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As the company continued to succeed, the stock price had to be revalued even though the stock was not publicly traded. This began to have tax consequences for the founders (in particular emptying Dan Drake's and my bank accounts because of a little Sin of Omission on the part of our Distinguished Legal and Accounting Advisors). Clearly, if the success continued, we needed to learn well and learn fast the rules under which we'd be playing in the stock arena.
Dan Drake researched this area in depth and wrote this memo which was originally circulated in August of 1984 and was revised and updated twice in 1985 as the public offering loomed closer. Though dated in some particulars of the law and tax rules, it's still the clearest statement I've seen of the twisty and treacherous passages one must negotiate to survive creating a new business and hundreds of jobs and not be either reduced to poverty or going to jail. Most companies don't warn their employees about any of this; the investment bankers were amused that Autodesk “took the risk” in giving this advice to the people who had built the company to the point the bankers could take it public.
![[Footnote]](i/footnote.png)
To: All stockholders of Autodesk, Inc.
From: Dan Drake
Subject: Taxes and such
Date: August 26, 1984 / March 6, 1985 / May 8, 1985
I have yet to see any problem, however complicated, which, when you looked at it the right way, did not become still more complicated.
— Poul Anderson
[This is a re-issue of a piece we distributed last summer. Not much has been changed, except to correct a couple of errors; in particular don't look for realistic prices in the examples. One of the errors, by the way, was based on published information from a Big Eight accounting firm. Does that mean that even they don't understand the law? Impossible.]
Some people have asked me for a summary of the stuff that I've learned about the landmines that the IRS, SEC, et al. have strewn in front of us. This is it. You should, as the saying goes, check with your own legal and financial advisers before believing any of this.
Much of this discussion concerns what happens when you sell stock, but don't get too excited: at the moment it's nearly impossible to sell our stock without going to jail. Sometime, though, our stock or a successor stock will be registered with the SEC so that it can be traded like any other, and you'll have to know the rules. If you persist to the end of this thing, you'll find some of the really amusing rules that apply when the stock is public, including Rule 144 and The Amazing Sixteen (b).
Actually, it may not be too hard to sell stock if the buyer is a California resident who already owns our stock, or if no citizens or residents of the United States are involved. (If you have reason to do it, ask for the details). Even so, it would be troublesome to trade the stock actively, but you've already signed an investment letter asserting that you have no intention of doing so before the stock is registered.
(The first two paragraphs are obsolete, but the rest may be of interest to people who have exercised warrants.)
When we first sold stock, we issued warrants as a sweetener to encourage people to invest hard cash. These allow you to buy additional stock at $.10 a share, provided you do it by April 30, 1986. To exercise (buy the stock) you fill out the form that's attached to the warrant, write a check, and give both to the corporate Secretary (me). The company will issue a stock certificate as soon as possible.
You can, in principle, sell warrants to other people; but the restrictions are as bad as those on selling stock.
The only tax problem associated with warrants, as far as I can tell, is that you want to watch the capital gains rules. From now until 1989 (?) this means that you want to exercise the warrant at least six months before you sell the stock; then you pay income tax on 40% of the difference between the selling price and the $.10 that you paid for the stock. (Does the $.001 that you paid for the warrant come into this? I think so, but it doesn't make much difference.) If you sell for $5.00, this means taxable income of $0.40×(5.00−0.10) = $1.96; this tax will not exceed 50% of the taxable amount, or 20% of the total gain, or $.98, unless they change the rules again.
If your tax bracket is below 50%, you will pay even less than 20% on your capital gains-but it's just possible that you'll get caught by Alternative Minimum Tax (see below) and have to pay 20% anyway.
While you're waiting for the capital gains treatment to ripen on the stock you got for a warrant, you're free to sell stock that you bought before; just be very careful to turn in the right stock certificate and to keep proper records. (Well, actually, if you're an insider, this isn't quite true; but we'll get to 16(b) later.)
First, the history and terminology: Incentive Stock Options are the things that used to be called Qualified Options. Qualified Options were eliminated in the 70's; ISOs were authorized in 1981; and an incredible confiscatory hook was embedded in them in 1982. They are not to be confused with stock purchase plans, though they often are; when Osborne went belly-up, many people who thought they had options discovered that they were legally obliged to pay for worthless stock, with no option at all in the matter. We have an ISO Plan in operation now; if we set up a stock purchase plan, no one will be allowed to be confused between the two.
