australian Qualified Startup Business (QSB), loosely derived from the US Qualified Small Business defined by the IRS. The central idea is that only Australian QSBs would be eligible for tax concessions on share options, which would entail deferring any taxation on options and exercised options until a liquidity event. For example, exercising options that convert to shares in a (QSB eligible) company that is still privately held incurs no taxation, as the taxation point occurs when the shares become liquid (i.e., resulting from an acquisition, public listing, etc). Further, with a standard definition for eligibility in place, the ATO would be in a position to authorize a standard Employee Share Option Program (ESOP) or Employee Share Scheme (ESS) (or a small number of schemes). Concessions could be limited to QSB eligible companies only if they adopt a standard ESOP or ESS 5

6 authorized by the ATO, thereby simplifying administration and compliance for all parties. Where Australian QSB wished to modify the ESOP or ESS they could do so on the basis of compliance with given guidelines and have the option of submitting any varied ESS or ESOP to the ATO for a Ruling if they wanted certainty of compliance. The metrics of an Australian QSB we propose are unlisted companies with $20M or less in annual revenue and no more than than 100 employees. Listed companies and companies paying dividends would be ineligible. Based upon discussions StartupAUS has had with startups, investors and incubators these figures are a reasonable reflection of the current startup sector. All existing share options issued by an Australian QSB (while it holds the status of an Australian QSB) should retain their taxable status beyond the company outgrowing it QSB status, i.e., be grandfathered. Share options issued after a company exceeds Australian QSB thresholds would be subject to standard tax treatment. The definition would then comprise the above metrics and apply to unlisted companies whose main characteristics are new emerging high growth businesses using technology and innovation to market globally. StartupAUS is aware of alternative definitions and suggest further consultation with a few key stakeholders to refine this definition. Should Government wish to preclude any specific activities they should only be precluded if they also do not fall within the main characteristics. f. ANY OTHER COSTS OR ISSUES ASSOCIATED WITH THE IMPLEMENTATION OF AN EMPLOYEE SHARE SCHEME What difficulties and costs do startups face in valuing shares or options for an ESS? As stated above valuations are costly and pointless to share interests that are incentivised speculations in the context of a startup as distinct from big end of town established companies If you are a startup, do you use an independent valuation? Why? No. For the reasons above. As a startup, how often do you carry out valuations for ESS purposes? Never for purposes of employee share incentives. See above. Do you require a valuation of your startup for other purposes? What type/s do you use? Only for purposes of IPO or Venture capital investment where the value attributed is again purely 6

7 speculative. What difficulties do startups face with respect to corporate regulation of ESS? See above and the below Background. Are there other regulatory requirements that impose costs or difficulties for startups wanting to offer an ESS? Corporations Laws are currently very limited in scope. StartupAUS refers in this regard to the submissions of PWC who kindly made its draft submission available to us. StartupAUS is very pleased to participate in this Discussion and welcomes the opportunity to assist in any way it can to bring about vital reforms that will reap enormous benefits to the Australian economy. Please do not hesitate to arrange follow up discussions by contacting Peter Bradd via Yours sincerely, Peter Bradd Executive Director Fishburners and board member, StartupAUS Bill Bartee General Partner Southern Cross Venture Partners and board member, StartupAUS Steve Baxter Founder & Managing Director, River City Labs and board member, StartupAUS Dr Jana Matthews Program Director, ANZ Innovyz Accelerator and board member, StartupAUS Alan Noble Director Engineering, Google Australia, co founder of SA Angels and board member, StartupAUS 7

8 [ANNEXURE] BACKGROUND Australians are great consumers of technology, but it s only through becoming a nation of creators of tech innovators that will we will be able to compete in an increasingly global and connected world. A strong homegrown tech sector is vital to future Australian jobs and wealth. The economic opportunity is huge. The tech startup sector has the capability to grow into an important part of Australia s economy, providing a significant number of jobs for the future. PricewaterhouseCoopers (PwC) in a report recently commissioned by Google The startup economy how to support tech start ups and accelerate Australian innovation found that the industry has the potential to unlock $109 billion in economic value, or 4% of the economy, and employ more than 540,000 people, by But unlocking this vast potential will take work. A highly skilled workforce and a strong entrepreneurial community is the key. A successful Australian tech sector will take a concerted effort that includes entrepreneurs fostering a more open and inclusive culture, boosting the number of people founding companies, increasing success rates, and ensuring students are taught computer science at an earlier age. PwC found that the five key ways to unlock the potential of the tech sector are, by order of importance: 1. Foster a stronger and open culture of entrepreneurship Australia has a considerably higher fear of failure rate than nations like the U.S. and Canada, constraining the sector. The tech community is key to changing this by celebrating its own success and becoming more inclusive. 2. Attract more entrepreneurs with the right skills in the short term Australia needs 2,000 more tech entrepreneurs each year drawn from the existing workforce. In the long term, our education sector must produce more skilled tech entrepreneurs. 3. Encourage more early stage funding funding for the Australian tech startup sector will need to increase. Australia invests approximately $7.50 per capita in venture capital per annum (all quoted in US$ figures), compared to the United States ($75) and Israel ($150). 4. Open up local markets to tech startups governments are major consumers with spending totalling $41bn in They can become more startup friendly with procurement reform. 5. Improve the regulatory environment the role of the government in the ecosystem should focus on creating a supportive environment for innovation and entrepreneurship, such as 1 PwC commissioned by Google (April 2013) The Start up economy how to support tech start ups and accelerate Australian innovation content/uploads/2013/04/pwc Google The startup economy 2013.pdf 8

