One major inconvenience in VC investing in French startups which consistently raises its ugly head is the complexity to incentivize key personnel with equity.
I’m not referring to the employees who eschew the upside potential afforded by equity in favor of fixed pay with high job security. While certainly understandable at certain positions in a startup, above a certain level of responsibility, this mentality does not usually endure (i.e. such individuals leave for more stable work environments, like large companies, or the startup never really achieves breakout growth, since scale is only as grand as the ambition of a startup’s people).
Rather, I’m referring to the startups that typically attract venture capital financing, in which the passion and enthusiasm for the endeavour extends well beyond the original founders to the entire management team and even rank-and-file employees. These people tend to value equity compensation as part of their overall remuneration packages.
VCs place a lot of value on equity compensation too, for two primary reasons: improved alignment between shareholders and personnel toward company success; and the affordability of employing strong, driven people without an unwieldy up-front cash outlay.
So already in France, where excitement over upside is not the human economic reflex that it is in the U.S. or Northern Europe, it’s a noteworthy accomplishment just to find a team clamoring for equity compensation.
Yet even with a collection of ambitious startup employees and enthusiastic investors eager to implement incentives that reward strong performance, the French tax code sure makes it tough.
For most of my tenure as a VC in France, my modus operandi on this topic was the following:
- forget about stock options, as the penalizing fiscal cost practically wipes out the incentive
- apply BSPCE wherever eligible, which had the most favorable tax treatment (BSPCE, or bons de souscription de part de créateur d’entreprise, are essentially ‘founder warrants’; however eligibility can be quite restrictive)
- for those ineligible, grant BSA instead (‘general warrants’), which are available to anyone yet carry a fiscal cost (still better than options)
- or as an alternative, consider granting free shares, which have straightforward fiscal treatment but other drawbacks
To broadly simplify, my choice of equity compensation instrument reflected four over-arching objectives:
- provide a genuine incentive to the employee, not a poisoned chalice. For example, requiring the employee to shell out money up front on an instrument that has an uncertain future gain is hare-brained (yet under French code this can actually occur)
- minimize the tax cost to the company (social and income)
- minimize the tax cost to the employee (idem)
- minimize any undesirable externalities (e.g. elements that could cause misalignments, extra administrative burdens, corporate governance issues, etc.)
From the investor perspective, I would generally favor ‘option-like’ instruments (i.e. like options or warrants) rather than free shares. While granting free shares to employees falls under a relatively straightforward fiscal framework, they can lead to misalignment. For example, let’s say I invest 6M€ in a company at a 15M€ post-money valuation and grant key employees free shares equivalent to 5% of the capital. If sometime later, an acquirer makes an offer to buy the entire company for 10M€, I would lose money on the deal, not even recouping my initial investment. On the other hand, the 5% holders of free shares would stand to gain 500k€, an infinitely positive return considering they received the shares for free, hence our interests are misaligned.
If on the other hand, I had granted the equivalent of 5% in options (or warrants) to the same key employees, the exercise price of these options would naturally be set at the same price of the investment transaction. Accordingly, the options would not be ‘in the money’ at any valuation below 15M€. So the option holders and investor would be more closely aligned.
Heads they win, tails we lose
In an ideal world, the fiscal code would acknowledge this uncertainty and allow me to grant options without an up-front cost to either the company or the employees. At time of redemption, if the options are worth something, the employees would pay some reasonable tax on their capital gain (i.e. proceeds minus exercise price).
The tricky part of all this has to do with social security tax. The administration’s fear is that a company might disproportionally weight an employee’s compensation with options, thus limiting the social tax intake. (I believe that in France this fear is unfounded for a variety of reasons, but that’s another debate). So to ensure that the company pays sufficient social taxes, the French government treats option grants essentially like salary, thus assessing social taxes on something whose ultimate value could be non-existent.
The BSPCE are exempt from this, providing a morass of eligibility criteria are met. The BSA are exempt if the beneficiary demonstrates a veritable risk, specifically by advancing money for them, otherwise the BSA could be construed as a gift, and thus treated like salary.
Hey, that Excel model looks familiar !
Now this is where I suspect the French government’s social tax department (called URSSAF) may have adopted my spreadsheet. During a tax audit of one of my portfolio companies a few years back, URSSAF carefully scrutinized a BSA grant that I had facilitated. They questioned whether the beneficiary paid enough for his BSA. If it was determined that he had not, his BSA grant would be re-qualified as a bonus, and thus merit substantial social and income taxes. I helped the employee demonstrate that he indeed had paid enough for the BSA. I did this by providing a Black-Scholes option valuation model to estimate the value of the BSA at the time of the grant and in turn proved that the employee’s investment exceeded the BSA value.
I could understand why URSSAF would want to penalize any unscrupulous practice of selling the BSA to the beneficiary for an almost negligeable sum. However, in this case, the up-front cost paid by the beneficiary for the BSA was significant, as demonstrated by my Black-Scholes model. URSSAF accepted our argument and the tax audit resulted in a clean bill of health. However, during the discussion, I had the impression that URSSAF was discovering a Black-Scholes option valuation model for the very first time.
Apparently for the past two years, URSSAF has been vigilantly applying a Black-Scholes methodology to every BSA grant they audit. Could my model have been a source of inspiration? (If so, I feel both honored and deeply apologetic!).
Regardless, the greater issue here is that granting equity incentives to stakeholders in a French startup requires navigating a labyrinth of mind-boggling complexity, and that is extremely unfortunate.