One Way Stock Options Are Hurting Businesses – And How to Fix It

Among the many challenges entrepreneurs face in launching and scaling a startup, recruiting talented employees is one of the most difficult. There’s already a shortage of tech workers in this country (there are currently more than 600,000 open computing jobs nationwide, and last year, only 43,000 students graduated with computer science degrees), and it’s even more dire for startups that must compete with some of the most successful companies in the world to recruit these employees.

It’s simply not feasible for a startup to offer a salary and benefits package commensurate with what Apple and Google can provide. So, to lure companies away from larger companies, startups usually have to offer some equity stake in the company, often in the form of stock options grants. According to one survey, 73 percent of venture-backed firms grant options to all of their employees.

In many ways, stock options are a win-win for startups and employees, helping startups can attract top talent without breaking the bank and ensuring that employees can directly benefit from helping the company grow.

Of course, stock options are only useful to startups and employees if they can actually afford to acquire the underlying shares, but because of poorly designed tax policy, it’s often incredibly hard for employees to realize the value of their options grants. Under current law, if an employee exercises stock options, she must immediately pay a tax on the fair market value of the options. But, because startups are almost always private companies with no public market for shares, employees can’t sell some of their newly acquired stock to pay down this tax liability.

At a rapidly growing tech company, the tax burden may be so high that only employees who are already wealthy can afford to acquire their options.

This only adds to the difficulty startups face in attracting the talent they need. No sane employee would choose to work for a startup instead of an established tech company if the principal compensation the startup offers comes with a price tag the employee can’t afford. And, once an employee joins a larger tech company, it can be even harder for a startup to recruit her away, since much of her net worth may be tied up in stock options with her current employer. As large tech companies now tend to stay private for long periods of time—in 2014, the median technology company was eleven years old at its IPO, up from five years old in 2000 and four years old in 1999—more and more employees face the prospect of losing their options if they want to leave to work for startups.

The net result of this tax policy is to give established companies yet another significant advantage over startups in the competition for the top talent, which diminishes competition and hurts economic growth.

Fortunately, fixing this problem doesn’t require a major overhaul of the tax code. Congress simply needs to pass a law establishing that tax liability incurred upon the exercise of stock options doesn’t need to get paid until an employee actually sells the underlying shares. Such a policy wouldn’t hurt Treasury revenues, as the employee will still ultimately be liable for paying the same tax, and the company issuing stock options won’t be able to claim the corresponding deduction until an employee actually pays tax on the shares. If anything, allowing employees to defer tax payments associated with options until sale will increase government revenues, as it will only make it easier for startups to compete and contribute to the economy.

A tax policy that puts startups at a competitive disadvantage with larger companies and makes it difficult for people without large bank accounts to participate in the startup sector is obviously broken. Considering startups are responsible for all new net job growth in America, policymakers interested in growing our economy should do everything possible to foster startup growth. Fixing a counterproductive rule like the tax on illiquid stock options is an easy place to start.

Evan Engstrom is the executive director of Engine, a nonprofit that supports the growth of technology entrepreneurship through economic research, policy analysis and advocacy on local and national issues.

Morning Consult