9 bringing crowd funding in line with the UK and the US. IMPORTANCE OF EQUITY Attracting top talent, particularly outstanding software engineers and experienced digital marketers is hard in Australia. Startups need to incentivise employees with equity (options and shares) to compete with larger corporations who are better resourced and can afford to pay potential employees far larger cash salaries. Traditionally, incentive stock option programs have been the most flexible and tax efficient way to incentivise employees. In competing countries where the best of Australia's talented technicians and entrepreneurs are being lured, especially the USA, Stock Options give employees skin in the game without incurring tax liabilities until they are exercised and (presumably) worth something. Employee share schemes Drive employee engagement and loyalty. Engaged, loyal employees are happier. Align interests of employees with the company which leads to greater success for the company, employees and the economy as a whole. Help attract top performing employees. Superstar software engineers, marketers, salespeople and others are able to work in many different countries in the global economy. Strong Employee Share Option Plans (ESOPs) can help keep them at Australian companies, and attract top talent from overseas to Australia. Allow wealth to be spread more evenly. If a company is successful, people working at the company benefit, not just the founders and investors. Employee share schemes are an essential ingredient to a successful startup ecosystem, and 2 part of the mix of every successful startup ecosystem around the globe. Combined with high employee engagement they have helped drive growth in the US economy in the last half century. It's estimated that 28 million US employees participate in an employee ownership plan, about 1/5 of the entire private sector. ESOP adoption rates are estimated at only 6% in Australia. CHALLENGES CREATED BY CURRENT SCHEME Taxation changes made in July 2009 mean that share options are now taxed at the time of the grant vesting rather than when they are exercised. Prior to July 1, 2009, employees could elect whether to pay tax on stock options at the time of grant, or at a later cessation date (e.g., the earlier of exercise date, ceasing employment, or 10 years from grant). No tax refunds are available if the options have a taxable amount (e.g., at vesting) but later sink underwater, even if the employee never exercises the options. 2 Pollenizer, from Little things, Startup Genome, Deloitte (2012) Silicon Beach : Building Momentum 9

10 This removes incentive for employees to join a startup as they have to pay tax on options up front at the time of grant but options might vest over several years so they are taxed for gains they may never make. This is applying tax on theoretical value, and is fundamentally unfair to small private companies. Options in most startups are worth very little unless the company makes a profit in a very short time. Startups by their nature experiment with a great many innovations and ideas and most often arrive at any success at all after a great deal of trial and error. There is a complicated and expensive way around this, its set up a loan plan to fund share plans, that involves a limited recourse loan arrangement provided by the employer to the employee. It requires legal advice and accountants to devise theoretical valuations of option values. Such plans are neither simple nor risk free and discourage many startups not to use options. nor have they been substantially tested. The PwC report found failure needs to be accepted not feared. To generate a vibrant startup eco system there needs to an environment where failure is not compounded by being taxed or subject to complex, expensive and risky alternatives as does the current system. Despite the desire and need for incentivisation to employees, under the current ESS The Deloitte 3 and Norton Rose report, Australian business experiences with Employee Share Options found that: of 104 technology companies surveyed, 94% believed stock options were a good motivator, yet only 37% issued options in the prior three years mostly due to the current tax structure surrounding ESS. of the companies who hadn t issued Employee Share Options (ESOPs), 81% agreed that tax considerations were the main reason for their reluctance to use them and 82% agreed that they were a disincentive to their use. 89% of respondents to the survey would be more inclined to issue share options if employees were taxed on financial gains at the time of ESOP proceeds rather than earlier. Furthermore, the study carried out in the report Silicon Beach Building Momentum: a study of 4 the Australian Startup Ecosystem highlighted that: only 57% of Australian Start Ups in the survey that had a staff incentivisation plan had 3 Deloitte/ Norton Rose ESOP survey report (2013) Australian business experiences with Employee Share Options (Source PwC Submission to ESS Discussion Paper 2013) 4 Ibid at Footnote 2 10

11 some kind of ESOP scheme and a total of 63% prefer to use a cash incentive instead. only 4.8% of Australian technology startups grow into successful, global companies whereas many more Silicon Valley (8%) and New York (6.7%) based start ups reach scale Scott Farquhar, 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. PRINCIPLES Tax when value is realised Don t tax a theoretical value, especially one that requires hand wavy valuations for unlisted companies. The likelihood of a return on most options in startups is very low. Keep costs low by keeping it simple Complexity is expensive, error prone and discourages uptake by startups who simply do not have the resources. Keep it simple, so as many startups as possible can access share schemes. Take a holistic approach Consider other important regulatory frameworks such as security laws, which can have a significant impact on startups when structuring ESS. Don t reinvent the wheel The US, UK, Singapore etc have well established practices. Let s borrow the best of global practices, not reinvent the wheel. Put the onus on employers to comply Consistent with overseas practices and PAYG withholding, employers can and should be be made responsible for withholding tax liabilities. Australia already has introduced ESS reporting, so the building blocks are in place. Focus on startups, but don t punish successful startups Startups benefit greatly from well designed share schemes, but successful startup companies become large companies. 11