Anthony Mouchantaf is co-founder and president of Toronto-based Rthm Technologies Inc.
We sit at the dawn of a technological revolution, one that will see the creation of products and services long thought to exist solely in the realm of science fiction. Invariably, in times of rapid economic transformation, old governance regimes become incongruous with the new realities that they purport to govern.
Modern technology companies operate in a unique ecosystem, with distinct customs of corporate governance, specialized capital markets and labour practices that are antithetical to those of the old economy. Nonetheless, they are subject to antiquated laws created for what will soon become a bygone economic era. One potent example is the unnecessarily pedantic taxation of employee stock options.
Traditionally, stock options were used as a form of incentive compensation for managers in mature companies. They are relatively simple contracts; they grant an individual the right, but not the obligation, to purchase shares in a company at a predetermined price (the exercise price) within a given time horizon.
In practice, however, this framework does not apply in the context of modern technology companies; there is a pronounced inconsistency in how stock options were used historically and how they are used today.
First, the notion that recipients of stock options are already wealthy corporate big wigs and Bay Street bankers dominates the public psyche. For startups, however, stock options are typically granted to debt-ridden young adults with science or engineering degrees – often young immigrants lacking the social safety nets that enable risk-taking behaviour or the pursuit of one's scientific and intellectual passions.
Second, the rationale for using options to incentivize executives is in large part obsolete in this context. Employees are overwhelmingly recruited for their technical talent, not to affect managerial-level decision making. Startups offer stock options for a more immediate reason – they simply lack the liquidity to offer competitive salaries.
The result of these aforementioned misconceptions is a tax regime consisting of a patchwork of complex rules premised on outlandish considerations; including whether the issuing corporation is a Canadian-Controlled Private Corporation (CCPC), the length of time that the employee has held the underlying shares and whether the exercise price on these options was below the fair market value of the shares when the options were issued.
First, preferential treatment for CCPCs is illogical in this context. The peculiarities of tech startups require specialized capital markets – markets that readily understand and embrace the idiosyncrasies of technology. Most of these capital markets are exclusively native to the United States. Punitive rules for locally domiciled companies with American investors is an anachronistic industrial relic.
Second, the length of time that an employee has held the shares betrays the wildly erratic and finite life cycles that are characteristic of tech startups; sometimes companies are acquired within a few months, sometimes companies IPO within a few years, and more often companies fail somewhere in between.
Finally, the aggressive dissuasion from issuing options with an exercise price below fair market value, while sound policy for mature companies, deeply frustrates a startup's ability to attract talent in job markets dominated by blue-chip companies. Relaxing this rule would create a useful non-monetary tool to reward early employees for the risks they take in foregoing high salaries to join new ventures.
The current regime is perplexing at best and draconian at worst. Employees often lack the wherewithal to effectively navigate the system, lack the pecuniary means to exercise their options effectually and lack the agency to affect the circumstance of their remuneration.
The solution is thus: notwithstanding existing rules, as it pertains to qualifying tech startups of a certain size, stock options must be taxed at the capital-gains rate, period. More importantly, up to a given threshold, they should be exempt entirely – the $800,000 Lifetime Capital Gains Exemption provides a good framework for this. It doesn't make sense, in any instance, for early employees to pay a higher tax rate than venture capitalists and founders.
If necessity is the mother of innovation, risk aversion is the mother of stagnation.