What is Wrong with our Fiction? The Perceived Attack on Reverse Vesting

Tax advisors in Israel are scrambling to find the best solution to the unknown risk of adverse tax treatment of reverse vesting.

Why the current increased interest in the topic? Paranoia or calculated anticipation of the Israeli tax authorities (the “ITA”) attacking a well established principle?

Reverse vesting is a commonly used technique to address the concerns that a founder of a company who is key to its success and owns shares of the company might simply walk away from the company causing damage to the enterprise’s prospects for success.

Using equity as a retention tool is nothing new. When an employee is granted stock options that are subject to a three or four year vesting period, the theory is that the employee is incentivized to stay at work for the full vesting period to receive the full benefit of the employee’s options. The shareholders are willing to share equity with the employees to align interests between the company and the employees, joining the level of the employees’ compensation with the success of the company and keeping the employee motivated during his or her period of employment.

But founders who set up a company own their shares from day one. When a few talented individuals get together to form a company, sometimes they worry about this from the beginning. They may set up a type of reverse vesting which is basically a call option. If one founder leaves the company, the others can buy his or her shares usually for par value.

The concern that this may raise tax implications is subdued. The value of the company and its shares in those early days are often low, and so the risk of a taxable transaction is by correlation also low.

The more popular use of reverse vesting addresses when our young company needs an investment of millions of dollars from a financial investor. Venture capital firms (“VC’s”) are well versed in understanding the crucial role founders may play in the chances of success for their fragile investments.

The venture capitalists could space out their investments to correspond to milestones including the continuation of the employment of the founders, but that is not popular and often not practical; they may not be putting in nearly enough funds to keep the company going for the full period they wish the founders to commit and the funds invested up to the point of departure of a founder can be tremendous.

The investors can’t force the founders to keep working. This is codified in Israel’s Basic Law: Freedom of Occupation[1]. They need another tool to safeguard their investment. A fine or penalty that the founders would have to pay if they leave the company? Not worth the wasted air expressing this out loud to a founder. It is the VC’s that are supposed to have the money, not the founders.

Reverse vesting is the obvious choice. If a founder refuses to keep working for the crucial first few years after the company has received a large investment, he or she should lose some of his or her shares and not benefit from the future success of the company. This is a penalty that sounds fair – it is in the control of the founder; it adjusts the equitable balance of ownership if the company is worth less because the founder left; and it does not impose an impossible financial burden on the founder.

So far, so good. So why are tax advisors in Israel wary of the ITA spoiling this wonderful solution that is so common in the global high tech world?

While there is no evidence that the ITA is about to challenge the arrangement, the ITA, obviously is not bound by the treatment of reverse vesting in the Silicon Valley for example[2]; some lawyers and tax advisors fear that the ITA may look at shares subject to reverse vesting as being deemed given in exchange for work and therefore could categorize the shares as work related income, taxable as ordinary income and not as capital gains. The ITA could take the position that when the founders eventually sell their shares in an exit event (a merger or acquisition), the income earned on the shares should be treated as ordinary income, even though this seems like a real stretch of the imagination. If a founder can lose shares of a company if he or she quits working for the company, the ITA could look at those shares as not really belonging to the founder until the reverse vesting lifts, as if the founders are actually receiving shares over time, in which case they should be taxed periodically at the time the shares were deemed to have been received; this translates into the dates that the shares are released from the threat of reverse vesting rather than the date of incorporation of the company when the company value was lower if not insignificant.

To protect from this troublesome threat, reverse vesting is dressed up in colorful non-ordinary income terminology.

For example, we don’t draft Reverse Vesting Agreements but rather Repurchase Agreements. We don’t state anywhere in the agreement that the rights to the founders’ shares vest over time but rather that the other shareholders will have the right to buy back some of the founders shares in decreasing amounts over time and for very little money if the founders stop working.

Not that there seems to be evidence of the topic heating up at the ITA, but nonetheless, lately there has been much discussion in Israel, or at least in the hallways of Tel Aviv tax departments and law firms, of the risk that all reverse vesting clauses in high tech companies could be in jeopardy. That adds up to a lot of clauses in a lot of companies in a country dominated by its high tech and start up culture.

Good advice is to distance the shares from employment. Make sure the founders’ shares in an exit event are not worth more than any other shareholders’ shares. Include language that the purpose of the reverse vesting is to avoid the damage and harm that would be caused to the company if the founder quit rather than any type of compensation to the founder for staying. Make sure it is shareholders who have the right to buy the shares of the founders if their employment terminates and not the company itself. Do not include death or disability as grounds to trigger repurchase so that it is punishment to the founders for quitting rather than just the founders no longer working. To the extent the founders have paid some cash for their shares and the price to be paid upon exercise of the reverse vesting returns their capital, the shares look less like ordinary income to the founders.

A more recent creative idea is to grant other shareholders anti dilution rights triggered if a founder leaves the company. To implement this concept, the other shareholders would be issued new shares or the conversion ratio of preferred shares would be adjusted to give the holders of preferred shares a larger percentage of the outstanding shares of the company; the founders’ shares of the capital of the company on a percentage basis would decrease.

It is yet to be seen if this obvious new ploy can trick the ITA into believing that the additional shares received by the investors from the company are not the same as the additional shares the investors would have gotten if they were entitled to buy shares from the founders all with the same trigger and lack of price tag.

In addition, if there is more than one founder, this smacks of collective punishment. If one leaves, all founders would be diluted including those that loyally stayed with the company. Morally it would be more appropriate to use this approach, if at all, if there is only one founder subject to reverse vesting so that other founders do not have to serve as guarantors of each other’s commitment to the company. But with only one founder, the net effect is just the same as the traditional reverse vesting. With multiple founders, there is more separation between the employment of a founder and the share ownership of the other shareholders.

Whether this fiction would be acceptable in favor of traditional reverse vesting is unclear and untested.

Until there is any clarity, some advice to investors. When you don’t need reverse vesting, don’t ask for it.   Use it when you do not have plausible alternatives to keep founders motivated. If the founders have less than 10% of the shares of a company and do not have the right to appoint a director, consider using shares or options granted under Section 102 of the Tax Ordinance[3].

General advice of course may not be applicable to your particular situation so do visit your tax advisors for the latest developments.

 

[1] The Basic Law: Freedom of Occupation (1994). The Law was passed by the Knesset on 9th March, 1994 and published in the Book of Laws No. 1454 of 10th March, 1994. It provides in part:
1. Fundamental human rights in Israel are founded upon recognition of the value of the human being, the sanctity of human life, and the principle that all persons are free; these rights shall be upheld in the spirit of the principles set forth in the Declaration of the Establishment of the State of Israel.

2. The purpose of this Basic Law if to protect freedom of occupation, in order to establish in a Basic Law the values of the State of Israel as a Jewish and democratic state.

3. Every Israel national or resident has the right to engage in any occupation, profession or trade.

[2] See for example Rev. Rul. 2007-49 from Internal Revenue Bulletin:  2007-31 dated July 30, 2007 specifying that Section 83 of the Internal Revenue Code does not apply to reverse vesting imposed by investors (changing “substantially vested stock” to “substantially nonvested stock”).

[3] Section 102 of the Israeli Income Tax Ordinance [New Version] 5721-1961, as amended, is the regime for employee stock option plans granting favorable deferred tax status; it is not available for holders of more than 10% of a company’s share capital or to those that have a right to appoint a member of the board of directors.