David Mytton was the CEO of his own UK-based software startup from 2009-2018, before it was acquired by a US cyber security business. He now runs product engineering for the acquirer and advises a number of London startup venture investment firms.
Employee ownership of company shares is a good idea. As an employer, you want your team to be incentivised towards the success of the business. That’s why it’s fairly standard for startup companies to offer generous stock options as part of the compensation package when competing in the hiring market. Linking employee effort to shareholder returns seems like a reasonable goal.
Unfortunately, it’s not quite as simple as that.
To begin with, options are just that: the option to purchase stock in the future at a price fixed today. You don’t actually own anything – only the potential to own something in the future. Options are used by new firms because the actual valuation of the company is often uncertain, and startups are typically unprofitable for some time, so dividends are not paid.
They are also used to encourage employees to stay with the business. It is usual to have vesting terms whereby the employee must stay with the company for at least a year, and then a certain proportion of the options vest over a period of years. This encourages employees to stay, which is good for the company. But if they do want to leave, they only have 90 days to exercise those options – assuming they have the cash to exchange them for stock. In the US, that limit is ten years.
Options are a necessary instrument because ,if you do decide to give someone stock, that stock is an asset which has a value. And that value incurs a tax charge in a similar way that giving someone cash would incur income tax. It’s simply considered an employment-related benefit, and so HMRC says it must be taxed.
But what if you’re given stock in a company that isn’t yet public? A large company might have a private valuation, but not have floated on the stock market. The stock is not easily tradable and has no public value, so employees are left with a tax charge against a theoretical valuation that must be paid in cash.
Of course, there is a mechanism to protect employees from that tax charge today, deferring it to the future – the so-called s431 election that must be signed within 14 days of the grant. If you forget, or don’t know, you might find you have to pay a significant amount. Hopefully your accountant is paying attention. Assuming you have an accountant?
This is just the beginning of the complex rules around employee company ownership, all built up over time, no doubt, to try and balance the benefit of employee stock ownership with the challenges of tax avoidance through elaborate corporate structuring. Perhaps the reason why employee ownership is so low is because of the unreasonable complexity?
Simplifying the tax code is where we should be focused. Not with a possible future Labour Government forcing companies to issue up to 10 per cent of stock to a collectively managed fund. A ten per cent stake is significant, particularly for the largest companies, and would mean material dilution for other shareholders. The ownership makeup of UK shareholders is not just individuals (who only make up only 12 per cent) but unit trusts, pension funds, insurance providers, and over 50 per cent of stock market ownership is foreign investment. When there is a sudden, unexpected transfer of wealth forced by central government, how would investor confidence be affected?
The structure of Labour’s proposed ownership fund itself is also unclear. How would the managers of the fund get elected? What voting rights would they have? What kind of employee is interested in getting involved, and what would that mean for the kind of actions they pursue? Shareholders rarely have all the information available to the executive team, even if they are part of the ordinary workforce: indeed, that is why operational responsibility is delegated to executives. Active management by activist shareholders is unusual and often drastic. A more pragmatic proposal to involve employees in key decisions is through worker representation on boards – then they at least have information rights to understand and participate in those decisions.
Linking employee benefits to the success of the business is a good incentive and gives workers a meaningful stake in the output of their efforts. But if this is indeed the goal, why is there a £500 annual cap? This is a clearly misaligned incentive: why put any more effort in once you hit the bonus level? There is a big altruistic assumption that employees would work more just for the benefit of the state, an assumption already disproved with the exodus of high earners during the period of extreme income tax bands in the 1970s.
When something isn’t working, the solution is rarely for the Government to force a solution that only involves first-order thinking. Employees don’t own enough of their company? Let’s have the government force them!? No. We must think deeper and consider the root cause. If the rules were a lot easier to understand and the tax implications less onerous, aligning incentives would be much more appealing, making employee ownership easier and more popular. Rather than more government intervention, the answer seems to be the opposite.