Under an ISO Plan the Board of Directors issues options which allow you to buy the stock at a set price (called the exercise price). If everyone follows all the rules exactly, you can exercise options at any time within a period specified in your option agreement; after waiting a while, you can sell the stock and pay capital gains tax on the difference between the price you paid and the price you sold for (see under Warrants).
Here are the most important of those rules that must be followed. First, the exercise price of the option must be at least the Fair Market Value of the stock as of the time when the option was issued; you hope, of course, to exercise at a time when the value is much higher, and to sell while it remains high. The option must expire within ten years after it's issued. Simple enough? Then remember that if the optionee owns 10% or more of the existing stock, the price must be at least 110% of fair market value, and the expiration must be no more than five years.
To exercise an option, send a check to the corporate Secretary (me) with a covering note to explain that you're paying this money to exercise options. We'll promptly record the sale of stock and issue a certificate. Please don't just mail or wire money to the company in the hope that we'll guess what it's for.
The time when you finally sell the stock must be (a) at least two years since the option was granted and (b) at least one year since you exercised the option. The recent change in the capital gains holding period doesn't affect (b). You also have to exercise the options First In First Out, and you can't get around this by getting the company to cancel old options before they expire. The reason for this is that a drop in the price of stock might tempt a company to cancel a lot of old, expensive options and issue new ones at the current, lower price; this is far too nice to the employees to be legal. (It's common practice to have a Vesting Period for options. This means that people can't exercise any of the options for (say) one year after the option date; then they can exercise up to (say) 25% of the option each year. The idea is to keep those bums from exercising their options and going off to take another job before the company has extracted full value from them. This is an industry norm, not a government requirement. Autodesk's vesting periods will conform to industry norms no more closely than the rest of our practices do.) That's all the important restrictions and traps, except for Alternative Minimum Tax and Section 16(b); we'll get to them later. So what if one of these rules is violated? Then [soundtrack: the Empire's theme music] the option becomes disqualified. When you exercise it, you become immediately liable for plain income tax (not capital gains) on the difference between the exercise price and the fair market value when you exercise. In the previous example, you exercise a $.10 option when the stock is trading for $5.00; whether or not you sell, you have income at that moment equal to $4.90, on which the federal tax could be up to $2.45. If you ever sell, your gain or loss will be computed against that $5.00 value rather than the $.10 exercise price. But what if the stock isn't registered, and it's illegal (as well as impossible) to sell it? No problem; the government will be glad to take your house if you can't raise the money to pay the tax on your non-existent gain.
If this happens to you, though, all is not lost: the company gets a tax deduction.
Important: Though most people don't have to pay any tax under this law, it appears to be necessary to file Form 6251 if you exercise any stock options, just to prove that you don't owe extra tax. So read this stuff. Alternative Minimum Tax is aimed at people who have a large dollar volume of capital gains, accelerated depreciation, option exercises, and intangible drilling costs (I'm not making this up).
Here's the theory behind AMT. Certain types of income get special tax preference, for reasons which are clearly in the National Interest. This results in some people paying low taxes, which is clearly not in the National Interest. Therefore, the government gives subsidies and takes them back again, which is in the National Interest.
If you have these special types of income, here's roughly what you do. Compute your taxable income, and compute the tax on it. Remember this number. To your taxable income, add back some of the deductions you took: accelerated depreciation, intangible drilling costs, 60% of capital gains, and various itemized deductions. Also, if you exercised any Incentive Stock Options in the year, add the difference between the exercise price and the Fair Market Value when you exercised them (the $4.90 in our example, which you thought you didn't have to pay tax on because the options weren't disqualified). Subtract $30,000 (single person) or $40,000 (joint return). Take 20% of that. If this exceeds your normal tax, this is what you pay; otherwise (the great majority of cases) you merely report it and pay the normal tax. Stock options were included in this calculation under the Tax Equity and Fiscal responsibility Act of 1982. The equity of taxing people on a gain which another part of the law says is not to be realized for at least another year (and yet another says can't be realized without going to jail) is self-evident, so I won't explain it. What makes it especially equitable is that while a passive investor pays 20% on his gains, an entrepreneur is allowed to pay up to 40% (plus Uncle Deukmejian's cut). Comments in an earlier edition about rates going up to 52% were wrong, based on an uncritical acceptance of an expert's opinion.
This cloud, too, has a silver lining: if you're paying AMT, then the effective tax rate on any additional ordinary income is down to 20% until you get so much that you're out of AMT land again. This can be significant if you're liquidating assets to get enough money to pay AMT. If you need to understand this in more detail, stop by sometime when you have an extra hour or two, and I'll be glad to give you a quick outline of the situation.
