Trust SO & New Incentives: What Changes?

Entering the “Warring States Period” of incentive compensation

Incentive design for Japanese startups has long been dominated by “tax-qualified stock options.” However, the landscape has changed dramatically in recent years. “Trust-type stock options“, which were introduced in search of a more flexible design, seemed to have created a huge boom, but in a dramatic turn of events, the clarification of taxation rules by the National Tax Agency suddenly put a brake on the system.

After this “trust shock,” the attention of managers and practitioners has turned to safe and effective alternatives. Currently, the traditional “paid stock options” are being reviewed, and “RSU (Restricted Stock Units)”, which are common in American tech companies, have been introduced under Japanese law, and the diversification of incentive compensation is progressing, which can be said to be reminiscent of the Warring States era.

The important thing for managers is not to jump on trendy schemes. It is important to correctly understand the “risk” and “return” of each scheme, as well as “to whom the message is directed,” and select the optimal combination according to the phase of your company. In this article, we will summarize the turbulent trends and present a compass for compensation design that will become the standard in the future.

1. What was the “trust-type SO shock”?

First, let’s turn back the clock a little and look back at the “trust stock option problem” that shook the industry. Understanding this history is extremely important in understanding the essence of tax risk.

Trust-type stock options are a scheme in which stock options issued by a company are temporarily deposited in a container (pool) called a “trust”, points are later awarded to employees according to their contribution, and stock options are distributed according to the points when the company goes public. The biggest advantage of this system was that you could decide who to give it to by playing rock, paper, scissors later. Normally, stock options must be decided at the time of issuance to whom and how many, but with trust-type stock options, the allocation can be determined after seeing the employee’s performance after joining the company, so it has become popular as a system that is extremely easy to use for merit-based startups.

Furthermore, the interpretation at the time was that by passing the tax through a trust, employees would only have to pay taxes on capital gains (approximately 20%) instead of employment income (up to approximately 55%). Flexible allocation is possible and taxes are low. It’s a dream-like scheme that has been implemented by more than hundreds of startups.

However, in May 2023, the National Tax Agency issued a new opinion. The idea was that “profits derived from trust-type stock options should essentially be treated as salary.” In other words, it was determined that a maximum tax rate of approximately 55% would be applied. Moreover, there is a possibility that the tax will be applied retroactively not only to future issues, but also to issues issued in the past, raising the risk that companies and individuals who have already made profits from listing will be subject to a large amount of additional tax.

With this announcement, the trust type boom came to an end. Currently, a “safe harbor rule” has been put in place that allows for taxation of approximately 20% if certain strict requirements are met, but due to the high implementation and maintenance costs and the high degree of design difficulty, it is no longer something that early stage startups can easily implement. The lesson left behind by this incident was the cold truth that schemes that attack tax gray areas run the risk of being removed from the ladder later on.

2. Re-evaluation of paid stock options (stock acquisition rights issued at market price)

A new option that is attracting attention as an alternative to the trust type isPaid stock optionsis. This is by no means a new mechanism; it is an orthodox method that has existed for a long time.

Normal stock options (free stock options) are rights that employees receive for free from the company. Paid stock options, on the other hand, are a system in which employees and executives “purchase” the fair value of their rights (option fee) by paying money to the company. For example, each right is priced at 100 yen, and if you want 10,000 units, you need to transfer 1 million yen to the company.

Why go to the trouble of paying money to buy the rights? The biggest reason isTax securityIt is located in Because you are taking risks out of your own pocket and purchasing them as financial products, the profits you receive from them are considered “profits on investment” rather than “compensation for labor (salary).” Therefore, the gain on sale will be treated as capital gain (approximately 20%) even if the tax eligibility requirements are not met.

This feature is very useful for those who cannot issue tax-qualified stock options. For example, this applies to owners and CEOs with a stock ownership ratio of more than one-third, outside collaborators, or CxO class who wish to grant further rights beyond the tax-eligible annual limit (up to 36 million yen to 60 million yen). Although they will bear a certain amount of risk (purchase price), they will be able to enjoy the upside benefits at a lower tax rate, creating a fair trade.

However, when implementing it, it is important to calculate a “fair valuation value (option fee)”. If it’s too cheap, it will be considered a “substantive gift” and poses a tax risk; if it’s too expensive, employees won’t be able to afford it. It should be noted that the cost will range from several hundred thousand yen to several million yen, as calculations must be made by a specialized evaluation organization.

3. Global standards “RS (Restricted Stock)” and “RSU”

Rather than stock options (rights),the stock itselfMechanisms for giving out money as a reward are also rapidly becoming popular. That is RS (restricted stock)andThese are RSUs (subsequently delivered shares). This is the mainstream at US tech companies such as Google and Amazon, and advanced companies such as Mercari in Japan are actively implementing it.

