Tax Law Influences on the Form and Substance of Equity Compensation in the United States

Abstract

This brief essay was written for a forthcoming book by Prof. Zenich Shisido, Enterprise Law: Contracts, Markets, and Laws in the US and Japan (Edward Elger). It summarizes recent scholarship on the influence of tax law on equity compensation in the United States. The essay finds there is little evidence or reason to believe that tax law significantly influences the substance of equity compensation, meaning the mix between equity and cash compensation and the risk and term structure of equity compensation. For publicly traded firms, tax law generally and roughly is neutral in the choice between equity and cash compensation once costs and benefits to both the firm and the recipient are considered. Tax law probably also has not had much impact on the form of equity compensation in publicly traded firms. Tax considerations do seem to have had an impact on the form of equity compensation in the venture capital (“VC”) and private equity industries both at the start-up company level and at the fund level. There is an arguable tax bias against giving founders equity compensation in the form of founders’ common in start-ups in the VC industry. And there is arguable tax bias in favor of giving fund managers equity compensation in the form of a profits interest in the private equity industry, which includes the VC industry.But there are reasons to be skeptical about whether these tax biases have had much of an impact on the substance of equity compensation. Start-ups are so poorly engineered from a tax perspective that it is unlikely that tax considerations significantly influence the economic deal struck between founders and investors. If the tax cost of founders’ common was perceived as an impediment to using equity compensation, then the parties would redesign the deals to eliminate those costs. On the other hand, funds are so exquisitely well engineered from a tax perspective that that we can expect engineers to design around any tax rules that are more than a minor irritant. The co-existence of these poorly and exquisitely designed structures in the same industry is curious.