The new book, Startup Communities: Building an Entrepreneurial Ecosystem in Your City is a great read on an important topic. My favorite line came on the last page:
“My favorite thing about startups is that they don’t require anyone’s permission.”
This just captures what makes entrepreneurship awesome. It’s about doing something worthwhile simply because you decide it needs done. More than any other aspect of the business economy, startups operate outside the bounds of bureaucracy, politics, and harmful regulation.
Good public policy has a role in building the national infrastructure of startup communities. Paraphrasing the popular Einstein quote, we need to make it as simple as possible to launch, operate, and scale a startup, but no simpler. Along with taxes and death, some regulatory overhead is inevitable. The World Bank currently ranks the U.S. 13th globally for ease of starting a business and falling. We can do better.
On the list of startup barriers that concern and disturb me, crony capitalism is the worst. Entrenched interests sometimes gain enough power to manipulate the political system to bar competition and restrict innovation. We have an example right now in my home state as the Colorado PUC is proposing a new set of rules that would shut down transportation startup, Uber, in the state. Make your voice heard on crimes against entrepreneurship like this.
Other regulations are less egregious but arguably more damaging because of their wet blanket effect. The most significant in my mind involve equity compensation. Take the standard practice of equity vesting, for example. It’s internally aligning, not to mention essential for raising venture capital, to give a startup the right to buy back a portion of founder’s shares for a team member who leaves the company early on. But what if you put these standard vesting provisions into place and don’t know the IRS requires filing an 83(b) election (who comes up with these names, anyway?) declaring the tax basis of your equity stake? Answer: if the company is successful, you owe taxes on the increase in value each time additional shares vest. Say you bought 1 million shares of stock for a penny a share and over the next year the company knocks it out of the park. If a year later the stock is worth $1.00 a share and 25% of your shares vest, the IRS can come after you for taxes on the paper gain of $990,000. Never mind the stock isn’t liquid and you’re still not taking a salary. The sin of not being able to afford a decent startup attorney who can help you and your co-founders file the one page 83(b) election puts you in a tax trap. This is shameful policy.
Almost as bad are the requirements of Internal Revenue Code 409A. In clamping down on some overreaching compensation and tax avoidance tactics of Exxon a decade ago, Congress passed legislation that caught startups, requiring companies to follow a rigorous process in valuing their equity grants. Issue stock options or stock grants without an independent 409A valuation report (which costs $5,000 to $20,000 four times a year) and the IRS can challenge your valuation. If you’ve issued stock options with a $0.25 strike price and the IRS asserts that $0.55 was the fair market value, you’re on the hook for back taxes, penalty, and interest on the $0.30 per share difference times the number of options granted. To date the IRS has rarely if ever challenged startup company valuations. But the existence of 409A regulations greatly increases the cost, time, and uncertainty of operating a startup.
Other examples include the hoops of employment laws. In a financial technology startup I co-founded I vividly remember trying to figure out what employee notification posters we were required to post in the break room, the dilemma of how to post in a virtual company operating out of three states, and the regulatory warnings about the steep fines we faced if we got it wrong. It wasn’t the largest hurdle in the world, but for a startup CEO to take a day out of his or her life to figure out posters in the critical first months is a big deal. Minimum wage requirements of the engineer who leaves a six-figure income job to work for equity is another regulatory issue that creates friction. Another I recall from my startup, was receiving notice of a near doubling of our state unemployment insurance tax rate. While I was taking no salary and investing everything in building a company, congress was extending unemployment benefits from 13 weeks to 33 weeks to 53 weeks. I understood there was a policy issue involved, but I’ll never understand why my startup was being taxed at dramatically higher rates because I was trying to build a new business and hire good workers.
Happily, startups will continue to be awesome and do awesome things. How much more cool can you get than the StartupWeekend that some of the folks at Startup Colorado Springs are bringing to the community in April. This three day hackathon epitomizes the light, lean, building culture of startup entrepreneurship.
We need to lower the hurdles and decrease the headwind as part of an effort to dramatically alter the startup success rate. I have a feeling the ‘no permission required’ culture of innovation and creation is going to prevail.