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Founder equity, startups and the taxman

I normally focus on the emerging areas of fintech in this column. However, I thought that I’d change the pace this month and look at an issue that I have seen blow up on a few fintech deals recently: founder equity and the taxman.

Beware the taxman

The frenetic pace of a tech startup means that the tax position of the founders and the early-stage management team can easily be overlooked. Getting the paperwork right at the outset can however be so, so important (albeit a bit boring…).

On an exit which delivers the returns that tech-entrepreneurs are likely to be hoping for, having your house in order from day one can mean, at least here in the UK, the difference between a 10% tax bill and a tax bill in excess of 45%. Not only that, but the tax bill will come at the end rather than as a nasty surprise at an earlier stage in the growth cycle. The name of the game is to ensure that all of the upside is treated as a capital gain rather income, which is taxed more punitively.

Founder shares

The starting point is for the founders of the business to incorporate a company and issue shares to themselves in the agreed allocations at the outset. The share issue will require a (properly minuted!) board meeting, the issue of share certificates and most importantly the entry of the founders’ names into the company’s shareholders’ register. It’s amazing how many times we see these basic housekeeping matters getting overlooked.

A situation to avoid is leaving these formalities until the first investment round. By then the company will have value which means that the taxman may say that he wants income tax on the value of the shares issued to the founders because they are employees. That’s money that doesn’t yet exist of course. Depending on the rights which the shares have, it may be necessary for the founders to sign what’s called a section 431 election to ensure all the exit proceeds are subject to capital gains tax, not income tax.

Management share options

If things go well then the founder team may want to bring in and incentivise fresh talent. Issuing free shares to the management team would give rise to income tax on the value of the shares when they join and they may not have the money to pay for the shares. Much better to give them “EMI” share options which have a market value strike price. EMI stands for enterprise management incentives, a share option arrangement specifically designed to provide a powerful tool for the recruitment and reward of employees in growth companies. They are turbo-charged from a tax viewpoint: there’s no tax upfront, no tax when the options are exchanged for shares and provided that a year has passed since the employee was given the EMI options, only 10% tax when the shares are eventually sold.

Getting all of this right from day 1 means less tax and less risk of a deal with a VC being blown by a stored up problem.

A corporate partner, Richard Goold heads the US desk and co-chairs the firm-wide tech sector group at Wragge Lawrence Graham & Co. He spends his working life leading complex corporate transactions, generally in the tech sector and usually across borders. To accompany his insights in Fintech Monthy, he will be writing a monthly column on the biggest trends in fintech.

This article was co-written by Michael Murphy, a London-based partner at Wragge Lawrence Graham & Co. He has more than 25 years’ corporate tax experience acting for a broad range of clients and specialises in corporate M&A, public listings and management incentives.