ROBERT PESTON: Inside out

ROBERT PESTON: Inside out - Wow is what most business people think when first meeting Mike Lynch, founder and chief executive of Autonomy. This creator of powerful tools for making sense of information on the internet has a brain of planetary proportions

by ROBERT PESTON, editorial director of Quest (www.csquest.com);e-mail Peston@Peston.com
Last Updated: 31 Aug 2010

Wow is what most business people think when first meeting Mike Lynch, founder and chief executive of Autonomy. This creator of powerful tools for making sense of information on the internet has a brain of planetary proportions coupled with business acumen. You will probably recognise him from his newspaper sobriquet of 'the UK's first high-tech billionaire'.

Another impressive individual is Hermann Hauser of Amadeus Capital Partners, one of the most successful backers of technology and internet businesses in the UK. Although some may question the wisdom of his early support for Lastminute.com, his record as a venture capitalist for the new economy is second to few.

These are obviously the elite members of a new economic order. So why do they persist in behaving like members of an oppressed minority? And what is the cause of their conviction that the Treasury and financial services establishment are on a mission to do them in?

You cannot spend much time with either of them and not be harangued about the allegedly appalling behaviour of the government in imposing employers' National Insurance on unapproved share option schemes. And when their eyeballs start rolling and mouths start frothing, they lambast the Accounting Standards Board for its plan to force companies to make a provision against profits for the 'fair value' of share options issued to staff and directors.

If you take them at face value, the UK's entire economic future is in jeopardy - which seems to me to be exaggerating just a touch.

Their argument goes like this: the brightest and best techies will work only for companies that shower them with share options; the Treasury and ASB are significantly increasing the costs for British firms of turning on this shower; as a result, high-tech companies will relocate abroad, and direct foreign investment will go to other countries with more benign tax and accounting regimes.

I do not dismiss these fears as trivial. But before looking at them in detail, I think we should examine the Government's and the ASB's case.

It is that share options are a form of remuneration. And, as with all remuneration, there is a cost to the issue of options that falls on the owners of a business, its shareholders. In the stock market euphoria of the late 1990s, this cost seemed to be ignored by everyone.

Now if share options are issued to staff in place of cash income, which is often the case, there is a strong argument that NI should be levied on them. It would be reasonable to press for the complete abolition of NI on cash earnings and all other income, since it has degenerated into a tax by another name and no longer has a special connection to the welfare state. But if we are forced to pay NI, it should apply to all remuneration, whether in pound notes, ingots or derivative instruments.

A similar argument is relevant to the accounting treatment of share options.

The issue of options usually has a dual effect. They can incentivise their holders to work harder to push up profits and a company's share price, to the benefit of all shareholders. This is the win-win scenario that champions of options extol.

But they also dilute the holdings of existing shareholders, at a potentially significant cost to them. For this reason, the world's greatest long-term investor, Warren Buffett, believes their value should be deducted from profits, like other overheads.

So the intellectual case for what the Treasury has done and what the ASB wants to do is powerful. But it is at this point that I part company with the mandarins and accountants and begin to side with the poor blighted entrepreneurs. The truth is that it is remarkably difficult to turn this coherent theory into sensible accounting and taxation practice.

The Treasury got itself into a fearful mess over the way it imposed NI.

Companies making no profit at all were forced to make rolling provisions to cover future NI liabilities on notional share option profits. The costs and inconvenience were substantial.

So the Treasury gave ground - and allowed companies to transfer their NI liabilities to the employees holding the options. The effect of this is to increase the tax payable on the exercise of options to 52%.

Meanwhile, the ASB's proposed accounting reform is equally fraught with problems, largely because techniques for assigning a 'fair' value to share options are controversial and varied. The chances are that this reform, far from helping investors, would make it more difficult for them to assess the intrinsic health of a company.

Both the Treasury and the ASB forgot the golden rule of modern rule-making - that best practice means adopting US conventions. So long as the tax and accounting approach to options is more benign in the US, that is where the cheapest capital and best people will migrate. This is one of those cases where good public policy requires government and regulators to be intellectually shallow and proud of it

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