First, let’s understand the crucial difference from stock options. Stock options only give you “gain from price appreciation”. If the stock price falls below the exercise price, the value becomes zero. On the other hand, with RS and RSU, you receive the “stock itself”, so even if the stock price falls, the asset value will remain as long as the stock price does not go to zero. This characteristic of “value not being easily reduced to zero” is extremely powerful as an employee retention measure for companies in later periods or after going public, where market capitalization is already high and it is difficult to expect the stock price to rapidly double.

RS (Restricted Stock) is a system that is relatively easy to implement under the current Japanese corporate law. A company provides monetary claims (bonuses, etc.) to employees, and employees invest the money in kind in the company, receiving stock in return. However, it is not possible to convert it into cash immediately because there are transfer restrictions such as “you cannot sell it for 3 years” and “it will be confiscated if you retire.” Employees have voting rights as “shareholders”, which has the advantage of increasing their sense of ownership, but care must be taken when handling the shares for tax purposes, as they may be subject to income tax upon receipt (even though they have not yet sold).

On the other hand, RSU (Restricted Stock Unit) is a system that is a little more convenient to use. This grants a promise (units) that “if conditions (years of service, etc.) are met, we will give you shares in the future.” Unlike RS, you do not receive the shares at the time they are granted. After the conditions are met, taxes will only be paid when the shares are actually delivered. For employees, tax liability arises at the same time as they acquire the stock, so it is easier to sell some of the stock and use it to pay taxes, making it better than RS from a cash flow perspective.

In Japan, the legal interpretation has progressed, and it has become possible to introduce a “subsequent delivery” system such as RSU. Especially for startups that want to expand globally and hire overseas talent, having RSU, which is a universal language, is becoming an essential condition for increasing hiring competitiveness.

4. Chart on how to choose the optimal incentive plan by phase

Now that there are so many options available, which one should your company choose? We organize recommended portfolios (combinations) for each company’s growth phase.

① Seed/early stage (founding ~ around Series A) The correct answer in this phase is simply choosing “tax-qualified stock options.” Since corporate value is still low and future upside (growth potential) is large, the “leverage effect” of stock options is maximized. Paid SOs that require employees to pay money and RSs that require complicated stock price calculations are premature. First of all, our top priority is to make the most of our tax-eligible slots and show our early members their dreams.

② Middle/late period (series B ~ just before IPO) At a time when organizations are expanding and bringing in diverse human resources, a hybrid type of “tax-eligible SO” + “paid SO” is effective. Basically, we use tax-eligible SO, but also provide a combination of paid SO for CFOs and outside collaborators such as advisors who require high compensation that exceeds the annual limit. Additionally, as the stock price rises as it becomes clear that the company will go public, the exercise price of stock options may become too high, making them less attractive. In that case, it would be a good idea to start considering the introduction of RSUs, which can provide value without being affected by the stock price at the time of joining the company.

③ Post-IPO・companies entering the market After listing, the volatility of stock prices stabilizes, making stock options relatively less attractive. Instead, the main players are RS (restricted transfer stock) and RSU. We prevent existing employees from leaving their jobs by providing them with stable compensation that guarantees them stock if they continue working for a long time. It is also common to replace a portion of executive compensation with stock compensation (RS) to emphasize alignment of interests with shareholders (being in the same boat).

5. Possibility of new schemes such as “pool trust” due to tax reform

Finally, I would like to touch on future prospects. Since the trust-type SO shock, the government and practitioners have continued to work toward building a “flexible incentive system that can be used with peace of mind.”

One of them is the new tax reform being discussed in 2024.Pool operation frameworkis. Detailed system design is still in progress, but in the future it may become possible to perform flexible operations such as “a company acquiring and holding stock options once issued, and re-granting them to a new eligible person” without tax risk. If this becomes a reality, it will be possible to enjoy the benefits of “post-fixing” that trust-type SOs were aiming for in a safer manner.

Compensation design for startups is no longer just a matter for the human resources department. The CFO, legal affairs, and management must work together to monitor trends in legal revisions and have the flexibility to rearrange the optimal compensation portfolio.

summary

Trends change, but the essence remains the same. That means “preparing appropriate rewards for people who take risks and take on challenges.”

• The basics are to make full use of the classic “tax-eligible SO”.
• For targets that cannot be covered (external collaborators, large grantors), supplement with “paid SO”.
• During periods of stability and global recruitment, it is important to have a weapon called “RS/RSU”.

The first step to creating the strongest organization is to choose the system that best fits your company’s phase and recruitment strategy, without being distracted by trendy schemes.