If the company succeeds, we would like to be able to cash in sooner or later. The normal way is to register the stock so that it can be sold on the open market. That, of course, is what we're planning now. Therefore, it's a good idea to know what to expect from a public offering. In order to register some of its stock with the Securities and Exchange Commission for public trading, a company spends $200,000 to $500,000 on lawyers, accountants, printers, etc., plus a few months of the management's time. If the deal falls through (which is quite possible from causes outside anyone's control), much of that money has to be paid anyway and is a dead loss.
The financial effect of the public offering is, to oversimplify, that the underwriters buy a few million dollars' worth of stock from the company and immediately sell it to the public at a profit. The buyers can then sell the stock to each other at ever-increasing prices, we hope. The part of the company that's sold in the offering varies widely, but might typically be 25%. The price is substantially higher than venture capitalists would have paid for the same percentage of ownership; a factor of two is often mentioned.
So now that the company is public, we can all start selling our stock to the public, right? Wrong. The underwriter may allow the existing stockholders to sell some of their stock at the same time that the company sells its stock, but the amount is limited by the public's desire to keep the founders a bit lean and hungry so that they'll make some further profits for the public before going off to lie on the beach. All the old stock that isn't sold then (the majority of the company) is still unregistered and still can't be traded easily.
Over the next few years the founders can dribble their unregistered stock onto the market under Rule 144, provided that the company keeps up with all the SEC's reporting requirements. The essence of this rule is that anyone who has owned his unregistered stock free and clear for two years can sell through a broker in the public market, subject to a limit of 1% of the company (or a formula involving average trading volume) per three months. A person who is not an insider can forget about the 1% rule after owning the stock for three years.
As I understand it, people who own large amounts of stock, as well as officers and directors of the company, fall under Rule 144 restrictions even in trading registered stock.
Three years after the company goes public, it can file a simple little form ($20,000) to register all its stock. In the interim the stockholders could get some more stock registered by persuading the company and the underwriters to make another public offering (another quarter million dollars of expense, shared by the selling stockholders) in which a larger amount of their own stock is sold.
More practically, 90 days after going public, the company can make a simple filing (S-8) which will automatically register any stock that people get later by exercising stock options. Under this system a person who exercises an option for cash right after the effective date of the S-8 filing may be able to sell the stock immediately (though with terrible tax consequences), while someone who exercised earlier has to wait for two years under Rule 144. Nonetheless, this is a very good deal for the employees.
The first rule about insiders is that there are stiff penalties for trading on inside information. If you know that the company is about to buy a half-interest in IBM, and you think that will raise the price of the stock when it becomes known, you'd better not buy chunks of the stock to profit from the rise. This rule applies not only to officers and directors, but to anybody who has access to interesting information that isn't public yet. To help people resist temptation, the SEC requires all officers and directors of the company to report all their transactions in its stock. These reports are a matter of public record for every busybody and corporate gadfly in the country to study.
If two rules are good, three are better; therefore, the SEC isn't content just to levy fines for trading on inside information and to require reporting of transactions. It's also illegal for insiders to profit in any way, though in perfectly good faith, on short-term transactions in the company's securities. This is the egregious Rule 16(b): if an insider buys and sells a security in any six-month period, he must hand over his profit to the company! In any doubtful case this rule gets the most unfavorable interpretation possible; for instance, you take the losses and the company takes the gains, and you can't balance off losses and gains in a six-month period.
It's not entirely clear to me who is an insider under this rule, but it seems to apply to more than just the officers and directors. In fact, I have the impression it's not clear to anybody.
What if the company fails to claim the profit from an insider's trading? Then any stockholder can require it to do so. Remember the bit about the reports being public record?
Of course, none of us would trade on inside information or do short-term trading in the company's stock (much less sell it short, which is also illegal), but the rule can make real trouble. Exercising an option, for instance, counts as a purchase of stock; so don't sell any within six months before or after—there goes the idea of selling some stock to cover AMT, unless you exercise in the first half of the year. (It's said that there's even a way for an exercise to count as both a purchase and a sale, causing instant confiscation, but this appears to be just a trap for people without lawyers.) Or suppose you buy some stock, and three months later General Motors comes along to buy the company—bye bye, profit. Remember, though, this just applies to insiders, if you can find out what an insider is.
This note has taken a fairly negative tone in places; in writing about regulatory matters one's attitude varies from heavy sarcasm to blind fury. It's as well to remember that people go through these things every day and come out with large bundles of money at the other end. If we can ace out Computervision, Autotrol, and IBM, not even the SEC can protect us against succeeding.
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