Though the tech sector often bemoans the partisan gridlock in Congress - particularly in an election year as bizarre and contentious as this one - Democrats and Republicans generally agree that lawmakers should strive to enact policies that make it easier for entrepreneurs to launch and grow startups. Last week, the House of Representatives put these principles into practice, passing the Empowering Employees Through Stock Ownership Act (EESO), a critical fix to the tax code that will make it easier for startups to attract top talent and for startup employees to realize the economic value of their contributions to their companies. While a bill addressing the taxation of stock options may not seem particularly exciting or monumental, small fixes like EESO can have an outsized impact on the startup economy.

The problem that EESO addresses is incredibly common in the tech sector these days: because of the way stock options are taxed, many employees at private companies can’t afford to exercise their options, making it difficult for startups to attract talent and for employees to participate in the success of their own companies. Because most startups don’t have the cash on hand to pay employees the types of salaries they could command at the larger firms that startups must compete with for top talent, they typically offer employees equity participation, usually in the form of stock options or Restricted Stock Units; around 75 percent of venture-backed firms grant options to all of their employees.

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However, under current tax law, employees must pay an immediate tax when they exercise certain types of options, equivalent to the difference between the strike price of the options (e.g. the value of the stock when the options were issued) and the current fair market value of the underlying shares. For employees at fast-growing startups, this tax burden might be many times greater than their liquid net worth, and because startups are private companies with no open market for their securities on which employees could sell some of their newly acquired shares to pay down this tax burden, they need significant cash on hand if they ever want to exercise their options.

This problem impacts startups and their employees in a variety of ways, beyond the obvious blow to morale if employees end up losing out on their compensation. As startups move into new industries, they must find ways to compete with established companies for talent, but if one of the major forms of compensation startups can offer to employees is effectively worthless to most potential hires, startups will find it impossible to attract talented employees. Considering there is already a massive shortfall in technical talent, startups cannot afford to face another structural hurdle in competing for the best employees.

The tax on options is also hurting startup activity by drastically limiting employee mobility. The ability for employees in tech clusters to move freely to different firms is routinely cited as one of the critical factors in Silicon Valley’s emergence as the world’s principal hub of tech innovation (as California does not enforce non-compete agreements). Many startups grow by hiring employees from larger competitors who want to contribute to the success of a new enterprise. But, because tech companies are staying private longer than ever before, employees that want to leave to join startups may be faced with the prospect of having to forfeit the options they’d received as compensation if they can’t afford the tax burden. The tax on options is often effectively a tax on employee mobility.

With the House’s approval of its version of the bill and companion legislation passing out of the Senate Finance Committee unanimously last week, the prospects for EESO look good, though the White House and some members in Congress have expressed erroneous concern that the bill is a costly tax cut that hasn’t been offset by other spending cuts. In reality, however, this isn’t a tax cut at all; it is merely a tax deferral, and one that will ultimately be a net plus for the economy and help spur the continued growth of the Nation’s principal source of new jobs. We hope that as the bill moves through the Senate, policymakers grasp this distinction and support the bill for what it is: a commonsense policy change and a win-win for startups, their employees, and the American economy.

Evan Engstrom is the Executive Director of Engine, a San Francisco-based policy, advocacy, and research organization.


The views expressed by authors are their own and not the views of The Hill.